To the interested observer of private equity, a typical leveraged buyout follows a relatively predictable sequence. Most buyouts begin with a sponsor such as KKR or Blackstone forming a limited partnership, serving as the general partner, and acquiring initial capital from investors who form the partnership’s limited partners.1 Once a target company has been identified,…
Tag: Caselaw
Denver Merchandise and “Make-whole provisions”
Earlier this year the U.S. Court of Appeals for the Fifth Circuit added another take on “make-whole provisions” in bankruptcy law when it held that, absent language to the contrary, prepayment penalties may not be included in the claims of lenders who accelerate their borrowers’ notes.1 “Make-whole provisions”, and related “no-call provisions”, are important mechanisms…
Experience and Logic?: The Strine Decision
The Strine Decision On October 23, 2013, the Third Circuit Court of Appeals declared the Delaware Chancery Court’s arbitration system unconstitutional.1 The arbitration system at issue was codified in the Delaware Code2 as well as the Rules of the Delaware Court of Chancery.3 Delaware’s program, established in 20094 provided for arbitration by a Delaware chancery…
Investment Plus What? Sun Capital and the “Investment Plus” Standard
Earlier this year, the First Circuit Court of Appeals delivered its opinion in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund1, overturning a lower court’s decision and sending lawyers in the private equity industry scrambling to make sense of it.2 In short, Chief Judge Lynch’s opinion held that, in…
Delaware Court Gives New Meaning to the Non-Disclosure Agreement
“But the road to true love seldom runs smooth, even for companies that make paving materials.” [1] This was just one of the memorable remarks from a recent Delaware Chancery Court decision, where Chancellor Leo Strine added a new twist to the way the court construes language in Non-Disclosure Agreements (“NDAs”). The opinion provides a plethora of information about NDAs and reminds law students – who may draft and negotiate these documents during their first years at a firm –that NDAs have significant strategic implications for clients and that standardized terms in these documents could be costly. Strine, in a lengthy opinion, strictly construed language in an NDA to have the effect of a standstill provision and issued an equitable remedy for the breach of the contract.[2]
This dispute began when Martin Marietta, a North Carolina aggregates corporation, entered into friendly discussions with Vulcan Materials (“Vulcan”), a large domestic aggregates corporation headquartered in Alabama.[3] Pursuant to the NDA facilitating these discussions, Martin Marietta could only use information acquired during the discussions for the purpose of considering a “business combination transaction” that was “between” the parties.[4] After discussions broke down, Martin Marietta used information it gained during the friendly talks in SEC public disclosure documents, investor calls, and press releases while it launched an unsolicited exchange offer proposing a deal of .5 shares of Martin Marietta for each Vulcan share.[5] Vulcan argued that the language in the NDA meant that any information gained from either side during the initial discussions was limited to use in “a friendly, contractual business combination between the two companies that was negotiated between the existing boards of the two companies, and that was not the product of a proxy contest or other unsolicited pressure strategy.”[6] Martin Marietta argued that the NDA allowed either side to use the information from the friendly negotiations for any type of business combination transaction between the two companies, and that Vulcan was attempting to read a standstill into the agreement even though it did not contain an explicit standstill.[7]
Strine looked to extrinsic evidence to resolve ambiguity in the contract language, focusing on Martin Marietta’s position as a potential target in the merger at the time of the NDA, and their sloppy attempts to gather and silo material gained during the friendly discussions in an effort to claim that information was not used in the hostile bid.[8] Martin Marietta’s changes to the initial NDA were “unidirectional: every one of the proposed…changes had the effect of making the NDA stronger in the sense of broadening the information subject to its restrictions and limiting the permissible uses and disclosures of the covered information.” According to Martin Marietta CEO Ward Nye’s own notes, at the time of the NDA he and his team were “interested in discussing…the prospect of a merger, but not an acquisition whether by [Vulcan] or otherwise.”[9] However, information gathered during discussions led Nye to believe there was an additional $100M each year in synergy potential above his initial estimates.[10] Nye claimed that the team evaluating the deal did not rely on any non-public information, but Strine held that once Nye had this information the deal was tainted. Any evaluation of a hostile bid at that point was an unauthentic attempt at using public information to rationalize synergy estimates derived initially from non-public information.[11]
