Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  A MAC clause is a standard provision in acquisition agreements. It provides a buyer with the ability to terminate a deal when unexpected, bad events occur between the signing of the deal and its completion. They are thus the first option a buyer looks to in order to exit a deal. Their invocation beginning in August 2007, the start of the financial crisis, heralded a long period of disruption in takeovers, particularly private equity transactions.

  The exact meaning of these clauses and the scope of their application has always been uncertain, though; their importance hidden from public view. The market turbulence caused by the subprime implosion and foreshadowed by the February market plummet would highlight the role of these clauses and their shortcomings.They would also bring a renewed focus on these clauses and their limitations.

  One takeover, that of Accredited Home Lenders Holding Co. by the private equity firm Lone Star Funds, ably illustrates the issues surrounding MAC clause invocations in these early days of modern, distressed dealmaking.This chapter is about the case of Accredited Home Lenders but also the MAC disputes that followed it. These later disputes are important because, together with the Accredited Home litigation, they showed how little latitude private equity firms had to escape their transactions through MAC claims.This would define the course and scope of the next wave of private equity failures to be discussed in Chapter 4.

  The Fall of Accredited Home Lenders

  The problems with the financial system began to come to light in the second quarter of 2007. It was in early April that New Century Financial Corp., a leading subprime lender, filed for bankruptcy protection. Increased competition in the preceding years and dubious selling standards had led home lenders to lower their standards for creditworthy loans. Mortgage originators had simultaneously extended loans to increasingly riskier borrowers while accepting reduced profit margins.The model was inherently defective in that these borrowers often could not afford to service the loan in the long term.This rather large defect had been covered over by ever-rising house prices, which prevented borrowers from defaulting. Instead, these borrowers could simply refinance their mortgages or otherwise sell their houses to pay off their loans. The slowing housing market began to bring down this Ponzi scheme.

  New Century was the first public victim, but as the market began to become aware of these problems, loan originators like Accredited Home Lenders found it increasingly difficult to sell the loans they had extended. Typically, loan originators sold these loans to investment banks or the government-sponsored entities Fannie Mae or Freddie Mac. The bought loans would then be grouped together and securitized, further sold as mortgage-backed securities. This would permit the loan originators to move the debt off their balance sheets, lock in their profits, and gain the capacity to extend new loans. It also enabled the mortgage originators to sell off these inherently risky and unstable mortgages, transferring the risk of default to third parties.

  As the market deteriorated, mortgage buyers became skittish, offering lower prices or otherwise withdrawing from the market, further reducing the profit margin on the loans for originators such as Accredited Home Lenders. Also, as borrowers began to increasingly default, the supply of distressed loans on the market increased, further reducing loan prices and spurring still more defaults and lower prices. The downward spiral was both self-perpetuating and continuing. Consequently, loan originators became stuck with significantly devalued mortgages that had yet to be sold for securitization, resulting in margin calls from capital lenders. Accredited Home Lenders, a leading mortgage originator, was no exception, and it was hit by numerous margin calls beginning in early 2007. The entirety of the mortgagebrokering industry was beginning to feel the great pressure of the deflating housing bubble. It was payback for years of lax lending standards and a failure, or maybe prescience, to recognize market risks.2

  Accredited was a leading subprime mortgage lender founded in 1990. It was still led by James A. Konrath who co-founded the company and served as its chairman and CEO. In February 2007, one analyst had described Accredited as the “best underwriter in the business … [and] the most efficient loan originator … [with a] more attractive corporate structure than many of its competitors [and] conservative [accounting and] plenty of liquidity.”3 The statement proved to be short-lived. In March 2007, Accredited disclosed just such liquidity problems and announced that it was “pursuing strategic options” to raise additional capital.4 This type of language is code typically used by companies to inform the world that the board and management have decided to pursue a sale. At the time of the announcement, it was assumed in the market that Accredited was simply experiencing limited cash-flow difficulties. The analysts’ view that Accredited was still one of the best positioned and run mortgage originators remained firm. In actuality, things were particularly bad for Accredited. The turmoil in the market had resulted in sustained losses for the company.Without additional capital, Accredited would have to file for bankruptcy.

  Accredited’s announcement started up the deal machine.Accredited’s investment banker, the now-defunct Bear Stearns, began making the rounds to attempt to find a buyer by running an auction of the company. Bear Stearns was Accredited’s historical banker, probably picked because of its strong background in structuring and trading mortgage securities, a connection that would come back to viciously haunt Bear Stearns, but then was viewed as a benefit for a quick sale.

