There were a number of lessons in this dispute that would emerge again throughout the financial crisis. First, shorthand or sloppy contract drafting could function as an unintentional landmine, lurking to create trouble. Second, the high-pressure atmosphere of takeover negotiations and the fast-paced timetable appeared to encourage mistakes, perhaps beyond a fault tolerance. Third, the mistakes made under this pressure were unlikely to come to light and tolerated by lawyers, but when they were discovered, they bit. It was doubtful whether the attorneys on either side enjoyed being put on the stand and having their ambiguous drafting parsed in the national news media. Fourth, complex agreements could never be complete in their terms. There would always be some omission or ambiguity. In the case of a litigation dispute, it would be fairly easy for one side to trump up a claim. Instead, what held these agreements together were extralegal factors like reputation.This was particularly true in the private equity context, where the deal was usually an optional one to begin with.
In the short term, the Cerberus ruling actually resulted in some bizarre negotiating techniques, as attorneys strained to avoid running afoul of the forthright negotiator rule. To avoid issues, some lawyers put a disclaimer of the rule in the agreement. Meanwhile, negotiations became more choreographed, with attorneys sometimes asserting their understanding of clauses in the negotiation.The goal was to obtain primacy of interpretation and leverage under the rule in any negotiation or future dispute. Attorneys on the other side were put in an unfortunate position, as they had to decide whether to challenge the statement or remain silent, hoping it would not count. The reaction showed the problems of the forthright negotiator rule in a world of sophisticated actors where ambiguity could not be eliminated.
In the longer term, the Cerberus decision was a watershed moment in private equity. After this litigation, it was now acceptable in the private equity market to simply walk from your deal. The reputational force that many sellers had thought would ensure that their transactions were completed had disappeared. In the period from December through February 2008, three additional private equity transactions would be effectively terminated: the pending acquisitions of PHH Corp. by Blackstone and General Electric Co., Reddy Ice Holdings, Inc. by GSO Capital Partners, and Myers Industries, Inc. by Goldman Sachs Capital Partners. In each case, no MAC claim was publicly asserted, but instead the buyer merely exercised the reverse termination fee provision in its agreement to exit the transaction. Each of the buyers could do this, since their agreement clearly permitted this action.
Thus, by early 2008, the fundamental understandings of the parties in private equity agreements appeared to have fallen by the wayside and the inherent optionality in this type of a reverse termination fee structure was realized. A reverse termination fee provision had become exercisable without significant reputational impact or other external normative constraints. At this, one had to laugh, or maybe cry, at the slogan of the now rejected Reddy Ice, the nation’s largest provider of packaged ice: “Good times are in the BAG!”
The Implosion of Private Equity
The economics and parameters of the pure reverse termination fee structure were largely redefined by the fall 2007 wave of collapsed private equity acquisitions. By 2008, most of these deals had either been terminated or consummated in accordance with their terms. However, the public impact of private equity firms’ reneging on their agreements was large. Private equity’s image and reputation were significantly tarnished by the perception that private equity had walked on a number of transactions in the fall. Private equity firms were viewed as having failed to honor their implicit promise to complete acquisitions.
Into 2008, a number of multibillion-dollar private equity transactions also remained pending. The completion of these transactions was delayed into the winter of 2008 on account of regulatory or financing issues. At the time, many speculated that these deals remained outstanding in part because of their less optional structures. Most of these transactions were structured along the lines of the deal United Rentals argued it had agreed with Cerberus. The private equity firms could not terminate the agreement unless financing became unavailable and the targets could sue to force the buyers to specifically perform their obligations. In the other transactions, the private equity firms could terminate for any reason and pay the reverse termination fee, but these fees were so large that termination was not an economic option. Trapped, the private equity firms waited, hoping the credit and stock markets improved sufficiently to make the economics of their transactions again viable.
The credit crisis continued unabated, though, and focus narrowed to five transactions, which I hyperbolically labeled in my New York Times DealBook column as the buyouts of the apocalypse:
• Blackstone’s pending $7.5 billion purchase of Alliance Data Systems, Inc.
• Thomas H. Lee Partners LP’s and Bain Capital’s pending $19.4 billion purchase of Clear Channel Communications, Inc.
• Hexion’s pending $10 billion purchase of Huntsman
• Fortress Investment Group and Centerbridge Partners LP’s pending $8.4 billion purchase of Penn National Gaming, Inc.
• The largest private equity deal ever, a consortium led by Ontario Teachers’ Pension Plan’s pending $48.5 billion purchase of Canadian BCE, Inc.16
All of these transactions had been agreed to before the market crisis. There was no doubt that the prices the private equity firms had agreed to pay were much higher than these companies were now worth. The stock market had declined and would later savagely fall in September and October 2008. Furthermore, the banks financing these transactions would bear the brunt of this decline, losing billions if these transactions were completed. Given this, even at the beginning of 2008, market spectators wondered whether these transactions would be completed, and they were right.17 Each of these deals would subsequently collapse or be renegotiated.The failure of these five large transactions would expose the weakness of private equity agreements and bank financing arrangements, as well as the failure of law and contract. Their collapse would also show the fragility of any agreement against the determined efforts of a buyer or lender.