Finally, the parties had included a clause in the NDA providing for injunctive relief in the event of breach by either side, and Strine held that “[t]he very fact that measuring the precise loss to Vulcan in terms of negotiating leverage, customer relations, and productivity loss from Martin Marietta’s misconduct is difficult to impossible is a reason why the parties’ voluntary agreement that any breach would give rise to injunctive relief should be respected and honored, not gutted by a judge, particularly of a state whose public policy is pro-contractarian.”[12] The injunction reflected the timing spelled out in the NDA restrictions and prevented Martin Marietta from making a hostile bid for four months.[13] While news reports have suggested that a renewed bid for Vulcan is on the table again because the injunction expired on September 15, 2012, the injunction has the practical effect of preventing a hostile bid for much longer.[14] The four month injunction prevented Martin Marietta from running its slate of directors at Vulcan’s June 1, 2012 annual meeting, and since only two Vulcan directors are up for election in 2013, the ruling eliminates Martin Marietta’s chances of taking control of Vulcan’s 10-member board until 2014.[15] Additionally, Vulcan’s position has now strengthened and analysts estimate that Martin Marietta would have to offer .7 shares for every share of Vulcan, a costly 40% increase above the previous bid.
Here are just a few takeaways from this decision:
You may not know your client is the target until it is too late
Vulcan entered into the initial NDA thinking it was the potential acquirer, and Martin Marietta ended up using information to turn Vulcan into the target. NDAs have the potential to enable or limit future strategic opportunities for clients, so they should not be viewed just as preliminary agreements that can be entered into without consequence.[16] The client’s position may shift based on information uncovered during friendly discussions and the thinking behind the language in the NDA should contemplate a range of potential outcomes.[17]
Establish a clean team to preserve a hostile takeover bid
Strine suggested that establishing a “clean team” may be a sufficient way to keep open the possibility of a hostile bid after friendly discussions are not fruitful.[18] Sequestering internal personnel, directors and advisors from exposure to confidential information could keep this option open, although in many cases this will not be available because senior executives need to be involved in both potential friendly negotiations as well as any potential hostile bid decisions.[19]
Do not count on a strict construction of the NDA – include a formal standstill to avoid a hostile bid
It is left for us to guess why Vulcan and Martin Marietta did not have a standstill agreement in their NDA. The most plausible reason is that neither party contemplated a hostile takeover bid. Something as simple as a friendship between executives may be a reason that parties do not include standstills in early conversations. But it’s better to be safe than sorry. Friendly relationships can easily sour during negotiations and clients concerned about a potential takeover bid would be wise to include a standstill provision. While a standstill provision may be a contentious issue, negotiating the types of information and the length of time applicable to any restrictive clauses may be a way to provide both sides what they need to fully engage in friendly discussions.[20] Additionally, the process of negotiating these items may uncover whether the other party wants to keep the hostile option on the table.
Do not forget about Injunctive relief
Delaware law allows parties to stipulate elements of a compulsory remedy.[21] While the injunctive relief in this case mirrored the initial timelines set in the NDA on restrictive use of information, there is no guarantee that the court will stick to timelines provided in the NDA when it comes to injunctive relief. Chancellor Strine noted that Vulcan’s request for relief was for the minimum period, and that a longer injunction may have been justified by the pervasiveness of the breaches.[22] It is plausible that the court in future cases could extend injunctive relief for up to a year beyond the NDA timing for the purpose of preventing a party from running directors at an annual meeting, which could then have longer-term implications for gaining board control depending on the timing of board elections.
