New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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In the investment world, there is no shortage of firms where everyone drinks the koolaid, believing the firm is a truly unique organization with values and a culture shared by no one else. Most times, the koolaid drinking is done in private, at partners’ meetings or golf retreats where the steady gaze of outsiders does not interfere with the collective daydream. It is therefore jarring to see the drinking done in public, especially in so formal a setting as a prospectus for an initial public offering.

The Summary section of the IPO prospectus of Blackstone Group contains the following announcement:

We Intend to be a Different Kind of Public Company

While we believe that becoming a publicly traded company will provide us with many benefits, it is our intention to preserve the elements of our culture that have contributed to our success as a privately-owned firm. In particular, as described below, we intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business. 

Because our businesses can vary in significant and unpredictable ways from quarter to quarter and year to year, we do not plan to provide guidance regarding our expected quarterly and annual operating results to investors or analysts after we become a public company.

The logic here appears to be that one fosters a long-term perspective on business by refusing to provide guidance to investors about quarterly and annual operating results. But then, it is not really evident how these things are connected.  Is it really true that by not disclosing its quarterly and annual profit expectations, which Blackstone surely prepares internally, the firm will better manage its business for the long term?

It seems one thing to believe in the long-term perspective, after having drunk deeply from the bowl.  It is another thing to prominently feature the belief in an IPO prospectus.  But then, it was only a statement of intent. 

And what of the belief itself? Do private equity firms really manage their investments with a “long-term perspective”? Happily, Christina Padgett of Moody's Investor Service has recently written on this subject. In a recent report, Ms. Padgett wrote:

While Moody's would agree that leverage is likely to impose discipline and provide higher equity returns, the current environment does not suggest that private-equity firms are investing over a longer-term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings"

The report goes on to note that Celanese US Holdings, a chemical business owned by Blackstone Group, borrowed money within a year of the acquisition to pay a dividend to the private-equity firm, removing more than 95% of the cash equity originally invested in the deal. 

Blackstone's investors at least can breath a sign of relief, knowing that the firm has a sharp eye for the short term as well as the long. 

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Contract parties very often want to pre-select the court in which any lawsuit arising under the contract must be brought. Issues of convenience and perceived fairness typically underlie the desire for these clauses. To be enforceable, forum selection clauses must be clear and unambiguous. 

A recent case from the Delaware Court of Chancery illustrates what happens when a forum selection clause is badly drafted. 

A manufacturer of microbial degradation and mold control products sued the investment banker it hired to assist with acquisitions. The manufacturer believed that the investment banker misused confidential information in the course of their relationship. The engagement letter tried to select the Southern District of New York as the sole forum in which litigation could be brought. The manufacturer sued in Delaware and the investment banker moved to dismiss the action.

Here is the defective forum selection clause:

“Any lawsuits with respect to, in connection with or arising out of this agreement shall be brought in a court for the Southern District of New York and the parties hereto consent to the jurisdiction and venue of such court for the Southern District as the sole and exclusive forum, unless such court is unavailable, for the resolution of claims by the parties arising under or relating to this agreement.” (emphasis added).

Because both the manufacturer and the investment banker were Delaware corporations, and no federal question existed, there was no basis for subject matter jurisdiction in the Southern District. That court was “unavailable”.

The investment banker argued that the parties “intended” to select any court located within the territory of the Southern District, not just the federal court called the Southern District of New York. But that’s not what the contract provision actually said, so the Delaware Court of Chancery ruled against the banker. For a forum selection clause to work, the parties must use “express language clearly indicating that the forum selection clause excludes all other courts before which those parties could otherwise properly bring an action.”  If the contractual language is not crystal clear, “a court will not interpret a forum selection clause to indicate the parties intended to make jurisdiction exclusive.”

The lesson? Use a proper forum selection clause, like this one:

Each party agrees to personal jurisdiction in any action brought in any court, Federal or State, within the County of New York, State of New York having subject matter jurisdiction over the matters arising under this Agreement. Any suit, action or proceeding arising out of or relating to this Agreement shall only be instituted in the County of New York, State of New York. Each party waives any objection which it may have now or hereafter to the laying of the venue of such action or proceeding and irrevocably submits to the jurisdiction of any such court in any such suit, action or proceeding.

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The ratio of total debt to EBITDA in mid-market private equity transactions is now as high as it was in 1997 – 4.7 times for companies with less than $50 million in EBITDA and 5.4 times for companies with more than $50 million of EBITDA (Source: Standard and Poors). The ratio of EBITDA less CapEx to Cash Interest in highly leveraged loans is also falling – in the 4^th quarter of 2006 the ratio fell to 2.2 times (Source: Standard and Poors).

At the same time, the covenants being written for leveraged loans are becoming more “lite”: several years ago, loan covenants were written at a 15% discount to model; now they are being written at a 25% discount.

“Covenant-lite” transactions come in many forms. In their most direct form, the covenants that require the borrower to “maintain” certain financial ratios are eliminated altogether, and the lenders are left to rely only on covenants that restrict a company from “incurring” or actively engaging in certain action. For example, a covenant that requires a company to maintain a ratio of debt to EBITDA can be breached if the financial condition of the company deteriorates, as the covenant is measured periodically, usually quarterly. But a covenant that only restricts a company from incurring new debt cannot be violated simply by a deteriorating financial condition, the company has to take affirmative action to breach it. 