The Alliance Data Systems (ADS) transaction was the first of these deals to implode. ADS was one of the nation’s leading credit card service providers. The company had agreed to be acquired by Blackstone on May 17, 2007. At the end of January 2008, it was disclosed that the Office of the Comptroller of the Currency (OCC) was refusing to grant a required regulatory approval for ADS to be acquired by Stephen Schwarzman’s Blackstone.The OCC justified its refusal on the grounds that the postacquisition leverage of ADS would leave it insufficiently capitalized to support its national bank subsidiary. The OCC did, however, ultimately express a willingness to reverse its position if the acquiring Blackstone fund itself provided a backstop, a $400 million guarantee of ADS’s bank liabilities effective upon completion of the sale. Blackstone refused, stating that it was not required to provide this guarantee under the acquisition agreement. Blackstone’s refusal was no doubt a product of the declining market and ADS’s vulnerable credit card businesses. If Blackstone paid the price it had agreed to, it would suffer a substantial loss on the deal, even if it could still force the banks to honor their own agreements to finance the transaction.18
ADS sued in Delaware Chancery Court to compel Blackstone to provide this guarantee. ADS had negotiated an acquisition contract that provided that ADS could sue to specifically force performance of the Blackstone shell subsidiaries’ obligations under the agreement. This arguably included the subsidiaries’ agreement to use “reasonable best efforts” to obtain any necessary regulatory approvals, including OCC clearance, for the transaction. ADS argued in court that the requirement to use reasonable best efforts by the shell subsidiaries required them to sue the Blackstone fund itself, their parent, to compel it to issue the OCC requested guarantee.19
Blackstone countered that ADS had entered into the acquisition agreement only with thinly capitalized shell subsi
diaries, a fact that ADS was fully aware of at the time it entered into the agreement. Blackstone’s only obligation was under its equity commitment letter issued to these subsidiaries and its own guarantee of the reverse termination fee. Therefore, the shell entities could not force Blackstone to provide the OCC guarantee, and since these entities could not provide the guarantee required by the OCC, the transaction could not be completed. 20 In the anonymous words of a Blackstone representative at the time: “It’s not a suicide pact. It’s a merger agreement.”21
Blackstone’s response highlighted a fundamental limitation of the specific performance form of private equity structure. The private equity shell subsidiaries are corporate limited liability entities whose only real assets are their financing commitments and agreement to acquire the target. If regulators or other events require the shell subsidiaries to act beyond these assets, specific performance becomes meaningless because no assets are available. The agreement thus effectively becomes unenforceable unless the private equity fund voluntarily agrees to support any such arrangements.
ADS attempted to sidestep this dilemma by arguing that the reasonable best efforts clause in its acquisition agreement contemplated more, a fact that the parties were aware of at the time of the agreement’s negotiation. This clause, standard in every acquisition agreement, obligated the Blackstone shell subsidiaries to use their reasonable best efforts to complete the transaction. The shell subsidiaries could be required under this clause to sue their parent Blackstone fund for any additional sums or contractual requirements required to satisfy regulatory demands. However, the meaning of reasonable best efforts under Delaware law had yet to be addressed substantively in any court and was therefore uncertain.
Vice Chancellor Strine, the judge assigned to adjudicate ADS’s complaint, openly questioned ADS’s argument in a hearing. He noted that Blackstone was not contractually bound to provide the OCC demanded guarantee in this structure. The grounds for any suit by the Blackstone subsidiaries against their parent would probably be slim.22 In the wake of Strine’s comments and his apparent favorable view of Blackstone’s arguments, ADS withdrew its complaint. At the time, ADS cited Blackstone’s public statements that it was still committed to completing the transaction as the reason for this withdrawal.23
ADS was probably just using these statements as a face-saving excuse to withdraw a suit that appeared to be on shaky legal grounds. At the time, most thought that Blackstone would continue to talk nice publicly but privately do nothing until the agreement termination date, that is, the date after which either party could terminate the agreement. This is what happened, and the agreement was terminated on April 18, 2008. ADS still sued again to collect the $170 million reverse termination fee, but lost before Vice Chancellor Strine on the grounds previously stated.24
The ADS litigation exposed the limits of the private equity structure. Under the traditional private equity agreement, a target could not force the actual fund to do any act to assist the buy-out. If the private equity firm’s assistance was necessary to complete the transaction, and they did not want to provide it, the acquisition would fail. This provided a wide out for the private equity firms, particularly with respect to acquisitions that underwent extended regulatory review or needed special regulatory approvals.