Think early and often about framing the executive storyline
Strine staged the legal analysis with an extensive account of the facts and particular emphasis on Ward Nye, Martin Marietta’s CEO. Strine noted that “Nye was not at all anxious to find his chance to be a CEO lost in a large synergistic merger, which was a possibility depending on the relative negotiating and financial strength of Vulcan and Martin Marietta in merger talks.”[23] He also noted that “Nye’s own desire to be CEO and to have the headquarters in Raleigh was simply a selfless manifestation of his and Lloyd’s obviously superior management approach and the undisputed fact that an aggregates company should be closer to ACC basketball than SEC football.”[24] Further, Strine wrote “Nye did not want to be demoted, even during a transition period, and evinced a willingness to forego a 20% premium for Martin Marietta stockholders in the exchange ratio to ensure he was slotted as CEO right away.”[25] As if that were not enough, Strine added in a footnote that “[t]he Chinese concept of face is a good one for effective negotiators and public figures to keep in mind. Nye and Lloyd [Martin Marietta’s CFO] seemed to have had the same grasp of that concept as the self-engraved chosen one.”[26] While Strine’s legal analysis regarding ambiguity focused on the circumstances leading to the NDA, we can wonder to what extent the court’s image of Nye may have played a role behind the scenes.
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[1] Martin Marietta Materials, Inc. v. Vulcan Materials Co., 2012 WL 5257252, at *15 (Del. Ch. May 4, 2012) aff’d, 45 A.3d 148 (Del. 2012) and aff’d, 254, 2012, 2012 WL 2783101 (Del. July 10, 2012), as corrected (July 12, 2012).
[2] Jonathan M. Grandon & Christina Bergeron, New Guidance on Confidentiality Agreements, 4 Fin. Fraud L. Rep. 607, 609 (2012). A traditional standstill provision expressly prohibits a party from pursuing any alternative acquisition of its securities or attempting to exert any control over its management or board of directors for a set time period.
Jahangier Sharifi, et al., The Accidental Standstill, Richards Kibbe & Orbe LLP (July 20, 2012), http://www.rkollp.com/assets/attachments/The%20Accidental%20Standstill.pdf.
[3] Martin Marietta Materials, Inc., 2012 WL 5257252 at 1-2.
[4] Id, at 3.
[5] Id, at 3, 25.
[6] Id, at 3.
[7] Id, at 4.
[8] Martin Marietta Materials, Inc., 2012 WL 5257252 at 36-37.
[9] Id, at 37.
[10] Id, at 14.
[11] Id, at 19.
[12] Id, at 58.
[13] Martin Marietta Materials, Inc., 2012 WL 5257252 at 58.
[14] Tara Lachapelle & Thomas Black, Martin Marietta Seen Bumping Vulcan Bid: Real M&A, Businessweek (Sept. 18, 2012), http://www.businessweek.com/news/2012-09-18/martin-marietta-seen-bumping-vulcan-bid-real-m-and-a.
[15] Martin Marietta Materials, Inc., 2012 WL 5257252 at *58; Fraud Report 609.
[16] Marc Kushner & Medard T. Fischer, Corporate E-Review: Strategic Lessons Arising From Canadian and U.S. Judicial Consideration of Confidentiality Agreements, JDsupra.com (October 17, 2012), http://www.jdsupra.com/legalnews/corporate-e-review-strategic-lessons-ar-71002/.
[17] Jonathan M. Grandon & Christina Bergeron, New Guidance on Confidentiality Agreements, 4 Fin. Fraud L. Rep. 607, 612 (2012).
[18] Martin Marietta Materials, Inc., 2012 WL 5257252 at *17
[19] Marc Kushner & Medard T. Fischer, Corporate E-Review: Strategic Lessons Arising From Canadian and U.S. Judicial Consideration of Confidentiality Agreements, JDsupra.com (October 17, 2012), http://www.jdsupra.com/legalnews/corporate-e-review-strategic-lessons-ar-71002/.
[20] Id.
[21] Jonathan M. Grandon & Christina Bergeron, New Guidance on Confidentiality Agreements, 4 Fin. Fraud L. Rep. 607, 611 (2012).
[22] Martin Marietta Materials, Inc., 2012 WL 5257252 at *59
[23] Id. at *5
[24] Id. at *17
[25] Id.