Less direct forms of “covenant-lite” include carve-outs in traditional maintenance covenants that forgive in advance a certain measure of deviation from the standard. It is sometime more palatable to embed these carve-outs in a traditional loan covenant than discard the covenant altogether.

In addition to covenant-lite structures, private-equity sponsored deals have started to include a greater number of “equity cure” provisions. These enable a borrower to cure a covenant deficiency by adding more equity into a deal to count as EBITDA, thereby curing the breach. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures. In effect, the private equity sponsor is pre-negotiating an equity infusion without having to get lender approval.

This trend is of course a function of the amazing amounts of liquidity available in the credit markets to fund acquisitions.  The impact of these covenant-lite transactions will be to retard the speed with which lenders will be able to take control over troubled deals.  That may not be such a bad thing.  Lenders are not equipped to own a business and typically sell too quickly when forced to take over a company.  The next downturn may provide less opportunity for distressed debt investors than previous business investment cycles, as fewer private equity sponsors may be handing over the keys to their lenders.  

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other. 

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

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Buyer will often make specific promises regarding hiring and retaining employees of the business. If so, the purchase agreement will identify the buyer’s obligations in this regard and identify the benefit plans, severance obligations, and accrued bonus and vacation rights of the transferred employees. For example, the buyer may agree to grant service credit to employees for purposes of vesting in benefits, even though these credits may not be required by law.

The contract will describe the circumstances under which the agreement can be terminated.  Both parties will be able to terminate if the other party breaches the agreement and fails to cure the breach after being given the opportunity to do so. Also, the contract can be terminated if the closing does not occur by a defined date. This may occur, for example, if a third party or governmental approval is needed but can’t be obtained, or if financing can’t be obtained within a defined time period. This outside termination date is usually negotiated in the term sheet.

As the parties generally conduct the transaction across the borders of several states, the laws of one state will be chosen to govern the contract. Also, the courts of a specified jurisdiction will be chosen to hear disputes arising under the contract. In lieu of court adjudications, the parties may elect to implement an alternative form of dispute resolution, such as mediation and arbitration.

The contract will often have a number of things attached to it, such as schedules of information, forms of notes or equity instruments delivered as part of the purchase price and allocations of the purchase price. These items are specifically incorporated in the contract and are often part of the items delivered by the parties at the closing.

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In private equity transactions, the most important thing that needs to happen before a closing occurs is the buyer needs to raise the financing needed to pay the seller the cash portion of the purchase price. Sometimes this is stated as an express condition, meaning that if financing cannot be obtained, the private equity firm will not be in breach of the agreement. If it is not an express condition, then the private equity firm will be in breach of contract if the financing cannot be raised. But because the private equity firm generally forms a special purpose entity for the sole purpose of completing the acquisition, there isn’t a company against which seller can assert a claim. For this reason, even where financing is not stated as an express condition, as a practical matter there is a financing condition in most private equity transactions.

Smart sellers sometimes require that a buyer provide firm financing commitments from equity and debt sources before a binding purchase agreement is signed. Alternately, sellers may demand that the buyer place cash in escrow that becomes forfeit in case financing is not raised by a stipulated date.

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The first covenant given by seller is the promise that it will operate its business only in the “ordinary course” and “consistent with past practice” between signing the purchase agreement and closing. The covenant goes on at length about specific things that seller will and will not do during this period without the permission of buyer. The purpose of these sections is to make sure that no significant or unusual transactions are undertaken without buyer’s knowledge and consent.

Seller agrees to give the private equity firm and its representatives access to its books, records, facilities and employees between signing the purchase agreement and closing. This is often necessary to bring in lenders for the transaction and let them complete their due diligence and investigation of seller and its business. 

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Representations and warranties serve two functions. They are part of the due diligence process where the private equity buyer looks at all material information about the target’s business; representations and warranties reflect the results of this investigation. They are also the insurance policy that the seller gives the private equity buyer about the truth and accuracy of the business information. The “representations” are assertions that the information furnished is correct and the “warranties” are legal obligations to stand behind the statements financially.

The subject matters of the representations and warranties cover all major facets of a business. Although the representations are worded in absolute terms, in practice the seller creates a schedule of exceptions and attaches them to the purchase agreement. These exceptions contain information about the company’s business and assets that deviate from the standard representations. Accordingly, these exceptions are important to the private equity buyer and their disclosure often provokes further negotiations.

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The sale of a company in a private equity deal typically begins with a term sheet spelling out the major terms of the transaction and setting out a timetable for due diligence, document preparation and closing. The parties then negotiate a definitive purchase agreement containing representations and warranties, covenants controlling actions before and after the closing and indemnification provisions. The time between contract signing and the closing is devoted to obtaining consents of third parties, waiting for clearance under the Hart-Scott-Rodino Act, securing financing to pay the purchase price or concluding other tasks that are required to be completed before closing.           

One of the key issues in any private equity transaction is who will manage the company after it is sold. Sometimes the answer is quite simple, as where the prior owners intend to retire. Other times the answer is more complex, as where the prior owners are required to remain involved in the company to ensure a smooth transition or to secure an earn-out.

Most of the time, the current senior managers of the target company are very important to sustain a core business, such as relationships with customers, product development or brand name. In that case, the private equity buyer may insist that these people sin independent employment contracts. They in turn acquire substantial influence over the transaction and may even have an impact on the sale price.

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