As ADS’s deal collapsed, the market attention turned to another buy-out, Clear Channel’s $19.4 billion purchase by Thomas H. Lee Partners LP and Bain Capital. The Clear Channel buy-out had had a rocky road. The deal had been pending since November 16, 2006, and the private equity buyers had agreed to raise the purchase price in the interim to forestall shareholder rejection of the transaction. In early February 2008, the deal finally received all regulatory clearances, and the period to complete the marketing of the debt necessary for the transaction began to run in anticipation of a March closing. Given the state of the debt and equity markets, it was feared that the private equity firms would now balk at paying this high price or that the lenders on the transaction would refuse to finance it.The banks had good reason to be hesitant. Documents would later show that the financing banks stood to lose more than $2.6 billion if the transaction were completed.25
The first hints of trouble in this deal came from a dispute involving the sale of Clear Channel’s TV station business to Providence Equity. As part of its own buy-out, Clear Channel, the owner and operator of more than 1,200 radio stations, had agreed to sell at a price of $1.2 billion 56 TV stations to Providence Equity, a private equity firm, to satisfy antitrust regulators. The sale of the TV stations was a necessary predicate to the main sale. Now that both sales appeared imminent, the lenders and buyers in the TV station transaction appeared to step back from the transactions.The rumor in the market was that Clear Channel and Providence Equity were renegotiating the transaction price.
No agreement was reached at that time. Instead, on February 15, 2008, Clear Channel preemptively struck. Clear Channel sued the Providence Equity shell subsidiaries in Delaware Chancery Court to force them to litigate against Wachovia Corporation to enforce their debt commitment letter and equity commitment letter.26 The agreement for the TV station sale was of the specific performance type. Clear Channel had a right to force Providence Equity to sue to enforce the financing.27 The rumors were true, and the parties were renegotiating the price, but Clear Channel still sued because of its continuing doubts about Providence Equity’s willingness to complete the transaction. Wachovia, one of the financing banks on the transaction, then countered. On February 22, 2008, Wachovia sued the Providence Equity shell subsidiaries in a North Carolina court to terminate its obligations under its debt commitment letter to finance the subsidiaries’ acquisition of the Clear Channel TV business. Wachovia asserted that any possible renegotiation of the purchase price constituted an “adverse change” under its debt financing letter. Providence Equity was clearly stuck in the middle.28
The deal was a jurisdictional morass. It highlighted the difficulty of enforcing the specific performance model of the private equity structure. The legal availability of specific performance in a cash transaction was still an uncertainty in many states, including Delaware. And the dual litigation due to the disharmony in the forum selection clauses in the financing documents and acquisition agreement raised the real possibility that the structure could completely collapse. In other words, not only could the private equity firm breach their financing commitment letters, but the financing banks could as well. This would create a situation where a target would be forced to sue the shell subsidiaries and, through some type of judicially ordered mechanism, arrange a suit on behalf of the subsidiaries against the banks and/or private equity firms to obtain necessary financing. The suits would have to be in different jurisdictions due to the differing forum selection clauses. Although a target could theoretically perform such acrobatics, the Clear Channel transaction appeared to be collapsing under its own weight at this point.
This problem was discussed at a February 26 hearing in the Clear Channel TV case before the ubiquitous and brilliantVice Chancellor Strine, who didn’t seem terribly troubled. He mused that in such circumstances, a remedy of specific performance could set free the shell subsidiaries.
The shell subsidiaries’ obligation to use reasonable best efforts to obtain financing would thus be interpreted to include a search by parties for financing and funds other than to the recalcitrant private equity firms. It would also include a right and obligation to sue the banks to collect the financing.29 The issues were never resolved, as this litigation unfolded and was settled in a few weeks. On March 14, Providence Equity agreed to pay a reduced price of $1.1 billion, but Clear Channel contributed $80 million in cash to the sold stations, thereby lowering the final price to $1.02 billion.30
The troubles of Clear Channel with Wachovia were ominous for two reasons: First, they did not portend well for Clear Channel’s own private equity buy-out. Wachovia had agreed also to finance Clear Channel’s buy-out. Wachovia’s litigation here appeared to be a te
st run for its attempts to escape that second, larger deal. Second, Wachovia’s actions marked the first public attempt of a bank to escape its financing obligations. There had been prior hints, though, that banks were balking at financing private equity deals.
In the fall of 2007, lenders in the HD Supply, Inc. and Reddy Ice Holdings, Inc. private equity acquisitions had aggressively worked to escape from their financing commitments. In both HD Supply and Reddy Ice, the private equity firms had renegotiated their deals with their targets, and the banks had used this change in terms to attempt to escape from their financing obligations. In each of these deals, the banks had asserted that the renegotiation of the transaction constituted a material adverse change under their debt financing letter, entitling the bank to terminate that letter. The Reddy Ice transaction ultimately was terminated through payment of the reverse termination fee by the private equity firm, and the banks’ position forced a renegotiation of the HD Supply transaction. In both instances, these disputes remained private and did not result in any litigation or public dispute. Similarly, in the Acxiom termination, the payment of part of the reverse termination fee by the banks hinted at their recalcitrance, but their role in the termination was not publicly disclosed by the parties.31 The Wachovia suit changed all this. It was now acceptable for lenders, as well as private equity firms, to openly challenge their commitments. Reputation did not particularly matter anymore.
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 11