[26] Id. at *17 n.80
Private Equity in India
Since the enactment of economic reforms in the early 1990s, India has experienced a period of rapid economic growth.[1] On average, GDP has grown over 7% per year since 1997,[2] making India one of the world’s fastest growing economies. In 2004, investors began seeing opportunities for private equity investment,[3] and the market grew from $6.6 billion in 2005 to $55.8 billion in 2007.[4] Despite taking a major hit in response to the economic crisis, investment grew back steadily through early 2011,[5] at which point India had the fastest growing private equity market in Asia.[6] However, towards the end of 2011, investment began trending downward and has languished ever since.[7] Unfortunately, this is due at least in part to the Indian government’s inconsistent policies, which have created regulatory uncertainty among foreign investors.
In January of 2012, the Supreme Court of India held that the Indian government may not tax capital gains from indirect transfers of capital assets located in India, an issue over which there had been much confusion.[8] The suit began after Vodafone, a Netherlands company, had purchased CGP Investments Ltd. (CGP), a company based in the Cayman Islands.[9] CGP’s main asset was an interest in Hutchison Essar Limited (HEL), based in India.[10] Under Section 9 of India’s Income Tax Act, a non-resident must pay tax on income arising through “transfer of a capital asset situate[d] in India.”[11] India’s tax authorities contended that this section applied to Vodafone, claiming that Vodafone’s acquisition of CGP was equivalent to a transfer of shares of HEL to Vodafone. Therefore, the government insisted that Vodafone owed taxes on capital gains derived from the acquisition of HEL.[12] The Supreme Court disagreed, holding that Section 9 did not cover indirect transfers of capital assets situated in India.[13] The case set an important precedent for a number of foreign investors whose deals were structured similarly to Vodafone’s, and provided clarity for others who were hesitant to invest due to the legal uncertainty of the pending case.[14] Unfortunately, the issue was once again opened in March of 2012, thanks to the Indian Financial Minister’s proposal of new tax rules. The proposal would enact General Anti-Avoidance Rules (GAAR),[15] making transactions between international companies with Indian subsidiaries liable for a domestic capital gains tax.[16] GAAR would “effectively overturn[]” the Supreme Court’s decision in the Vodafone case.[17]
The Financial Ministry’s proposal sparked massive uncertainty. GAAR would be retroactive through April 1st, 1962, creating the potential for many cases, including Vodafone’s, to be re-examined.[18] In addition, the outcome of several pending cases regarding M&A deals between international companies that hold Indian subsidiaries is once again uncertain.[19] Moreover, GAAR created further uncertainty among those who might have been planning to invest in Indian companies through deals structured similarly to Vodafone’s.[20] To assuage investor concerns, India’s Prime Minister issued a statement in June of 2012 saying GAAR would not be finalized without his approval.[21] The Prime Minister is expected to soften GAAR’s impact on investors, but exactly how he will do so is still unclear.[22]
The recent actions of the Government of India are problematic for two reasons. First, they re-open the issue of whether the Indian government may tax capital gains from indirect transfers of capital assets situated in India. Hopefully, the Indian government will soon clarify what GAAR’s practical effects will be, and resolve the matter once and for all. Second, even if the Indian Government resolves the GAAR issue in favor of investors, they have now set an example to the world that the law of India is volatile. Private equity deals are carefully structured to gain benefits from whatever legal systems they are subject to, so the fact that India’s laws seem to be constantly in flux is highly discouraging to anyone looking to acquire Indian companies. If the country wants any sort of private equity market, it must find a way to rebuild investors’ confidence in the stability of India’s laws. At any rate, it will not be easy to do so before Indian private equity investment falls even further.
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[1] Central Intelligence Agency, Economy: INDIA, The World Factbook, https://www.cia.gov/library/publications/the-world-factbook/geos/in.html#Econ (last visited Oct. 27, 2012). See also T.C.A. Anant & N.L. Mitra, The Role of Law and Legal Institutions in Asian Economic Development: The Case of India 4, 57 (Harvard Institute for International Development 1998).
[2] Central Intelligence Agency, supra note 1.
[3] Malini Goyal, PE: The story of greed, boom and the fall of private equity in India, The Econ. Times (May 17, 2012), http://articles.economictimes.indiatimes.com/2012-05-17/news/31749390_1_pe-firms-pe-investments-subbu-subramaniam.
