In a May blog post we discussed several initial observations regarding the dozens of M&A transactions that were signed prior to March 2020 and that were in jeopardy as a result of COVID-19. Since that post, the Delaware Chancery Court has had the opportunity to consider some preliminary issues relating to certain of those jeopardized transactions involving private equity-backed buyers. The decisions from the court on those preliminary matters, as well as the arguments raised by legal counsel, offer some valuable lessons for sellers considering sale transactions that require debt financing, and may motivate sellers to re-evaluate certain provisions and remedies that have become customary in those transactions.
Sellers Face Uphill Battle in Obtaining Specific Performance
In pending transactions involving targets that were materially impacted by COVID-19, buyers have generally justified their attempts to renegotiate, delay closing or terminate those transactions on two contractual grounds: (i) target has suffered a material adverse effect (an MAE) as a result of COVID-19 and/or (ii) target has breached the interim operating covenants by virtue of its actions (or inaction) in response to COVID-19. At the time of this post, the Delaware courts have yet to weigh in on those matters, other than acknowledging that claims relating to MAE and covenant breaches in the context of COVID-19 were inherently fact-intensive and would require a trial on the merits.[1] However, in disputed transactions requiring debt financing, several private equity-backed buyers have asked the Delaware Chancery Court to make a preliminary determination—before any hearing on the occurrence of an MAE or covenant breaches—that the seller is not entitled to specific performance of the buyer’s obligation to close the transaction. The decisions from the court in this context, on both procedural and substantive matters, highlight the (steep) uphill battle sellers face in obtaining specific performance of a private equity-backed buyer’s obligation to close, particularly when the target’s business has suffered significant economic losses following the execution of the purchase agreement, and there is a legitimate question as to whether buyer had a right to terminate.
In virtually all transactions that require debt financing to fund a portion of the purchase price (and where the private equity sponsor is not providing a 100% equity backstop), specific performance of buyer’s obligation to close is only available as a remedy if the debt has been funded or would be funded if the sponsor’s equity is funded. In other words, the specific performance remedy is conditional, and neither buyer nor the sponsor can be forced to close without the debt financing. In the event of a legitimate financing failure, a seller’s sole remedy would be to terminate the purchase agreement and collect the negotiated reverse termination fee. Consequently, as certain sponsor-backed buyers indicated an unwillingness to close pending transactions due to COVID-19, sellers in those transactions requested expedited proceedings in the Delaware Chancery Court, knowing that their chances of obtaining specific performance would be significantly reduced (if not impossible) if the original debt financing commitment expired prior to the specific performance trial. In at least two instances, despite establishing a colorable claim and showing sufficient possibility of threatened irreparable injury, those requests for expedition were denied.
Timing of the Essence in Bringing Court Proceedings
The dispute between Juweel Investors and the Carlyle Group (in addition to other investors)[2] revolves around Carlyle’s failure to consummate the acquisition of a 20% interest in American Express Global Business Travel, a corporate travel management services business heavily impacted by COVID-19. On May 6, Juweel brought suit seeking specific performance of Carlyle’s obligation to close, and requested an expedited trial in advance of June 30, the day the debt commitment was set to expire. Vice Chancellor Slights denied Juweel’s request for an expedited trial, in part due to Juweel’s delay in filing the suit. In denying the motion, VC Slights chastened Juweel for not seeking specific performance “at the first instance of trouble” (i.e., when Carlyle first alleged that the target business had suffered an MAE), and instead waiting almost a month before filing suit, despite the impending expiration of the debt financing commitment. VC Slights concluded that the delay in filing, taken together with the complexity of the issues, and the additional logistical challenges posed by COVID-19, made an expedited discovery, trial and ruling (to meet the financing commitment expiration date) untenable.
