Alert October 07, 2008

Delaware Chancery Court Issues Opinion Concerning the Application in M&A Context of MAE Condition and Covenants to Use Reasonable Best Efforts

The Delaware Chancery Court (the “Court”) issued a ruling that addressed some common M&A agreement provisions, particularly “material adverse effect” closing conditions and covenants to use “reasonable best efforts.”  The opinion highlighted the difficulty that acquirers will face in calling off merger transactions, even if difficult economic conditions have rendered the transaction inadvisable or difficult to finance.  Hexion Specialty Chemicals, Inc. v. Huntsman Corp. involved a dispute over whether the acquirer, Hexion Specialty Chemicals, Inc., a portfolio company for a large private equity group (“Hexion”), could be excused from closing its proposed acquisition of Huntsman Corp. (“Huntsman”).  The parties entered into a merger agreement in July 2007 prior to the onset of the credit crisis.  After that time, Huntsman’s financial results weakened.  Hexion asserted that it was not obligated to close the merger because a “material adverse effect” or “MAE” had occurred with respect to Hunstman.  If that were the case, Hexion would have no liability to Huntsman for such termination.  Alternatively, Hexion argued for termination of the merger agreement on the basis that the necessary financing was impossible to obtain because, post-transaction, the combined company would be insolvent.  In that situation, Hexion asserted that its liability was limited to $325 million.

First, the Court ruled that no “material adverse effect” had occurred with respect to Huntsman.  The Court held that, as the party invoking the MAE condition, Hexion bore the burden of proving that an MAE had occurred.  The weight of this burden was highlighted by the Court’s reminder that Delaware courts have never found an MAE to have occurred in the context of a merger agreement.  In the Court’s view, MAE conditions are aimed at “protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”  In other words, the adverse impact must be shown to “be expected to persist significantly into the future.”  In light of the fact that the deal was all-cash, the Court also held that EBITDA was the appropriate metric for assessing the existence of an MAE in this case, because earnings per share was dependent on a company’s capital structure and acquirers may or may not be assuming the target’s existing debt.

Second, the Court rejected Hexion’s assertion that the projected insolvency of the combined company could be a basis for terminating the agreement.  The merger agreement was not conditioned on Hexion being able to obtain its financing, i.e., there was no “financing out.”  Hexion had entered into a commitment letter with its lenders that conditioned their loan of the necessary funds on delivery of a certificate that the combined company would be solvent.  An inability to deliver such a certification would excuse the lenders from lending the funds, but did not excuse Hexion from closing the merger.

Nevertheless, under the terms of the merger agreement, Hexion’s liability to Huntsman for not closing was limited to the $325 million termination fee unless it had “knowingly and intentionally” breached the merger agreement, which the Court interpreted as the taking of a deliberate act that in and of itself constitutes a breach (regardless of whether the party knows that the action constitutes a breach).  The Court focused on Hexion’s obligation to use reasonable best efforts to obtain the necessary financing and analyzed in detail Hexion’s actions leading up to its decision to terminate the merger agreement.  Hexion was not required to ignore its own interests, but was required to consider whether it had commercially reasonable options short of termination.  The Court determined that Hexion’s failure to discuss alternatives with Huntsman constituted a failure to use reasonable best efforts and showed a lack of good faith.

The Court ordered Hexion to specifically perform its covenants but held that the merger agreement did not allow for an order to close the merger based on a strict reading of the merger agreement.  In light of the finding that it knowingly and intentionally breached the merger agreement, however, Hexion could face uncapped contract damages for not closing.