[4] Deloitte, Private Equity: Fueling India’s Growth 6 (2012), available at http://www.deloitte.com/assets/Dcom-India/Local%20Assets/Documents/Thoughtware/Private%20Equity.pdf.
[5] Id.
[6] Id. at 4.
[7] Id. at 6.
[8] Vodafone International Holdings B.V. v. Union of India & Anr., (2012) __ S.C.R. __ (India), available at http://judis.nic.in/supremecourt/imgs.aspx.
[9] Id. at ¶ 2 (India), available at http://judis.nic.in/supremecourt/imgs.aspx.
[10] Id.
[11] Id. at ¶70.
[12] Id. at ¶ 71.
[13] Id.
[14] Amol Sharma and R. Jai Krishna, Vodafone Overturns Tax Bill in India, Wall St. J. (Jan. 21, 2012), http://online.wsj.com/article/SB10001424052970204616504577172152700710334.html.
[15] 5 Facts About the General Anti-Avoidance Rule (GAAR), NDTV Profit, http://profit.ndtv.com/news/market/article-5-facts-about-the-general-anti-avoidance-rule-gaar-300693 (last updated May 14, 2012, 19:27 (IST)).
[16] James Crabtree, India to Change Tax Law After Vodafone Case, Fin. Times, http://www.ft.com/intl/cms/s/0/d9d96cde-6f59-11e1-9c57-00144feab49a.html#axzz2ASEttu4q (last. updated Mar. 16, 2012 8:32 PM). Language in the amendments seems to be specifically targeted at the Vodafone decision. One of the explanatory notes reads, “[A]n asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India.” Crabtree, supra.
[17] Crabtree, supra note 15.
[18] Crabtree, supra note 15.
[19] Crabtree, supra note 15.
[20] After Vodafone, GAAR; PM Takes Charge of Finance Ministry, The Times of India (June 30, 2012, 2:16 AM IST), http://timesofindia.indiatimes.com/business/india-business/After-Vodafone-GAAR-PM-takes-charge-of-finance-ministry/articleshow/14513903.cms.
[21] Id.
[22] FE Bureau, PM Moves to Soften GAAR, Vodafone Blow, Fin. Express (June 29, 2012, 32:00 IST), http://www.financialexpress.com/news/pm-moves-to-soften-gaar-vodafone-blow/968019/0 See .also FinMin May Amend GAAR Rules to Boost Investor Confidence, Firstpost (Oct. 2, 2012), http://www.firstpost.com/economy/finmin-may-amend-gaar-rules-to-boost-investor-confidence-476521.html
LLC Fiduciary Duties in Delaware Private Equity and Venture Capital
In its January 27th decision of Auriga Capital Corp. v. Gatz Properties, LLC, the Delaware Chancery Court put to rest any ambiguity in its reading of the Delaware LLC Act as it applies to establishing default fiduciary duties in the LLC context. (1) Although the topic had been addressed in a number of recent cases, none approached the depth and breadth of analysis exhibited by the Court in Auriga. (2) In his opinion, Chancellor Strine definitively establishes that a manager or member of an LLC owes the default duties of care and loyalty to all other members, unless an LLC agreement effectively expands, limits, or eliminates these duties.
Auriga Capital v. Gatz Properties
The dispute in Auriga centered on Gatz Properties, LLC’s management of property held by Peconic Bay, LLC. William Gatz, as the sole actor for Gatz Properties, formed Peconic Bay with Auriga Capital Corporation in order to develop land held by the Gatz family into a golf course. Peconic Bay then leased the golf course land from Gatz Properties. While the LLC Agreement required dual class majority approval for any “major decision affecting the company,” Gatz was effectively able to approve his own decisions as Manager without interference from minority members due to majority control of both the A and B Peconic share classes by Gatz Properties and the Gatz family.
