Hexion v. Huntsman; Vice Chancellor Lamb Hammers Hexion

Vice Chancellor Lamb delivered a stunning decision on September 29, 2008, hammering Hexion Specialty Chemicals, Inc. for its conduct in seeking to withdraw from its July 2007 merger agreement with Huntsman Corp., and delivering a smashing victory to Huntsman. Not only did the Vice Chancellor reject Hexion’s claims that Huntsman had suffered a MAE since the signing of the merger agreement, but he also concludes that by its conduct in seeking an “insolvency” opinion from Duff & Phelps and publicly announcing it before making any attempt to confer with Huntsman on Hexion’s concerns about the insolvency of the combined entity, Hexion “knowingly and intentionally” breached numerous of its covenants under the merger agreement. The Vice Chancellor therefore entered an order requiring Hexion to specifically perform its obligations under the merger agreement.

It is hard to imagine a more crushing rejection of the strategy pursued by Hexion and its counsel, Wachtell Lipton, and a more rewarding victory for Huntsman and its legal strategists at Vinson & Elkins, particularly the deal team at Vinson & Elkins that drafted the merger agreement. At almost every turn in his opinion, Vice Chancellor Lamb cites language from the merger agreement demolishing Hexion’s claims. If Academy Awards were given for deal drafting, Jeff Floyd and his crew at Vinson & Elkins would take home an armful of Oscars for their work on the merger agreement.

Great opinions on complex disputes lead the reader to conclude that the decision reached obviously flows from the facts of the dispute and the applicable law. By this measure, the Vice Chancellor’s opinion is a great one. One is left with the conclusion, after reading it, that Hexion and its advisors committed a stupendous error in the path they chose to withdraw from the proposed merger with Huntsman. This decision will tarnish the reputation of some and enhance that of others. It will also become must reading for deal lawyers.

A. The Crux of the Decision

Hexion filed its declaratory judgment action in the Delaware Chancery Court on June 18, 2008. Hexion sought the court’s judgment allowing it to back out of the deal with Huntsman by paying the contractual break-up fee of $325 million to Huntsman by reason of its alleged inability to secure financing for the deal. Alternatively, it sought the court’s declaration that Huntsman had suffered a MAE by reason of a decline in its business and an increase in its indebtedness, thus allowing Hexion to back out of the deal without any payment.

Hexion argued that because it was now apparent that the combined firm would be insolvent, its lenders (Credit Suisse and Deutsche Bank) could not be expended to fund the deal. While the availability of financing was not a condition to Hexion’s obligation to close, the delivery of comfort on insolvency to the lenders is a condition to their obligation to fund, and therefore the insolvency of the combined company meant that the lenders could not be expected to fund.

Since the merger agreement provided for a break-up fee of $325 million in the event of a failure by Hexion to close, Hexion sought the Court’s imprimatur that Huntsman’s damages against Hexion be limited to that amount.

The cap on damages, limited to the break-up fee, do not, however, apply to a “knowing and intentional breach” of the merger agreement under the express terms thereof. And that is what Vice Chancellor Lamb found Hexion to have committed by its actions in seeking to withdraw from the merger agreement.

The direction in which Vice Chancellor is headed can be found from the beginning of his discussion of the merits of Hexion’s claim:

“… as Apollo’s [Hexion’s controlling shareholder] desire for Huntsman cooled through the spring of 2008, Apollo and Hexion attempted to use the purported insolvency of the combined entity as an escape hatch to Hexion’s obligations under the merger agreement.”

Slip Opinion at 61.

Here, Hexion ran into the brick wall of the merger agreement’s best efforts covenant vis à vis securing the financing from Credit Suisse and Deutsche Bank:

“(a) [Hexion] shall use its reasonable best efforts to take, or cause to be taken, all actions and to do, or cause to be done, all things necessary, proper or advisable to arrange and consummate the Financing on the terms and conditions described in the Commitment Letter, including (i) using reasonable best efforts to (x) satisfy on a timely basis all terms, covenants and conditions set forth in the Commitment Letter; (y) enter into definitive agreements with respect thereto on the terms and conditions contemplated by the Commitment Letter; and (z) consummate the Financing at or prior to Closing; and (ii) seeking to enforce its rights under the Commitment Letter. Parent [Hexion] will furnish correct and complete copies of all such definitive agreements to the Company [Huntsman] promptly upon their execution.”

