United States: Reverse break-up fees aren't working

Author: | Published: 1 Jul 2008
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It has become increasingly common for purchasers of companies to insist that acquisition agreements include so-called reverse break-up provisions, particularly if the purchasers are private equity groups. The provisions in theory give the purchaser the right to walk away from an acquisition agreement by paying the seller a specified sum, and until recently they went relatively unnoticed.

As the credit crisis hit the US and purchasers began to have difficulty obtaining the financing to complete transactions, or began to view the prices to which they had agreed as being too high, reverse break-up provisions became a critical part of their efforts to terminate transactions. But the reverse break-up provisions did not work as had been contemplated. Instead, they led to several highly-publicised and hotly-contested litigations. The explanation lies both in the concept of reverse break-up provisions and in the way they were drafted.

Break-up fees

In many respects, the idea of a reverse break-up provision parallels the fiduciary out and break-up fee provisions, which for years have been inserted in US agreements on the sale of publicly-traded corporations.

Fiduciary out/break-up fee provisions were a response to Delaware court decisions that said if a company is put up for sale, its board of directors must obtain the terms most favourable to the corporation's stockholders. This doctrine is not a problem if the sale agreement is the product of an actively-conducted auction process, but it is if the sale follows an approach by a single potential purchaser – the board of directors of the company being sold cannot be sure when it approves the sale that somebody else would not pay a higher price.

The problem becomes acute if another potential buyer does offer a higher price. If that occurs, it indicates that the board of the company being sold probably did not fulfil its fiduciary obligation to obtain the terms most favourable to stockholders. Further, in most instances, the stockholders have to approve a sale of a publicly-traded corporation, and they are not likely to do so if they learn that a higher payment is available.

The solution if a higher bidder comes along after a sale contract has been signed was to include in the contract a provision giving the board of the company being sold the right to terminate the sale contract and to accept the better proposal but to do that the company must make a payment (the break-up fee) to the original purchaser. The Delaware courts accepted this concept, but made it clear that the break-up fee could not be so high that it would make it too difficult for there to be a superior bid – a higher bid will be superior only if it is greater than the amount the original purchaser agreed to pay plus the amount that must be paid to terminate the original contract. Courts have usually accepted break-up fees of between 2% and 3%. They have sometimes permitted fees and expense reimbursement totalling as much as 5% of the sale price.

No funding

As sellers' termination right and break-up fee provisions became standard in US agreements for sales of publicly-traded companies, it is not surprising that buyers, and particularly private-equity funds managed by investment professionals, would want a similar ability to terminate acquisition agreements on the payment of reasonable sums. But reverse break-up fees did not emerge to enable purchasers to terminate contracts. Instead, what are now referred to as reverse break-up fees arose when sellers began to insist that private equity firms ensure the ability of the acquiring companies they form to respond in damages if they breach their contracts.

In a typical private equity purchase, the equity portion of the purchase price comes from a fund managed by the private equity firm. The private equity firm forms an acquisition company that enters into the acquisition agreement. When the acquisition takes place, the fund provides the acquisition company with the money it needs to complete the purchase. However, until an acquisition company is funded, which usually doesn't happen until the day the transaction is completed, it has no assets. So if it breaches the acquisition agreement by refusing to complete the transaction, the seller may be awarded a judgment against the acquisition company. But there are no assets from which it can collect the sum awarded.

Walking away

Sellers became increasingly conscious that they had no effective remedy here. They began to insist that the private equity firm, or one or more of its funds, guarantee to provide the money that the acquisition company would need to satisfy a judgment for breach of the acquisition agreement.

A number of private equity firms were willing to agree to provide money with which acquisition companies could satisfy breach-of-contract judgments, but insisted that the amounts to which they were exposed be limited. That seemed to give the acquisition company the option to walk away from the acquisition agreement if its private equity firm sponsor was willing to pay the specified maximum damages for breach of contract. In other words, it was viewed as making the maximum damage amount into a buyer's break-up fee (that is, a reverse break-up fee).

Not surprisingly, private equity buyers insisted that the maximum damages be similar to the amount the sellers would have to pay if the board of the company being sold terminated the purchase agreement to accept a better proposal. Agreements including seller termination rights and limitations on the damages the acquisition company and its sponsors could be required to pay seemed to give both the seller and the purchaser the option to walk away from the transaction on payment of a fee.

But a provision limiting damages is not the same as an option to terminate a contract. The difference became critically apparent in three recent situations in which private equity firms walked away from agreements to make major acquisitions.

The first involved the failure of JC Flowers to complete a $26 billion acquisition of SLM Corporation, better known as Sallie Mae. The acquisition agreement limited Flowers' damages for failure to complete to $900 million. But instead of paying the $900 million when it terminated the agreement, Flowers argued that an event had had a material adverse effect on Sallie Mae, so Flowers was not obliged to complete the deal. Flowers said it was not breaching the contract and was not obliged to pay the $900 million or any other sum as damages.