Gatz made and approved such a “major decision” when he chose to perform a sale of Peconic, which ultimately led to a dispute with Auriga and other minority owners of Peconic Bay. In 2010, after the underperforming golf course operator with a sublease on the property chose to exercise its early termination option, Gatz turned away a serious bidder for Peconic Bay and orchestrated a sham auction. Gatz was the only bidder for the company, and purchased Peconic Bay at an unfairly low price. The minority members, whose invested capital amounted to $725,000, received a paltry $20,985 distribution from the sale. This led them to file suit and claim Gatz breached his fiduciary duties.
At trial, Gatz raised various defenses. However, of particular interest was his assertion that the LLC Agreement of Peconic Bay “displaced any role for the use of equitable principles in constraining the LLC’s manager,” and thus removed his actions from any fiduciary duty analysis. The Court rejected this argument, however, and affirmatively determined the existence of default restrictions on the actions of a managing member of an LLC beyond the requirements of good faith and fair dealing.
Existence of Default Duties
Like the Delaware General Corporation Law (“DGCL”), the LLC Act (the “Act”) does not plainly state the fiduciary duties of care and loyalty apply by default to managers and members of an LLC. However, unlike the DGCL, 6 Del. C. § 18-1104 of the Act provides an explicit default application of the “rules of law and equity.” Do those rules of law and equity include the duties of care and loyalty? Footnote 34 of Auriga explains they do.
That § 18-1101(c) provides for the contracting out or modification of fiduciary duties implies these duties exist by default. The Court goes on to explain that when §§ 1101(c) and 1104 are read together, these sections establish that when a manager or member would traditionally owe fiduciary duties, they are a fiduciary and are subject to the express right of the parties to contract out of those duties. So far as a manager or member would not owe fiduciary duties under traditional equitable principles, they do not owe any in the LLC context. This is not by operation of the Act, but by those same traditional equitable principles. The Act does not create a broader range of duties.
The Court also pointed to the 2004 amendment of the Act (in addition to the amendment of Delaware Revised Uniform Limited Partnership Act (“DRULPA”)) by the Delaware Legislature. The amendments were instigated by a Delaware Supreme Court holding in Gotham Partners L.P. v. Hallwood Realty Partners L.P, which questioned the extent to which default duties could be completely eliminated in the partnership context. (3) Both the Act and DRULPA were reworded to permit the complete elimination of fiduciary duties, as well as full contractual exculpation for breaches (through the introduction of §18-1101(e) for LLCs).
The Court in Auriga reasoned if the “equity backdrop” did not apply to LLCs then: 1) the amendment would have provided that members and managers owed no duties to the LLC other than those set forth by agreement or in the statute; 2) the General Assembly would have eliminated or modified the default application of the rules of law and equity in §18-1104; and 3) the General Assembly would not have provided for the elimination and exculpation of something if that something did not exist. These factors combined with the case law establishing the existence of default duties in the LLC setting and the policy concerns surrounding displacement of a widespread investor belief in the same, firmly established, in the Court’s mind, the alignment of those holdings and the legislature’s intent.
Outcome of Auriga
The Court determined, and Gatz conceded, as an LLC manager without clear and unambiguous elimination or modification in the LLC Agreement, Gatz owed the other members of Peconic Bay the fiduciary duties of care and loyalty. The Court then determined that:
“Gatz breached his fiduciary duty of loyalty and his fiduciary duty of care by: (1) his bad faith and grossly negligent refusal to explore any strategic alternatives for Peconic Bay from the period 2004-2005 forward when he knew that American Golf would terminate its lease; (2) his bad faith refusal to consider RDC’s interest in a purchase of Peconic Bay or a forward lease; (3) his bad faith conduct in presenting the Minority Members with misleading information about RDC‟s interest and his own conduct in connection with his buyout offers in 2008; and (4) his bad faith and grossly negligent conduct in running a sham Auction process that delivered Peconic Bay to himself for $50,000. The results of this conduct left the Gatz family with fee simple ownership of the Property again, a Property that had been improved by millions of dollars of investments and now contained a clubhouse and first-class golf course. The Minority Members got $20,985.” (4)
Chancellor Strine awarded the minority members what they should have received in a fair auction: their initial investment of $725,000 and a 10% return. He deemed this “a modest remedy and the record could support a higher one.” Additionally, because the “record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue,” Strine required Gatz to pay one half of the minority’s attorneys’ fees and costs. If the manager or a member of an LLC wants a lesson on what not to do, this case is a very instructive read.
