Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion
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Targets themselves became less concerned with preserving their own culture through contractual agreement. The two notable exceptions during this time were the acquisitions of Pixar and Dow Jones & Co. When the Walt Disney Co. acquired Pixar in 2006 for $7.4 billion, the parties agreed to strong measures to preserve the separate Pixar culture, including a requirement in the acquisition agreement that “Pixar’s operations will continue to be based in Emeryville, California.
The Pixar sign at the gate shall not be altered.”5 And when Rupert Murdoch’s News Corp. acquired Dow Jones for $5 billion in 2007, the parties established a five-member independent special committee of “distinguished community or journalistic leaders.” This committee was provided postacquisition approval rights over the Wall Street Journal managing editor and editorial page editor and the Dow Jones managing editor. This was a unique arrangement driven by the distrust of the tabloid-owning Rupert Murdoch and the leverage of the selling Bancroft family, who controlled Dow Jones.6
Strategic transactions during the sixth wave were also strongly influenced by the globalization of dealmaking discussed in Chapter 5. Cross-border transactions rapidly rose in value during this time, from $589 billion in 2004 to $1.79 trillion in 2007.7 Groundbreaking domestic transactions also occurred. Most prominently, Hewlett Packard Co.’s landmark acquisition of Compaq Computer Corp. spawned its own proxy contest, as HP’s shareholders revolted against the takeover. The transaction morphed into a referendum on the tenure of Carly Fiorina, then CEO of HP, as former HP director Walter Hewlett led an insurgency against the deal. Fiorina won, and the combination was approved by HP’s shareholders.8 She then proceeded to write about this victory in a memoir titled Tough Choices.9 The HP shareholders lost, but their objections showed that buyer shareholders could wield their own power to forestall deals.
During this period, innovation in strategic transactions was reduced as the limelight stayed on private equity.There were only two truly significant game-changing legal shocks to the system during this time.The first was Vice Chancellor Strine’s opinion in In re IBP Inc., Shareholders Litigation discussed in Chapter 3, which was decided in 2001, just before the sixth wave’s beginning. In this decision, Strine provided strong guidance on the scope of a MAC and confirmed the availability of specific performance in an acquisition transaction.
The second was a 2005 decision in federal court decided by the Second Circuit Court of Appeals sitting in New York City: Consolidated Edison, Inc. v. Northeast Utilities.10 In that decision, the court held that under New York law, a target could not sue for lost share premium in a failed acquisition transaction. Instead, the only remedy to the company itself was its out-of-pocket losses. The decision was an odd one. After all, what were buyers agreeing to do in these contracts, if not to pay the share premium? Still, the New York court relied on the particular no third party beneficiary language in the acquisition contract to make this decision.
The decision likely led even more buyers to switch their acquisition agreements to be governed by Delaware law, firmly cementing Delaware’s role as the primary regulator of takeovers. However, the issue still remained whether a party, even under Delaware law, could obtain specific performance of their transaction, and if they could not, whether Delaware courts would apply the holding of the Con Ed case. This issue would arise in the private equity litigation of 2007-2008 but would not be definitively addressed in that time. As we will see in this chapter, though, this issue would again come into focus as Dow Chemical struggled to escape its obligations to acquire Rohm & Haas.
Strategic transactions had thus become a background affair during the credit bubble and the sixth takeover wave. In the ashes of private equity and the stress of the financial crisis, though, renewed focus would come to these transactions and their structure.
The Changing Structure of Strategic Transactions
The global credit crunch and the implosion of private equity did not leave strategic deals unaffected. Prior to this time, the structure of strategic takeovers was well set and defined. A buyer would typically agree in the acquisition agreement to specifically perform the transaction. In other words, the target could contractually force the buyer in a court of law to comply with its agreement and complete the takeover. This structure contrasted with the more optional nature of the private equity structure discussed in Chapter 2. In a takeover with a private equity buyer, the target would contract with shell subsidiaries created by the private equity fund.These agreements would typically limit specific performance and provide only for the payment of a reverse termination fee if the private equity buyer breached the agreement and refused to complete the transaction.