Specific Performance Claims in M&A Context Generally Require a Trial
Vice Chancellor McCormick similarly denied Snow Phipps’ request for an expedited proceeding in its dispute[3] with affiliates of private equity firm Kohlberg & Co. over Kohlberg’s failure to consummate the purchase of DecoPac, a leading wholesaler of cake decorations. In justifying its failure to close, Kohlberg argued, among other things, that DecoPac suffered an MAE, given the cessation of social celebratory events for the foreseeable future (negating the demand for target’s products). Snow Phipps filed its original suit and its motion to expedite on April 14 (the day regulatory approval for the transaction was obtained and—in Snow Phipps’ view—all closing conditions were satisfied). Snow Phipps requested that the court compel specific performance in advance of May 12, the day the debt commitment was set to expire. However, given buyer’s claims that the target suffered an MAE, and breached the interim operating covenants in a material way, there were factual disputes that the court would need to consider, necessitating a trial on the merit of the claims (rather than allowing for summary judgment). In denying Snow Phipps’ request for an expedited trial prior to expiration of the debt commitment on May 12, VC McCormick explained that the actions required to prepare for such a trial would include document collection, review and production, depositions, expert discovery, and preparation and submission of pre-trial briefs, and concluded that the “threatened irreparable harm to plaintiff does not outweigh the extraordinary cost of moving forward on the requested schedule.”
These decisions by the court illustrate how difficult it can be for a seller to obtain an expedited trial when there are fact-intensive claims to sort through, making it increasingly likely that the debt commitment will have expired prior to a trial on seller’s request for specific performance. Once the original debt financing has expired, a seller’s only real chance of getting to a closing is having the court require buyer to seek and obtain alternative financing, which may not be a realistic option if the target’s business has suffered significant economic losses following the execution of the original debt commitment.
Suing PE Sponsor for “Non-Retained Claims” Can Extinguish Specific Performance Remedies
A July bench ruling from Vice Chancellor Zurn illustrates additional pitfalls sellers need to be mindful of when seeking specific performance in transactions involving private equity buyers. Realogy and SIRVA, a portfolio company of Madison Dearborn Partners (or MDP), entered into a purchase agreement in November 2019, pursuant to which SIRVA agreed to acquire Cartus, a subsidiary of Realogy that provides relocation counseling. In April, SIRVA refused to close alleging that an MAE had occurred (both because Cartus had been disproportionately affected by COVID-19 and because solvency issues materially impaired Cartus’ ability to perform its post-closing obligations). In response, Realogy filed a complaint seeking specific performance of SIRVA’s obligation to close, or in the alternative if specific performance was not available, payment of the reverse termination fee.[4] Realogy’s original complaint named SIRVA and MDP as defendants, alleged material breaches of the purchase agreement by both SIRVA and MDP and sought declaratory judgment that SIRVA and MDP had breached their obligations under the purchase agreement. The decision to bring suit directly against MDP under the purchase agreement turned out to be fatal to Realogy’s request for specific performance—by virtue of two concepts that are customary in deals with debt financing and private equity-backed buyers.
First, the transaction documents provided that MDP’s equity commitment would immediately and automatically terminate if Realogy brought any claims against MDP except for claims to enforce the equity commitment and the limited guarantee in accordance with their terms. The types of claims that were prohibited by the transaction documents are commonly referred to as “non-retained claims.” Second, Realogy’s right to compel funding of the equity commitment and consummation of the closing was conditioned upon the availability of the debt financing. If the debt financing failed, Realogy’s sole remedy would be to terminate and collect the negotiated reverse termination fee.
After Realogy filed its complaint, SIRVA immediately sought a motion to dismiss Realogy’s claim for specific performance, arguing that specific performance was no longer available as a remedy because Realogy’s complaint made non-retained claims (in this case, direct claims against MDP under the purchase agreement). Realogy later amended its complaint to remove the non-retained claims, but Vice Chancellor Zurn ruled that the flaw was not curable under the terms of the transaction documents, and granted SIRVA’s motion to dismiss Realogy’s specific performance claim. By filing a non-retained claim, the equity commitment automatically terminated, which in turn caused a failure of the conditions to the debt financing and cut off SIRVA’s obligations to seek alternative debt financing. The debt financing also terminated on its own terms during the pendency of the litigation. The court found that Realogy caused this cascade of events and precluded specific performance by the clear terms of the transaction documents. The court did not dismiss Realogy’s alternative claim for payment of the reverse termination fee and scheduled a hearing for November, but the parties subsequently disclosed that they had confidentially settled the payment of the reverse termination fee.