  The procedures for a company auction are fairly well set and a common way for public and private companies to sell themselves. First, a hired investment bank contacts interested parties, primarily strategic buyers and private equity firms. If the potential buyer expresses a desire to proceed, it signs a confidentiality agreement and receives an offering memorandum describing the for-sale company. The prospective buyers are then invited to submit preliminary indications of interest, including the range of prices they are willing to pay. From these indications, the seller decides whether to proceed and with whom. The field is narrowed to those buyers who provide acceptable indications.The remaining potential buyers then conduct due diligence, a technical term for an inspection of the company. During this time, an acquisition agreement is circulated, and sometimes another round of bids is requested and submitted. The remaining bidders then submit final bids with a marked-up agreement showing the terms they are willing to agree to in order to make the acquisition. The final negotiations then occur, and provided there is a winning bid, one acceptable to the seller’s board, a buyer is picked and a deal announced.

  The auction of Accredited largely followed this well-worn process. Between March 24 and April 9, 2007, 20 potentially interested parties entered into confidentiality agreements with Accredited and were provided access to company information. Meanwhile, in late 2006, Lone Star Funds had begun investigating acquiring or investing in a subprime lender. Lone Star, founded in 1995 and headed by John Grayken, is a private equity fund specializing in distressed acquisitions. Lone Star has invested in assets as diverse as golf courses in Japan, the Korea Exchange Bank, and Bi-Lo LLC, a chain of supermarkets headquartered in South Carolina.5 Most famously, Lone Star’s Korean Unit has been accused by the Korean government of illegally manipulating the stock price of Korea Exchange Bank to acquire it on the cheap, a claim that Lone Star has vigorously fought by claiming that the prosecution was politically motivated due to Lone Star’s foreign status.

  Lone Star entered the Accredited auction and submitted a second-round bid on June 1, 2007, along with four other bidders. This led to price negotiations between Lone Star and Accredited. Late on June 2, Accredited’s special committee communicated that it would go forward with another bidder if Lone Star did not raise its bid, and Lone Star responded by making a final bid of $15.10 per share. On June 4, Accredited executed a definitive agreement with two affiliates of Lone Star. Lone Star had agreed to pay $15.10 a share in a deal valued at approximately $400 million. Lone Star had won its target. The heated competition showed that many informed people still thought that Ac
credited’s and the industry’s difficulties would be short-term and Accredited’s capital troubles a passing phenomenon. They were, of course, completely, utterly wrong.6

  Unaware of coming events, the parties now turned to completing the deal. Lone Star commenced its tender offer on June 19, 2007. Throughout July and into August, Lone Star extended the expiration dates for the tender offer a number of times. The extension was contemplated and necessary for Lone Star and Accredited to obtain approval for the transaction from lending regulators. The tender offer was conditioned on the receipt of regulatory approval from regulators in states representing 95 percent of Accredited’s 2006 loan production volume. Lone Star was not required to close the tender offer until this condition was met.7

  Accredited, though, continued to further deteriorate. On August 2, Accredited finally filed its overdue annual report with the SEC. In the report, Accredited’s independent auditors qualified their 2006 audit opinion with the statement that Accredited may not “continue to operate as a going concern” and that its “financial and operational viability is uncertain.”8 This was auditor code for a possible bankruptcy.

  The markets continued their own parallel decline. In June and July, two hedge funds run by Bear Stearns that invested in subprime mortgage securities, the High-Grade Structured Credit Enhanced Leveraged Fund and the High-Grade Structured Credit Fund, very publicly imploded, losing billions in capital.9 A director of an agency rating service was quoted at the time as stating: “This is a watershed… . A leading player, which has honed a reputation as a sage investor in mortgage securities, has faltered. It begs the question of how other market participants have fared.”10 The implosion of these two funds and rapid decline of the housing market began to seep into the general market. Volatility increased almost exponentially, and the credit markets began to freeze up. Only a few months after Accredited’s agreement to sell, the subprime crisis was becoming a general one, and Accredited’s prospects were clearly diminished. Lone Star was now overpaying for its hard-won prize.

  On August 10, 2007, Accredited announced that the required regulatory clearances had been received, satisfying the regulatory approval condition and clearing the way for Lone Star’s tender offer to close. Later that day, Lone Star notified Accredited that it believed that Accredited would fail to satisfy the necessary conditions to close the tender offer. Lone Star was mum on what conditions were not met. However, it was widely speculated that Lone Star was asserting another condition to the tender offer had failed to be satisfied: namely, the condition requiring no MAC.