Key Takeaways for Private Equity and Venture Capital
In reflecting on Auriga, drafters and parties to LLC Agreements should find some comfort in the relative certainty the holding provides. In drafting their LLC Agreements for Management Company, General Partner, and Portfolio LLCs, parties should ensure their Agreements clearly and unambiguously reflect their intentions as to the types and extent of duties they intend to apply between members and management. Some key takeaways include:
• The traditional duties of loyalty and care apply by default to Delaware LLCs.
• A manager of a Delaware LLC is a fiduciary and subject to those default duties.
• Such duties may be altered or eliminated and liability exculpated by clear and explicit agreement under the LLC Agreement.
• Evaluation of fiduciary duty claims “cannot occur without a close examination of the LLC agreement itself.”
• The duties of good faith and fair dealing, as they exist independently from the duty of loyalty, apply to all LLCs and cannot be contracted around.
• LLC agreements in existing Private Equity and Venture Capital investments should be evaluated for clarity in any desired modification of fiduciary duties, with necessary amendments made to bring them in line with the intentions of the parties to the agreement in light of the Court’s clarifications.
1- Auriga Capital Corp. et al v. Gatz Properties, LLC et al, C.A. 4390-CS (Del. Ch. Jan. 27, 2012).
2- See Kelly v. Blum, 2010 WL 629850 (2010), Bay Ctr. Apartments, 2009 WL 1124451 (2009).
3- Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160 (Del. 2002).
4- Auriga, C.A. 4390-CS at 62.
Private Equity Firms Continue to Utilize Material Adverse Effect Provisions as a Device to Force Sellers to Renegotiate Agreements
A Material Adverse Effect (“MAE”) is a provision that is included in a negotiated agreement to allocate risk between a buyer and seller during the period separating signing and closing. A pro-buyer MAE will provide the buyer with the ability to walk away from a transaction if there is a material adverse effect; whereas, a pro-target MAE will make closing of the deal fait accompli.
An example of the standard MAE is: “There shall not have occurred a Material Adverse Effect on the Company.” Consequently, the provision acts as a mechanism to protect the buyer from the occurrence of unknown events, which threaten the long-term health of the seller’s business. Sellers, however, will want to attenuate the provision’s applicability by requiring there to be certain carve-outs. For example, the seller may exclude from the definition of a MAE “Acts of God, earthquakes, hostilities, acts of sabotage or terrorism or military actions or any escalation or material worsening of any such hostilities, acts of sabotage or terrorism or military actions.”1 Otherwise buyers would be able to walk away from a deal under their own economic discretion.
Indeed, the chronological progression of MAE disputes have become all too predictable over the course of the past decade: (1) a buyer and seller reach a negotiated agreement that includes a MAE; (2) the buyer walks away from the agreement claiming that there has been a material adverse effect as a result of a change to the sellers business, assets, liabilities, operations, conditions or prospects; (3) the seller files suit asserting that the buyer improperly terminated the binding agreement; and (4) instead of progressing through trial, the buyer and seller renegotiate the purchase price (or some other remedy that is favorable to the buyer’s position), resulting in a settlement and dismissal of the lawsuit.
This is precisely what happened in In re Innkeepers USA Trust v. Cerberus Series Four Holdings2, which follows the recent trend of private equity firms using MAEs as an effective tool to force renegotiation and strike better deals for its stakeholders.3 Innkeepers filed suit against Cerberus and Chatham on August 29, 2011 for walking away from its $1.12 billion deal to purchase multiple hotels owned by Innkeepers. In Cerberus’ answer, it claimed there was a material adverse effect because of the “adverse changes in the debt and equity markets.” Nevertheless, the parties reached a settlement agreement on October 19, 2011, which resulted in a decrease of the purchase price by $180 million.