In a narrow sense, the court’s ruling in the Realogy / SIRVA dispute was procedural and makes clear that provisions regarding non-retained claims and conditional specific performance will be enforced. In a broader sense, these types of provisions further illustrate the additional risks sellers take in transacting with private equity sponsors, against whom direct recourse can only be sought in limited circumstances. Accordingly, when seeking specific performance, it is critically important that the litigation and corporate teams work together to ensure that the suit being brought does not extinguish seller’s right to specific performance—which may be more difficult than expected considering the extreme pressure sellers are under to file suit as quickly as possible. In fact, before L Brands and Sycamore Partners agreed to terminate their transaction (also discussed in our May blog post), Sycamore filed a motion to dismiss L Brands’ claim for specific performance because L Brands’ complaint named the buyer and Sycamore (the private equity sponsor) as defendants and requested money damages in the alternative to specific performance. By naming Sycamore Partners as a defendant in a complaint that included a request for monetary damages, Sycamore argued that the equity commitment letter automatically terminated, and specific performance was no longer available as a remedy.
Illegitimate Financing Failures and the Prevention Doctrine
While the court denied seller’s request for a May trial in the Snow Phipps / Kohlberg dispute discussed above, it did schedule a November trial and heard an oral argument on buyer’s motion to dismiss seller’s request for specific performance in early August. The court has yet to issue a ruling on the motion, but the arguments made by the respective parties’ counsel underscore buyer’s leverage in these transactions. Unsurprisingly, buyer argued that specific performance of its obligation to close was not an available remedy because the debt commitment expired by its terms on May 12. In support of its argument, buyer pointed to seller’s own rationale in requesting an expedited trial (stating that seller would have no opportunity to obtain specific performance following the expiration of the debt commitment), which almost derailed the specific performance trial before it got off the ground—highlighting another potential pitfall in the quest for specific performance. Despite the contradictory positions taken by seller, VC McCormick ultimately determined that a trial on the merits was necessary.
One of the primary points of contention between the parties at the August oral argument was whether specific performance of buyer’s obligation to close was available as a remedy if the debt financing was unavailable as a result of buyer’s breach and bad faith conduct (i.e., an illegitimate financing failure).[5] In arguing that specific performance should still be available under those circumstances, seller invoked the prevention doctrine—a common law principle—which essentially says that if a contracting party caused the failure of performance, it should not be able to take advantage of that failure to excuse its own performance. Under seller’s position, buyer cannot claim that the specific performance remedy is unavailable if its own actions (in this case, by allegedly causing the debt not to be funded) made the remedy unavailable. In arguing that the prevention doctrine should not be applied, buyer notes that the purchase agreement included explicit prevention doctrine language in the termination provisions (as is customary) but not in the specific performance provisions. Regardless of how the court ultimately rules on the application of the prevention doctrine, it is hard to see how specific performance of buyer’s obligation to close could be enforced if the debt financing is unavailable, given the limited recourse against the sponsor. As is typical in these types of transactions, the buyer under the purchase agreement is a shell entity with no assets, and the sponsor cannot be required to fund any amounts in excess of the equity commitment.
Snow Phipps points the court to its decision and remedy in the Hexion / Huntsman dispute that arose in connection with the 2008-2009 financial crisis.[6] In that case, the court held that the purported termination of the acquisition agreement by Hexion (the private-equity backed buyer) was invalid after finding that Huntsman did not suffer an MAE and that Hexion’s actions were designed to sabotage the debt financing and constituted a knowing and intentional breach of the acquisition agreement. Although the acquisition agreement did not allow the court to order specific performance of Hexion’s obligation to close, the court compelled Hexion to comply with its obligations to use reasonable best efforts to obtain alternative financing and close or be subject to uncapped damages (unlike the agreements in the current disputes, the Hexion / Huntsman acquisition agreement subjected Hexion to uncapped damages in the event of its knowing and intentional breach). The court also extended the end date under the acquisition agreement (beyond the time permitted by the acquisition agreement) to determine whether the buyer had met that obligation.
As in Hexion, it would appear that the only equitable remedy available to seller in the Snow Phipps / Kohlberg dispute is to obtain specific performance of buyer’s obligation to seek alternative financing, but buyer’s obligations are generally limited in this respect. Most purchase agreements only require buyer to use alternative financing if such financing can be obtained on terms comparable[7] to that of the original debt financing—a tall order if the original debt financing terms were negotiated pre-pandemic and the target’s business has subsequently been materially impacted by COVID-19. If buyer is unable to obtain alternative financing on those terms, Snow Phipps’ alternative remedy would be to terminate the agreement and collect the negotiated reverse termination fee.