The historical reason for this difference was private equity’s dependence on financing. Without financing, a private equity firm could not complete an acquisition. Accordingly, the private equity firms bargained hard to retain the ability to terminate their agreements if financing became unavailable. Otherwise, the private equity firm would be required to complete an acquisition when it did not have the funds to do so. In the wake of the financial crisis, these same forces undergirding the optionality of a typical private equity agreement began to worry strategic buyers. Strategic buyers began to fear that their financing might fall through, leaving them without sufficient cash to acquire a target. This fear was reinforced by the conduct of the banks in the Clear Channel and Genesco litigations. In those and other deals, banks had shown that they were not afraid of walking on their financing obligations, even if it resulted in the bankruptcy of their client, the buyer.
Fearful of any credit risk whatsoever, strategic buyers began in the spring of 2008 to negotiate the optional features common to private equity deals but previously unheard of in strategic transactions.The most notable of these was the first: Mars Inc.’s agreement to acquire Wm. Wrigley Jr. Co. for $23 billion. In the acquisition agreement for that deal, Mars negotiated a reverse termination fee. This provision allowed Mars the right to walk from the transaction at any time by paying approximately 4.5 percent of the equity transaction value, or $1 billion.11 Mars no doubt demanded this optionality on account of its need for significant financing to complete the deal and its concern that this financing might fall through.
Wrigley probably accepted this provision because of the high price Mars was offering and the particular social problems surrounding the deal as a result of the Wrigley family. Wrigley was still controlled by the Wrigley family and the family members remained a pillar of the Chicago community. Wrigley’s agreement to a reverse termination fee probably reflected the Wrigley family’s ambivalence about the transaction and their unwillingness to force Mars to complete it. Moreover, Warren Buffett’s Berkshire Hathaway Inc. was an investor in this transaction, investing $2.1 billion directly in the postacquisition Wrigley itself and providing $4.4 billion in financing.12 The involvement of the legendary Buffett no doubt assuaged Wrigley of Mars’s commitment to the deal but also highlighted the troubled financial market and consequent need for alternative sources for credit.
The Mars-Wrigley deal opened up the door for the negotiation of more optional deal structures in strategic transactions. In the wake of Mars-Wrigley, strategic buyers began to negotiate provisions that allowed the buyer to terminate the transaction if the financing for the transaction failed. In such circumstances, a reverse termination fee would instead become payable. This was a stronger provision than that in the Wrigley acquisition because it purported to allow the buyer to walk only if the financing became unavailable. In all other circumstances, the target could specifically force the buyer to complete the deal.13 Examples of 2008 strategic deals with this feature included Third Wave Technologies Inc.’s agreement to be acquired by Hologic Inc. for approximately $580 million, Brocade Communications Systems Inc.’s $3 billion agreement to acquire Foundry Networks Inc., and Ashland Inc.’s $2.6 billion agreement to acquire Hercules Inc.14
The grafting of the reverse termination fee onto the strategic structure was problematical, thou
gh. It falsely equated private equity and strategic transactions. Unlike private equity firms, strategic buyers are not in the business of making acquisitions and for the most part are not repeat players in the takeover game. The reputational penalty for walking is thus not as substantial. Moreover, a strategic buyer must answer to its shareholders. An adverse public reaction by a buyer’s stockholders to the announcement of an agreed acquisition could incentivize it to abandon or renegotiate the deal.This was proven by subsequent events. In at least two strategic deals with private equity features negotiated in 2008, buyers leveraged this optionality to attempt to renegotiate the transaction. The two were Foundry’s acquisition by Brocade and i2 Technologies Inc.’s acquisition by JDA Software Group Inc. In the latter instance, i2 refused to renegotiate, leaving it with only the reverse termination fee as compensation for its failed deal.15
In the wake of these collapses, Pfizer Inc.’s acquisition of Wyeth Pharmaceuticals Inc. for $68 billion was announced in January 2009. The attorneys in that deal appeared to have learned from the travails of Foundry and i2. In the Pfizer deal, Wyeth negotiated a reverse termination fee of $4.5 billion. This was a substantial payment and 7.6 percent of the enterprise value of the transaction or approximately half the share premium being offered by Pfizer. Like the other strategic transactions following the Wrigley deal, this fee was payable if Pfizer’s financing became unavailable.