Flowers' argument was based on a very narrow reading of a bargained-for exception that limited the definition of what constituted a material adverse effect. Flowers had nothing to lose by arguing that it was not required to complete the deal. If it won, it would not have to pay anything. If it lost, its damages would be limited to the $900 million originally agreed. Eventually, Flowers paid a lesser amount and litigation over the failure to complete the transaction was settled.

The second situation involved the decision of a company formed by Cerberus Capital Management to terminate its agreement to purchase United Rentals for $7 billion. Section 8.2e of that agreement said that the right to terminate the agreement and to receive a $100 million parent termination fee was "the sole and exclusive remedy" of the company against the purchaser or any parties related to it. Section 8.2e went on: "In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [the purchaser or any persons related to it], either individually or in the aggregate, be subject to any liability in excess of the Parent Termination Fee". Finally: "In no event shall the Company seek equitable relief or seek to recover any money damages in excess of such amount from [the purchaser or any persons related to it]".

The problem arose because another provision, Section 9.10, said: "In addition to any other remedy to which such party is entitled at law or in equity," United Rentals "shall be entitled to seek an injunction or injunctions to prevent breaches of this Agreement ... or to enforce specifically the terms and provisions of this Agreement and the Guarantee to prevent breaches of or enforce compliance with those covenants of [the purchaser and its parent] that require [the purchaser or its parent] ... to consummate the transactions contemplated by this Agreement". But Section 9.10 also said: "The provisions of this Section 9.10 shall be subject in all respects to Section 8.2e hereof [the provision making the right to a $100 million Parent Termination Fee United Rentals' sole and exclusive remedy], which Section shall govern the rights and obligations of the parties hereto ... under the circumstances provided therein".

The Delaware Chancery Court thought the juxtaposition of Sections 8.2e and 9.10 was ambiguous about whether United Rentals could specifically enforce the contract (that is, get a court order requiring Cerberus to complete the transaction). The Court resolved the issue in favour of the purchaser (Cerberus), not because of the express words of the agreement, but because of a finding that during the negotiations the purchaser's lawyer had made it clear that the purchaser thought the right to specific performance would be eliminated by paying $100 million and United Rentals did not disagree.

The drop-dead date

The third situation involved an agreement by a company formed by Blackstone Group to acquire Alliance Data Systems for $7.8 billion. The purchaser agreed to pay a $170 million business interruption fee if it breached the agreement. One of the investment funds Blackstone manages guaranteed the obligation to pay that fee and to provide the $1.8 billion of the purchase price that was expected to be an equity investment. Allegedly because of pressure from its banks not to complete the transaction so they would not have to provide $6.6 billion of debt financing, Blackstone refused to agree to a requirement imposed by a governmental agency as a condition for necessary approval of the deal, even though Alliance suggested several ways by which its shareholders would bear what Alliance claimed was the full cost of complying.

Blackstone did not have the right to end the agreement because the governmental approval was not obtained, but either party could terminate it if the transaction was not completed by a specified date, referred to in the US as the drop-dead date. Because the transaction could not be completed without governmental approval, and that approval was not forthcoming without Blackstone's agreement, the transaction was not completed by the drop-dead date. Blackstone terminated the agreement the next day. Alliance sued, claiming Blackstone had breached the agreement by not fulfilling its contractual obligation to use its reasonable best efforts to consummate the transaction and "to obtain any requisite approvals," including the approval that was not obtained.

Simplest is best

The striking thing is that none of the three disputes would have arisen if a reverse break-up arrangement had given the purchaser the option to terminate the acquisition agreement on payment of an option-exercise fee.

In the Sallie Mae situation, Flowers could have argued it was not required to complete the transaction or could have exercised the termination option. But it could not have had its cake and eaten it. Flowers would either have had to pay the option-exercise fee, or rely on its argument that a condition to its obligation had not been fulfilled – and be faced with unlimited potential damages.

In the Cerberus case, United Rentals could not have argued that it could obtain specific enforcement of the contract. If Cerberus had exercised a termination option and paid a $100 million fee, the contract would have been over. Nothing would have been available to be specifically enforced.

In the Blackstone situation, as in the Flowers situation, Blackstone would have had to choose between exercising the termination option and paying the $170 million fee, or arguing that it had the right to terminate the agreement after the drop-dead date because the required governmental approval had not been obtained, but it would have faced unlimited damages if it lost.

The business logic of a buyer, and particularly a private equity firm buyer wishing to limit its exposure if it does not complete an acquisition is not unreasonable. However, if a buyer wants an option to terminate an agreement on paying a specified amount, it should insert that termination option in the agreement. The three situations described above show that using a limitation-on-damages for breaching a contract as a termination option does not work.

Sometimes the direct and simple way of doing business is the best way.

By David Bernstein of Clifford Chance

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