By settling the case, the judiciary– in this instance, the United States Bankruptcy Court for the Southern District of New York – is once again left unable to interpret another MAE provision. Such judicial interpretation is important for elucidating MAEs and clarifying when a buyer can successfully invoke a material adverse effect to walk away from a negotiated agreement. A small number of cases involving the interpretation and application of MAEs have been litigated from start to finish.4 To date, the Delaware courts have never found there to be a material adverse effect in the specific context of a merger agreement.
The question, therefore, is what is a MAE’s true purpose? This is a valid query since, in most cases, invoking a material adverse effect will be futile due to the fact that a court is highly unlikely to find that one has occurred. In a recent survey, Nixon Peabody identified that the use of MAEs in publically filed agreements consisting of asset purchases, stock purchases, and merger agreements, increased from 93% to 96% between June 1, 2010 and May 31, 2011.5
This undoubtedly demonstrates that, post the financial turbulence in 2007-2009, buyers, such as Cerberus and Chatham, are still negotiating for MAEs to use as leverage – in effect, arming themselves with a quasi-mulligan to renegotiate the agreement. Forcing a seller to litigate whether the buyer is entitled to invoke a material adverse effect is extraordinarily costly.
Consider the magnitude of the expense a seller would incur if it were to engage in full-scale discovery to prove the non-existence of a material adverse effect. There would be depositions of integral executives, which would contribute to a lack of productivity and presumably decrease the value of the firm; there would be a battle of highly expensive experts explaining, in their opinion, why or why not a material adverse effect occurred to the target; and there would be an unimaginable amount of documents produced in order to prove or disprove the claim. Therefore, in most cases, the economically prudent firm will simply renegotiate the purchase price to save the headache, expense, and, not to mention, expedite the efficient closing of the transaction so that new strategies can be effectively implemented.
Although Nixon Peabody reports that the current economic environment provides attractive sellers with a lot of leverage in the negotiation of MAEs (which is evidenced by the 23% increase in the use of definitional carve-outs), firms, such as Cerberus and Chatham, are still able to utilize MAEs as leverage to renegotiate deals. It is worthwhile to note that Inkeepers was in Chapter 11 during the negotiations; therefore, it certainly was in a weak position and not an attractive target. The actual MAE was heavily favored toward Cerberus. Nevertheless, the case demonstrates that MAEs continue to be of value to buyers.
A significant portion of the MAE puzzle remains to be filled-in by the courts. As a result, many questions persist: How much longer will targets endure this strategy? Are targets utterly defenseless? Are there any defensive measures that sellers can adopt to counter its inherent vulnerability? If one thing is for certain, however, firms such as Cerberus and Chatham are still negotiating for MAEs and reaping the economic benefits.
1 See, e.g., Weil Briefing: MAC/MAE Provisions. ↵
2 In re Innkeepers USA Trust v. Cerberus Series Four Holdings, Case No. 11-02557. ↵
3 Such as Bain Capital’s acquisition of Home Depot’s wholesale supply unit or KKR and Goldman Sachs termination of the transaction with Harman International and taking it private. ↵
4 IBP, Inc. v. Tyson Foods, Inc. 789 A.2d 14, 54-55 (Del. Ch. 2001) (where the Delaware Chancery Court, applying New York law, stated that MAE clauses are to be construed narrowly against the party invoking the clause); Genesco v. Finish Line, Inc., No. 07-2137-II(III) (Tenn. Ch., Dec. 27, 2007) (where the Tennessee Court of Chancery found that the buyer failed to demonstrate the existence of a MAE because the genesis of the target’s financial deterioration was the result of general economic conditions, which was expressly carved-out); Hexion Specialty Chemical, Inc. v. Huntsman Corp., 965 A.2d 715, 738-739 (Del. Ch. 2008) (where the Delaware Chancery Court stated that the party claiming the material adverse effect bears a heavy burden of proof and emphasized that successfully demonstrating one has occurred is extremely difficult). ↵
5 Nixon Peabody’s 10th Annual “Study of Current Negotiation Trends Involving Material Adverse Change Clauses in M&A Transactions”. ↵