The two key innovations in the Pfizer agreement, however, were the size of the reverse termination fee and the nature of the financing out. First, unlike other deals, where the reverse termination fee was small enough to be treated as an option payment, the fee in this case was sizable enough that Pfizer would be quite hesitant to walk on the transaction or otherwise attempt to trump up a financing failure to excuse its performance. Second, the parties narrowly drafted what would constitute a financing failure to encompass only a ratings downgrade of Pfizer below investment grade. In all other circumstances, Wyeth could force Pfizer to specifically perform its obligations under the agreement.16 This tight objective standard ensured that Pfizer could not trump up a financing failure to escape its obligations.
A variation of the Pfizer-Wyeth strategic form subsequently appeared in the March 2009 acquisition of Schering-Plough Corp. by Merck & Co., Inc. In that transaction, if the financing was available and Merck refused to complete the transaction, then Schering’s only remedy was to terminate the agreement and collect a $2.5 billion reverse termination fee from Merck, plus expenses up to $150 million.17 Otherwise, Schering retained the ability to force Merck to specifically perform the transaction.
This was a variation of the Pfizer model with two important distinctions. First, it was a lesser amount—Pfizer’s reverse termination fee was at 6 percent of deal value, compared with 6 percent for Merck. Second, the Pfizer reverse termination fee was payable only upon a ratings downgrade of Pfizer. In all other circumstances, Pfizer was required to close. Pfizer took the risk that it would lose the financing only if it wasn’t an investment grade company. In Merck’s case, there was a wider out, encompassing circumstances where the financing became unavailable for any reason—a proviso that included the possibility of a financing bank going bankrupt.
The Pfizer-Wyeth strategic model appeared to get it right and will probably set the model in some variation for future deals. It also showed the ability of attorneys to innovate and how such innovation goes through iterative stages to arrive at a more stable deal model. Still, the use of private equity types of features in strategic deals remains unusual. The majority of strategic transactions in 2008 and 2009 were structured in the traditional manner. These included InBev’s $50.6 billion takeover of Anheuser, Dow Chemical’s $15.3 billion agreed acquisition of Rohm & Haas, and Altria’s $10.3 billion acquisition of UST. However, these three buyers were hit by the credit crisis in September and October 2008, and Altria was forced to delay its acquisition because of an inability to obtain financing.18 The possibility was real that financing could fail in a takeover, leaving a buyer in the sad state of Finish Line in the Genesco acquisition and Hexion in the Huntsman transaction. The buyer would be ordered to complete an acquisition but without the cash to do so.
The Rohm & Haas deal in particular highlighted the perils of a lack of a financing out. The collapse of Dow’s joint venture with the Kuwaitis in late December 2008 had left Dow struggling to finance its acquisition of Rohm & Haas without dismembering Dow itself, cutting its dividend, or undertaking a dilutive equity issuance. It was at this point that Dow, on January 26, 2009, simply refused to complete the acquisition. Rohm promptly sued Dow in Delaware Chancery Court to force it to specifically perform the agreement. From the prior MAC battles of 2007 and 2008, it was clear that Rohm & Haas had not suffered a MAC and that Dow had no financing out in the acquisition agreement.
Faced with few legal options, Dow decided to argue the issue of whether specific performance was available in a cash transaction. Despite having agreed in the acquisition agreement to specific performance, Dow argued that if it were forced to complete the takeover, it would significantly and adversely affect Dow and force it to slash costs, close plants, and lay off employees. Because of this, the Chancery Court should use its equitable discretion to ignore the language in the agreement, refuse to order specific performance, and instead award monetary damages. Dow then argued that the Delaware court should apply the Con Ed case and award Rohm & Haas only its out-of-pocket expenses.19
The case appeared to be more a public relations campaign than a legal argument. Dow CEO Andrew Liveris even went on CNBC to praise Rohm & Haas but argue that the deal no longer made sense despite Dow’s legal obligations. On the eve of trial, Dow settled without a reduction of the purchase price but an agreement of two significant shareholders of Rohm to roll over up to $3 billion of the proceeds into a preferred share investment in Dow.The failure of Dow to obtain a reduction in the share price and the relatively high yield of 15 percent on the preferred showed the weakness of Dow’s arguments.20 The settlement appeared to be one that Dow may have been able to get without litigation.