Let’s Just Settle
The risks that a court would limit a seller’s remedy to the reverse termination fee or that the buyer would not be able to secure financing to close the transaction were seemingly risks that Forescout Technologies was unwilling to take in its transaction with Advent International, a global private equity firm. In February 2019, Advent agreed to acquire Forescout for $1.9 billion. Advent was not required to fund the original equity commitment and close if it did not have debt financing in hand, and Advent’s liability for a financing failure or willful breach was capped at $112 million (or approximately 6% of the purchase price). There was an argument that the original debt commitment papers expired in June. Forescout disagreed and argued that the extension of the acquisition agreement extended the term of the debt financing commitment. Even if the court ruled in Advent’s favor, if the original debt commitment had expired (or there was an argument that it had), Forescout would have been forced to rely on Advent obtaining alternative financing. Rather than continuing to litigate, in July, Forescout and Advent announced that they were moving ahead with their transaction in exchange for Forescout agreeing to a 12% purchase price reduction and Advent agreeing to provide a full equity backstop. The parties closed their transaction on August 17.
Re-Evaluating Deal Terms and Remedies
In order to mitigate the risks highlighted by the foregoing decisions—and maximize the opportunity to obtain the deal it bargained for in transactions requiring debt financing—sellers may want to re-consider certain provisions and remedies that have become commonplace in transactions requiring debt financing.
100% Equity Commitment
In recent years it has become fairly common, particularly in middle-market transactions, to have a private equity sponsor provide an equity commitment equal to 100% of the purchase price (i.e., an equity backstopped deal). In fact, Forescout negotiated for a full equity backstop from Advent, but only as part of a price renegotiation. Sellers should continue to push for a 100% equity backstop whenever possible, understanding that it will be more difficult to obtain such a commitment from smaller sponsors or for larger transactions. If seller has more than one offer, appropriate significance should be placed on offers that promise a 100% equity commitment.
Reverse Termination Fees / Willful Breach
Given the difficulty in obtaining specific performance, sellers may be better positioned to argue for higher reverse termination fees, or a two-tier fee, with the lower fee being payable in the event of a true financing failure, and the higher fee (above the current market standard) being payable in the event of buyer’s willful breach. We may also see sellers negotiate for the ability to seek damages in excess of the reverse termination fee, or separate from the reverse termination fee, in the event of a willful breach by buyer (i.e., not a legitimate financing failure). In the current (pre-pandemic) market, sellers’ monetary damages are generally capped at the amount of the reverse termination fee, but the aforementioned Hexion / Huntsman dispute highlights the advantages of a different structure. In that dispute, the seller had negotiated for uncapped damages in the event of a knowing and intentional breach by the buyer. The transaction was never consummated following the court’s ruling, but Hexion’s exposure for uncapped damages was likely a significant factor in the eventual $1 billion settlement—an amount significantly higher than the $325 million reverse termination fee.
To enable the collection of damages in excess of the reverse termination fee, sellers will need to ensure that they have recourse against a credit-worthy entity, whether that is provided for in the limited guarantee or elsewhere. One potential downside to this construct (as opposed to a higher reverse termination fee) is that sellers would have to prove damages.
Drafting Considerations
- When negotiating buyer’s obligation to obtain alternative financing, try including a standard that does not require that the buyer obtain debt financing at the same or better interest rates and/or fees than the original committed debt financing or that provides that comparability of interest rates and terms is measured against the original committed financing assuming that it were “fully flexed”.
- Consider making it clear that the covenant to obtain alternative financing survives until the acquisition agreement is validly terminated.
- Carefully review the transaction documents to ensure that they do not exclude any potential claims against the sponsor which should be preserved, and that valid claims can still be brought without inadvertently triggering the non-retained claims provisions.
Debt Commitment Timing / Sources
Given the difficulty in obtaining specific performance in a timely manner, sellers may push for a longer period to close a transaction and a concurrently longer debt commitment (beyond the customary 120 to 180 days) to account for realistic litigation timetables. Of course, requiring buyers to secure longer-term debt commitments will likely increase commitment fees and may require a “ticking fee”, and banks may still struggle to obtain credit committee approval for a longer timetable. That said, for many acquisitions valued under $1 billion, traditional banks (which often require increased “price flex”) are losing market shares to private lenders (which may not require flex rights because they are not syndicating the debt). Private lenders tend to be more flexible than banks and some of those lenders would likely agree to a longer commitment period, but these financing sources are generally more expensive than traditional bank debt. In any event, sellers should look at the buyer’s financing sources more critically, and may want to give more weight to buyers who have direct lenders that will not need to syndicate acquisition debt.