  On August 11, Accredited responded to Lone Star’s assertion by suing in Delaware Chancery Court. The suit was filed in Delaware because this was required by the forum selection clause in the acquisition agreement.That clause selected Delaware as the site of all litigation disputes between the parties. Lone Star responded to the suit on August 20, asserting that Accredited had indeed suffered a MAC.

  Lone Star alleged a laundry list of adverse events in its answer to support its claim. It pointed to Accredited’s recent disclosure in its annual report that it may not continue to operate as a going concern. In addition, Accredited’s independent auditors had qualified their opinion. Management’s projection of Accredited’s losses for the third quarter had also increased from $64 million to $230 million in only a two-month period from May 28, 2007, to July 26, 2007.11

  The day after Lone Star filed its answer, First Magnus Financial Corp., another large U.S. mortgage lender, filed for Chapter 11 bankruptcy protection.

  Material Adverse Change Clauses

  To fully understand the claims made by Lone Star, it is first necessary to understand the purpose and role a MAC clause plays in an acquisition agreement.

  THE PARAMETERS OF AN ACQUISITION AGREEMENT

  Acquisition agreements typically follow a standard format and structure. These agreements are necessary to govern payment of the consideration for the acquisition, as well as to privately order the parties’ conduct between the time of the signing of the agreement and the completion of the acquisition. The following sets forth some typical terms in an acquisition agreement. For convenience, I have set out these items in their standard order of inclusion:

  Section 1 (Form of Acquisition). Sets forth the form of the acquisition and whether it will be a merger, tender offer, asset sale, or other form of transaction. I further discuss the differences between these forms of acquisition and the considerations informing this choice in Chapter 11.

  Section 2 (Consideration). Sets forth the consideration to be received by the target and the mechanics of the consideration payment and calculation.

  Section 3 (Target Representations and Warranties). Sets forth the representations and warranties of the target to the buyer. Representations and warranties are statements of fact about the target and provide the acquirer assurances as to the state of the target. A typical representation and warranty is that no MAC as defined in the agreement has occurred to the target since the date of the target’s last full accounting period.

  Section 4 (Buyer Representation and Warranties). Sets forth the representations and warranties of the buyer to the target. Typically, these are fewer than those made by the target, as the target is primarily concerned with the ability of the buyer to pay the consideration. If the buyer is paying stock consideration, the representations and warranties are usually more fulsome because the target’s shareholders are effectively investing in the buyer.

  Section 5 (Ordinary Course Covenant). Sets forth the agreements of the target to mandatorily operate the business in the ordinary course during the period between signing and closing.

  Section 6 (Other Agreements). These include the obligations of the target and acquirer to prepare the necessary federal filings and hold the required shareholder meetings to complete the transaction, use some level of efforts to obtain regulatory clearances and other approvals, and, if applicable, obtain necessary financing. This section also sets forth the procedures a target must follow when considering or receiving a subsequent, higher bid by a third party.

  Section 7 (Closing Conditions). These are the conditions to closing that must be satisfied for the parties to be required to complete the transaction. The failure of a condition allows a party to refuse to complete an acquisition. Typical conditions include obtaining regulatory clearances and shareholder approvals. Importantly, a standard condition is that the representations and warranties of the target be true and correct except as would have a MAC. Representations and warranties already qualified by MAC (such as the no MAC representation) are required to be true and correct in all respects. Thus, the MAC standard determines if the buyer is required to complete the transaction. This was the prime area of dispute during the MAC wars of 2007—buyers claimed that the no MAC representation was no longer true and therefore the related closing condition was not satisfied.

  Section 8 (Termination and Expenses). Sets forth the termination rights of the parties. Typically, there is a drop-dead date, a date after which if the deal is still pending, it can be terminated by either party to the agreement. In addition, the termination and reverse termination fees are set forth here since they are triggered by a termination of the agreement. The reverse termination fee is often phrased as an aggregate cap on liability for the buyer.

  Section 9 (Miscellaneous). These provisions contain the parties’ choice of law and forum for disputes and other miscellaneous provisions. This section also typically contains a clause addressing the availability of specific performance in the transaction. It would be this last clause and its interaction with the liability cap often set forth in Section 8 (Termination and Expenses) that would spur the Cerberus-URI litigation discussed in Chapter 4.

  The Purpose of a MAC Clause

  A MAC clause is a device to allocate risk between a buyer and a seller. When a company like Accredited agrees to be acquired, there will typically be a period between the execution of the original acquisition agreement and completion of the transaction.
During this period, necessary regulatory and shareholder consents required to complete the sale will be obtained. In particular, if the deal is in an amount greater than $260.7 million, adjusted each year for inflation, a mandatory waiting period for government antitrust review will need to elapse.12 A MAC clause is a means for the parties to contractually allocate who will bear the risk of adverse events during this time between signing and closing.