Dow’s failure to obtain a better settlement showed the hazards of a public relations campaign. By repeatedly and publicly claiming that it would be faced with possible default on its debt obligations if the transaction proceeded on its prior terms, Dow locked itself into a litigation strategy.Yet, the litigation case was weak, and on the cusp of trial Dow was forced to recognize that. This forced it into a settlement as the alternative; an adverse judgment was only likely to now severely spook Dow’s lenders.
Ultimately, the travails of Dow and the Pfizer precedent are likely to spur increased use of reverse termination fee provisions in strategic transactions. In negotiating these provisions, though, targets and buyers will continue to bargain over the scope of optionality. Targets will prefer the Pfizer model, and buyers will argue for a more traditional type of private equity reverse termination fee. The course of these negotiations will affect the future structure of strategic transactions.
The Phenomenon of the Distressed Deal
The financial crisis brought on another new development in the world of strategic transactions, the rise of the distressed takeover. During 2008 and through to 2009, the credit markets remained frozen. Because of this, distressed companies often could not obtain the necessary debtor in possession financing to continue their operations in a bankruptcy. Moreover, the so-called reforms implemented by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made it much harder for companies to reorganize in bankruptcy even with such financing. Instead, locked out of the normal bankruptcy restructuring process, these companies turned to strategic buyers to preserve their businesses and avoid liquidation.
But buyers were scarce, as companies were either unwilling to risk a troubled takeover or lacked the financing to make an acquisition. In some extreme instances, the lack of buyers led to reverse auctions, as companies competed with each other for a single buyer. A prominent example
arose when Lehman’s ex-CEO Richard Fuld Jr. repeatedly tried to reach Bank of America Corp. CEO Kenneth D. Lewis at his home in order to speak to him about purchasing Lehman. Lewis’s wife told him that if Lewis wanted to speak to him, he would call him back. Lewis did not call back, and Lehman Brothers lost out on landing Bank of America as a buyer when Bank of America chose to acquire Merrill Lynch instead. Unable to find a buyer or obtain government assistance, Lehman was forced to declare bankruptcy and liquidate.21
Buyers confronting these distressed situations resurrected a number of legal tactics to drive hard bargains on both price and acquisition terms. Buyers sought to lock up targets as firmly as possible while simultaneously obtaining as much flexibility as possible to terminate the transaction before its completion if the target further deteriorated. In the pursuit of these dual goals, dealmakers during 2008 and 2009 would push the envelope of the law, negotiating terms that tested the bounds of Delaware and other states’ law.
Perhaps the best example of this unfortunate development was MidAmerican Energy Holdings Co.’s agreement on September 19, 2008, to acquire Constellation Energy Group Inc. MidAmerican was a subsidiary of Warren Buffett’s Berkshire Hathaway Inc. Constellation was on the verge of insolvency and agreed to accept a buy-out from MidAmerican for $26.50 a share, approximately $4.7 billion. In addition, to meet Constellation’s near-term capital needs, MidAmerican also purchased $1 billion of Constellation preferred stock, yielding 8 percent.
In exchange for this near-term liquidity infusion, MidAmerican negotiated hard. MidAmerican’s right to close was conditioned on Constellation’s unsecured senior debt still being rated investment grade, a form of back-door MAC clause. MidAmerican also negotiated a due diligence termination right in the agreement. If, prior to closing, MidAmerican found a material deterioration of Constellation’s business as measured from June 30, 2008, in an amount greater than $400 million, then MidAmerican had a right to terminate the agreement. This was a significant out. The sale of Constellation, an energy company, involved the transfer of Constellation’s nuclear power plant. The state and federal regulatory approval process oftentimes can last longer than a year. By negotiating a broad due diligence out during this time period, MidAmerican received substantial protection for an extended period of time over and above a MAC clause.