Seller Financing
Given the likely resistance from lenders to extending the availability of the debt commitment, consider requiring the buyer to use seller financing if the original debt commitment falls through, a compromise we have seen utilized in recent deals given the uncertainty in the financing market. Under this construct the seller could retain the option to provide the seller financing and proceed to closing or terminate the agreement and collect any negotiated reverse termination fee. Seller financing will not work for all sellers and deals but could reduce the motivation that buyers may otherwise have to manufacture a financing failure under the original debt commitment in order to gain leverage to either terminate the deal or reduce the purchase price.
Bringing Suit
After the purchase agreement has been signed, sellers should be prepared to file suit as soon as it becomes clear that buyer does not intend to close the transaction. “Suing first” is not always the first instinct since sellers and buyers acting in good faith commonly try to resolve potential closing issues right up until the scheduled date for closing, but given the recent decisions from the court, and the logistical hardships posed by the pandemic, sellers may need to rethink their strategy, and bring suit as soon as possible to preserve the possibility of obtaining specific performance.
Conclusion In many respects, the current deal litigation resulting from COVID-19’s impact on certain businesses represents the first opportunity that the Delaware Chancery Court has had to weigh in on a number of provisions that have become customary in deals requiring debt financing following the 2008-2009 financial crisis. As sellers in industries impacted by COVID-19 seek to gain the benefit of the deal they bargained for, they will likely find many obstacles in their way, given the legitimate defenses a buyer may have to its obligation to close (and the time it will take a court to reach a decision on the merit of those defenses), and the difficulty in obtaining alternative financing on terms comparable to debt financing that was negotiated prior to the pandemic. Much like deal terms evolved in response to the litigation resulting from the 2008-2009 financial crisis, it would not be surprising to see a similar evolution—addressing some of the obstacles currently faced by sellers—in deal terms going forward.
Contributors
[1] The Delaware Chancery Court held an expedited three-day trial in the AB Stable / Mirae matter (AB Stable VII, LLC v. MAPS Hotel and Resorts One, LLC, et al., C.A. No. 2020-0310, Delaware Chancery Court) at the end of August. The litigation involves Mirae’s failure to consummate the sale of AB Stable’s, Strategic Hotels & Resorts, a portfolio of fifteen luxury American hotels. One of the substantive issues being argued is whether the buyer’s termination of the purchase agreement was valid due to alleged breaches by the target of its interim operating covenants to operate in the ordinary course following the onset of the pandemic. Seller argues that its actions did not violate the interim operating covenants because they were consistent with actions taken by other hotel operators. Buyer argues that there was no qualification on seller’s obligation to operate in the ordinary course consistent with past practice, and by shutting down or significantly reducing the operation of the hotel properties, seller clearly violated the covenant, regardless of what others in the industry were doing. As VC Laster indicated prior to trial: “the real question is whether an ordinary course covenant means ordinary course on a clear day or ordinary course based on the hand you’re dealt”.
[2] Juweel Investors Ltd. v. Carlyle Roundtrip, L.P, e. al., C.A. No. 2020-0338, Delaware Chancery Court.
[3] Snow Phipps Grp., LLC v. KCake Acquisition, Inc., No. 2020-0282, Delaware Chancery Court.
[4] Realogy Holdings Corp. v. SIRVA Worldwide, Inc., No. 2020-0311, Delaware Chancery Court.
[5] Seller asserted that the lenders were willing to fund on the committed terms and it was buyer who refused to close on the financing when the lenders would not accede to buyer’s requests for more favorable terms. Buyer countered that the lenders refused to fund unless the buyer agreed to less favorable terms after the target business had deteriorated as a result of the pandemic.
[6] Hexion Specialty Chemicals, Inc. v. Huntsman Corp., C.A. No. 3841-VCL (Del. Ch. Sept. 29, 2008).
[7] The standard of comparison differs from transaction to transaction depending on facts of the transaction and the leverage of the parties when negotiating the standard (e.g., terms of alternative financing must be substantially similar to that of the original debt financing; or not materially less favorable than.)
