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

In our third and final post today on noteworthy deal protection provisions in the KKR-Sum Total merger agreement, we review Sum Total’s remedies for a breach or termination of the agreement by KKR. (Our first post covered the agreement’s “go shop” and “no shop” provisions and KKR’s break-up fee; our second post discussed the absence of a “financing out” for KKR.)

No Reverse Break-Up Fee

Sum Total is not entitled to a reverse break-up fee if KKR breaches or terminates the agreement under any circumstances.     

Specific Performance

The merger agreement pointedly provides that specific performance constitutes Sun Total’s “sole and exclusive remedy” for breaches of the merger agreement by the KKR merger vehicle or of the guarantee by Accel-KKR Fund III, L.P. Sum Total’s only recourse, in other words, is to get a court order compelling KKR to complete the merger. Sum Total has even agreed that if a court declines to enforce the specific performance remedy and awards monetary damages instead, the company may only collect its court ordered award if KKR is no longer willing to go ahead with the merger. 

The remedies section of the merger agreement appears to have been drafted in the shadow of the Delaware Chancery Court’s ruling in United Rentals v. Ram Holdings. In that case, the target company United Rentals moved for summary judgment on its claim that it was entitled to specific performance from a Cerberus-led private equity fund consortium under the terms of their merger agreement. The court, however, found that the priority of the two remedies provided to United Rentals under the merger agreement -  a reverse break-up fee and a right to specific performance - was ambiguous. Determining that neither United Rentals nor Cerberus was able to demonstrate that its proposed interpretation of the merger agreement was the only one that would be reasonable as a matter of law, the court resorted to extrinsic evidence by applying the forthright negotiator principle to divine the parties’ intent at the time of contract. The remedies section of the KKR-Sum Total merger agreement appears to be closely drafted to memorialize the parties’ intent that Sum Total’s only remedy is specific performance and that KKR’s right to specific performance does not preclude it from seeking its break-up fees.     

NB: The merger agreement also gives Sum Total the right to force the shell holding company serving as KKR's merger vehicle to compel Accel-KKR Fund III, L.P. to finance the purchase price of the merger.

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Following our post earlier today in which we reviewed KKR's break-up fees and the "go shop" and "no shop" provisions in the KKR-Sum Total merger agreement, we now examine the absence of a “financing out” in the agreement.

No Financing Out

In private equity buyouts, the acquisition vehicle tends to be a shell holding company with no assets. At the closing of highly leveraged cash-for-stock mergers, the holding company is funded by an equity investment from the funds participating in the merger and by senior and mezzanine, or “bridge,” loans from a syndicate of banks. Upon receipt, the holding company immediately transfers these funds to the target company for distribution to the target’s shareholders to complete the merger.   (The movement of these funds as they’re wired from entity to entity is mapped out in painstaking detail beforehand by the accounting firms in a chart dubbed the “funds flow.”) 

Although private equity firms usually have obtained signed letters from the banks committing their funds to the transaction before they enter into a merger agreement, firms always face the danger that, at some point between signing the merger agreement and closing, their lenders renege on their financing commitments or increase the costs of borrowing. To protect themselves against the possible loss of debt financing on acceptable terms, private equity funds in years past have negotiated a “financing out” in merger agreements by setting the continued availability of financing from their bank syndicates as a condition to closing the deal. 

The merger agreement does not have a “financing out” for KKR because the firm is financing the Sum Total merger solely with an equity investment from Accel-KKR Fund III, L.P., a fund dedicated to investing in mid-market technology companies. With no fear of a third-party’s failure to make good on its loan promises, KKR faces very little risk that it will not be able to come up with the cash to complete the transaction. 

Guarantee from KKR Fund

In fact, it is Sum Total who bears some risk that the KKR fund may fail to contribute cash to the shell holding company serving as KKR’s merger vehicle. The merger agreement gives Sum Total additional comfort by having the right to force the merger vehicle to compel the KKR fund to finance the purchase price. Sum Total also has a direct guarantee from Accel-KKR Fund III, L.P. for the holding company’s (and its subsidiary’s) obligations under the merger agreement. In effect, Sum Total’s contractual right to force the KKR fund to finance the transaction serves as an alternative, extra-judicial means of enforcing its right to specific performance under the agreement.

Sum Total’s right to specific performance will be the subject of our third and final post on the deal protection terms in the KKR-Sum Total merger agreement.

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A signed merger agreement with Accel-KKR in hand, Sum Total’s board has a month to go to the market to find a better deal. On Friday, Sum Total Systems, Inc. announced that Accel-KKR had offered its shareholders $3.80 per share in a definitive merger agreement filed with the SEC. For this deal at least, the private equity fund has foregone the LBO model, financing the entire $124 million price tag with an equity investment from a KKR fund focused on mid-market technology companies. By the time the markets closed on Friday, Sum Total stood at $3.83 a share, a 22% jump from the previous day’s closing price of $3.13. Trading volume for Sum Total’s shares skyrocketed to 5,759,368 on the day, compared to an average daily trading volume of 330,000 shares. 