  The MAC clause is thus one of the most important provisions of the agreement. It is the catchall provision that provides the buyer the ability to walk, and it is a primary condition to deal completion. In deals without significant regulatory issues, it can be said that the entire agreement is really just one big MAC clause. Today, it is a particular focus of any takeover negotiation.13

  An actual MAC clause is a defined term in the acquisition agreement. The seller will attempt to negotiate as narrow a definition as possible in order to place as much closing risk as possible on the acquiring entity. Conversely, the buyer will attempt to negotiate as broad a definition as feasible, one that will provide leeway to terminate the agreement in the event of postsigning adverse events. If you want to see the real beast, read the page-long MAC clause in Accredited’s agreement with Lone Star.

  MAC CLAUSE IN ACCREDITED’S AGREEMENT WITH LONE STAR

  Section 1.01(A) (MAC Definition)

  “Material Adverse Effect” means, with respect to [Accredited Home Lenders], an effect, event, development or change that is materially adverse to the business, results of operations or financial condition of [Accredited Home Lenders] and [Accredited Home Lenders’] Subsidiaries, taken as a whole; provided, however, that in no event shall any of the following, alone or in combination, be deemed to constitute, nor shall any of the following be taken into account in determining whether there has been, a Material Adverse Effect: (a) a decrease in the market price or trading volume of Company Common Shares (but not any effect, event, development or change underlying such decrease to the extent that such effect, event, development or change would otherwise constitute a Material Adverse Effect); (b) (i) changes in conditions in the U.S. or global economy or capital or financial markets generally, including changes in interest or exchange rates; (ii) changes in applicable Law or general legal, tax, regulatory or political conditions of a type and scope that, as of the date of this Agreement, could reasonably be expected to occur, based on information that is generally available to the public or has been Previously Disclosed; or (iii) changes generally affecting the industry in which [Accredited Home Lenders] and [Accredited Home Lenders’] Subsidiaries operate; provided, in the case of clause (i), (ii) or (iii), that such changes do not disproportionately affect [Accredited Home Lenders] and [Accredited Home Lenders’] Subsidiaries as compared to other companies operating in the industry in which [Accredited Home Lenders] and [Accredited Home Lenders’] Subsidiaries operate; (c) changes in GAAP; (d) the negotiation, execution, announcement or pendency of this Agreement or the transactions contemplated hereby or the consummation of the transactions contemplated by this Agreement, including the impact thereof on relationships, contractual or otherwise, with customers, suppliers, vendors, lenders, mortgage brokers, investors, venture partners or employees; (e) earthquakes, hurricanes, floods, or other natural disasters; (f ) any affirmative action knowingly taken by [Accredited Home Lenders] or Purchaser that could reasonably be expected to give rise to a Material Adverse Effect (without giving effect to this clause (f ) in the definition thereof ); (g) any action taken by [Accredited Home Lenders] at the request or with the express consent of any of the Buyer Parties; (h) failure by [Accredited Home Lenders] or [Accredited Home Lenders’] Subsidiaries to meet any projections, estimates or budgets for any period prior to, on or after the dates of this Agreement (but not any effect, event, development or change underlying such failure to the extent such effect, event, development or change would otherwise constitute a Material Adverse Effect); (i) any deterioration in the business, results of operations, financial condition, liquidity, stockholders’ equity and/or prospects of [Accredited Home Lenders] and/or [Accredited Home Lenders’] Subsidiaries substantially resulting from circumstances or conditions existing as of the date of this Agreement that were generally publicly known as of the date of this Agreement or that were Previously Disclosed; (j) any litigation or regulatory proceeding set forth in Section 5.09 of [Accredited Home Lenders’] Disclosure Schedule (but only to the extent of the specific claims and allegations comprising such litigation or regulatory proceeding existing as of the date of this Agreement; and (k) any action, claim, audit, arbitration, mediation, investigation, proceeding or other legal proceeding (in each case whether threatened, pending or otherwise), or any penalties, sanctions, fines, injunctive relief, remediation or any other civil or criminal sanction solely resulting from, relating to or arising out of the failure by either [Accredited Home Lenders] or the Reporting Subsidiary to file in a timely manner its Annual Report on Form 10-K for the fiscal year ended December 31, 2006, its Quarterly Report on Form 10-Q for the quarter ended March 31, 2007, and/or the Quarterly Report on Form 10-Q for the second and third quarters of 2007.