Investors seem eager to become beneficiaries of an anticipated bidding war. While Sum Total’s board of directors has recommended the KKR merger, the company’s shareholders have yet to vote on the deal. According to the website Mergers Unleashed, a JPM Securities’ analyst report affirmed its $5 per share target value for Sum Total’s stock after Accel-KKR announced the merger deal. KKR has laid its cash and deal terms on the table, now it’s time to see whether anyone else will sit down and ante up.  

Over the course of the day, we’ll take a look at some of the noteworthy deal protection measures in the KKR-Sum Total merger agreement: 

“Go Shop” Period and "No Shop" Provisions

The Sum Total board of directors has a one-month “go shop” period (ending just after midnight on May 24) to solicit competing offers for the company’s shares. From May 24 until the company’s shareholders approve the merger, Sum Total’s board may not engage in any discussions with other parties regarding the sale of the company. This “no shop” provision has a customary fiduciary exception that allows the company’s board to entertain unsolicited written acquisition proposals so that Sum Total’s directors can fulfill their Revlon duties under Delaware corporate law to bargain for the highest price obtainable for the company’s shareholders. Though the Revlon court observed that “no shop” provisions are a legal deal protection measure under Delaware law, the court held that an absolute “no shop” prohibition on a company’s board of directors “when a board’s duty becomes that of an auctioneer for selling the company to the highest bidder” is impermissible.     

Even if it receives a better offer, Sum Total can’t terminate the agreement without first going back to KKR. If the board considers approving a merger agreement with another buyer, Sum Total must give KKR detailed information about the proposal, negotiate a potential counteroffer with KKR, and permit KKR to present a revised merger agreement to the board of directors for their consideration. KKR has found some relief, it seems, from the Revlon restrictions placed on their ability to lock-up the deal by negotiating a right of first refusal if a competing bidder proposes a higher price.    

Break-Up Fee

If the merger agreement is terminated because the Sum Total stockholders don’t approve the deal, the company breaches certain of its covenants (including the no shop restrictions), or the board changes its recommendation without entering into a merger agreement with another buyer, Sum Total must pay KKR a $4.95 million break-up fee. If the company terminates the agreement because the board has authorized the company to execute a merger agreement with another buyer offering the company’s shareholders a better deal, then KKR’s break-up fee is reduced to $3.1 million.  

Update:  Other aspects of the deal protection measures in the KKR-Sum Total merger agreement are discussed in:

No "Financing Out" Required: KKR's Equity Financing of the Sum Total Merger

Sum-Total's Remedies Under the KKR Merger Agreement

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Does Cerberus have the unilateral right to walk away from its deal with United Rental and limit its exposure to a break up fee of $100 million?  Or does United Rentals have the right to specifically enforce the merger agreement?  That's the issue at the heart of lawsuits currently pending in Delaware and New York arising out of this failed acquisition. 

Cerberus had this to say about United Rental's Delaware action for specific performance in a press release issued November 19th:

"We believe that United Rentals has been less than forthright in its legal filings and its communications concerning those filings.  The fact is that RAM negotiated for and obtained the right to withdraw from the Merger Agreement of July 22, 2007 and instead make a one-time payment in the aggregate amount of US $100 million.  This ability to walk away from the transaction with this limited exposure was specifically bargained for, is clearly and unambiguously stated in the Merger Agreement and related documentation, and is not in any way conditional on the occurrence of a material adverse change, the termination of the Merger Agreement by United Rentals or any other event."

Also, according to Bloomberg, Cerberus started its own lawsuit in New York Supreme Court seeking a declaration that its maximum exposure to United Rentals is $100 million. In the suit, Cerberus says United Rentals has no remedy other than the right to pursue the $100 million brake up fee, which serves as a cap for any or all losses or damages relating to or arising out of the merger agreement.

Let's see where that clear and unambiguous statement appears in the merger agreement.  Section 8.2(c) of the agreement says:

"In the event that this Agreement is terminated by [United Rentals] pursuant to Section 8.1(d)(i) or Section 8.1(d)(ii), then [Cerberus] shall pay $100,000,000 to [United Rentals] as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds."

OK then.  Section 8.1(d)(i) says that United Rental can terminate the agreement upon certain breaches by Cerberus of the merger agreement, and Section 8.1(d)(ii) says that United Rental can terminate the agreement if the merger isn't completed by a certain date.  Neither of these things has happened, and United Rentals isn't seeking the fee. 

Later on, in Section 8.2(e), there is a clause limiting liability for termination events to $100 million.  It says that United Rental's right to terminate the merger agreement under Sections 8.1(d)(i) or (ii) and receive the $100 million fee under Section 8.2(c) is the "sole and exclusive remedy" of United Rentals against Cerberus for "any and all loss or damage suffered as a result thereof" and Cerberus shall not have "any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination."  This fee is "the sole and exclusive remedy for recovery" in the event of "the termination of this Agreement by [United Rentals] in compliance with the provisions of Section 8.1(d)(i) or (ii)."  

So far, it looks as though United Rentals has the winning position, as this language pretty clearly says that the $100 million payment is the sole remedy only in the situation where United Rentals has terminated the merger agreement due to a misrepresentation or failed deadline.  Up until now, there isn't any absolute cap on liability if Cerberus breaches the agreement and walks away.

But keep reading.  At the very end of Section 8.2(e), comes the provision that finally supports Cerberus:

"In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [Cerberus] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [United Rentals] seek equitable relief or seek to recover any money damages in excess of such amount from [Cerberus].

That's pretty clear.  Although there is plenty of language in the agreement that appears to support United Rentals' position, this one sentence appearing at the end of Section 8.2(e) seems to cap Cerberus' exposure at $100 million.   The stock market seems to agree as well.

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United Rentals Inc. recently sued the shell companies formed by Cerberus Capital Management to acquire the company after Cerberus informed it that it was not prepared to proceed with the $7 billion deal. Cerberus wants to cancel the deal because of trouble with financing. United Rentals is doing fine, having just reported a great quarter. The lawsuit raises an interesting issue on the interplay between the specific performance remedy and a liquidated damages provision providing for a $100 million payment in the event the merger agreement is canceled.

Cerberus and United Rental agreed to the deal in July 2007. The merger agreement has detailed provisions regarding financing. For example, it provides that if the Cerberus entities are not able to obtain financing from syndicated sources, it will draw down on a $4 billion of bridge financing commitments given by a group of lenders including Banc of America, Credit Suisse, Morgan Stanley and Lehman Brothers. As everyone knows, the syndication market for these deals has dried up, so people are looking at the bridge financing package.

Cerberus went along through the fall and the United Rental shareholder vote as though everything were fine. Several days ago, apparently reacting to pressure from the bridge lenders, it notified United Rental that it was not prepared to impair its relationship with the bridge lenders by forcing them to fund, even though the merger agreement required them to do so. Instead, it notified United Rental that it “elected not to consummate the transaction” and would pay a break-up fee of $100 million.

Cerberus or its advisers also leaked news of the potential breakup to the press and the stock dropped fast, erasing more than $1.2 billion of market cap.

The lawsuit is a study in the remedy of specific enforcement. United Rental wants to force the Cerberus entities to go through with the deal, and wants the Delaware Chancery Court to order Cerberus to draw down the bridge financing. Cerberus on the other hand acts as though it holds an option to buy the company which can be canceled by paying the $100 million break up fee. 

The break up fee section says the fee is due only if the merger agreement is terminated. Cerberus doesn’t seem to have the right to terminate the agreement. Cerberus is counting on the fact that specific performance is not a favorite judicial remedy, especially where the parties have contemplated a specific financial damages remedy, like a break up fee. But this agreement has all the makings of a good specific performance action. 

Right now, the market doesn’t think the chances of United Rentals are so good, as the stock price is substantially below the merger price.

 

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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.

Whether a claim fell under the working capital adjustment or the indemnification claim was critically important, as indemnification claims were subject to a threshold of $4.45 million, while claims for a working capital adjustment were not subject to any threshold. There was an important procedural difference as well. Claims concerning the closing net working capital were to be resolved solely by a specific accounting firm. Indemnification claims were to be resolved in accordance with the Commercial Arbitration Rules of the American Arbitration Association, which give the parties the ability to challenge and investigate claims.  

The parties saw ahead of time that disputes involving, for example, misrepresentations could fit within both arbitration schemes. They decided that any matter relating to the closing working capital had to be resolved by the accounting firm mechanism, even though the matter could also be raised as a misrepresentation under the AAA procedure.

Shortly after the closing, a messy dispute arose involving a customer of CorSolutions. The customer instituted an audit of a CorSolutions disease management program. Matria dealt with the matter after the closing by negotiating a resolution with the client that involved, among other things, a cash payment of $1.5 million and amendments to the customer contract. Matria applied the $1.5 million payment as a debit to the closing working capital and asserted a claim against the escrow account.

The dispute could have been raised as both a working capital adjustment and a claim for indemnification. CorSolutions thought the working capital arbitration was too narrow a context to allow a full airing of the issues, and it asserted that the AAA was the only proper place to hear the dispute. It also, of course, wanted the claim to be subject to the $4.45 million threshold for indemnification claims.

The court agreed in substance with CorSolutions, but ruled in favor of Matria, on the strength of the clear hierarchy of arbitration contained in the merger agreement. Even though the dispute was one that typically would be subject to an indemnification threshold, the clear hierarchy of arbitration procedures forced the claim into the working capital adjustment, for which there was no threshold. Clever drafting by Matria’s attorneys.

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