Merger Agreement § 5.12(a), quoted at page 61 of Slip Opinion.

Moreover, Hexion agreed to keep Huntsman informed about its progress in nailing down the financing from Credit Suisse and Deutsche Bank:

“(b) [Hexion] shall keep the Company informed with respect to all material activity concerning the status of the Financing contemplated by the Commitment Letter and shall give [Huntsman] prompt notice of any material adverse change with respect to such Financing. Without limiting the foregoing, [Hexion] agrees to notify [Huntsman] promptly, and in any event within two Business Days, if at any time ... (iii) for any reason [Hexion] no longer believes in good faith that it will be able to obtain all or any portion of the Financing contemplated by the Commitment Letter on the terms described therein."

Merger Agreement § 5.12(b), cited at page 62 of Slip Opinion.

I first discussed this case by my post of June 28, 2008. After reciting Hexion’s securing of an “insolvency” opinion from Duff & Phelps, I questioned Hexion’s failure to confer with Huntsman:

“Why didn’t Hexion sit down with Huntsman, explain its concerns, get the lenders involved, and try to work it out?”

It was this failure that doomed Hexion. Even prior to its securing the opinion from Duff & Phelps, the Vice Chancellor questions Hexion’s failure, after it first became concerned about the insolvency of the combined entity, from complying with Section 5.12 of the merger agreement and conferring with Huntsman:

“At that time a reasonable response to such concerns might have been to approach Huntsman’s management to discuss the issue and potential resolutions of it. This would be particularly productive to the extent that such potential insolvency problems rested on the insufficiency of operating liquidity, which could be addressed by a number of different ‘levers’ available to management.”

Slip Opinion at 62 (footnote omitted).

This is not, observed the Vice Chancellor, what Hexion did. Instead, it engaged counsel (Wachtell Lipton) to “ostensibly” provide Hexion with guidance as to whether the combined entity would be in danger of being considered insolvent. The record is devastating on the procedures Hexion sought to secure such “guidance.” It compels the conclusion that the effort was pretextual, meant to support a walkaway from the merger agreement. The record includes Hexion’s retaining two different groups within Duff & Phelps, one to provide litigation consultation to Wachtell (thus cloaking it in the work product privilege) and, once that group concluded the combined entity would be insolvent, retaining a supposedly separate “opinion team” to prepare and deliver a formal “insolvency” opinion (which, the Vice Chancellor concluded, was unreliable).

Once Duff & Phelps reported back to Hexion that, based upon the projections Hexion had provided to Duff & Phelps, the combined company would be insolvent, then, under the merger agreement, “Hexion was then clearly obligated to approach Huntsman management to discuss the appropriate course to take to mitigate these concerns.” Slip Opinion at 63. Hexion, in that event, had “an absolute obligation to notify Huntsman of this concern within two days of coming to this conclusion, i.e., within two days of receiving Duff & Phelps’s initial report.” Id. at 64. Because Hexion did nothing to approach Huntsman management, that failure alone “would be sufficient to find that Hexion had knowingly and intentionally breached its covenants under the merger agreement.” Id. (footnote omitted).

But there is more. Hexion then proceeded to compound its breach by violating the negative covenant under Section 5.12(b) of the merger agreement. It did so on June 18, 2008, by the Hexion board’s adoption of the Duff & Phelps insolvency opinion and its approval of the filing of the lawsuit that same day:

“In that complaint, Hexion publicly raised its claim that the combined entity would be insolvent, thus placing the commitment letter financing in serious peril. The next day, June 19, 2008, Credit Suisse, the lead bank under the commitment letter, received a copy of the Duff & Phelps insolvency opinion from Hexion, all but killing any possibility that the banks would be willing to fund under the commitment letter.”

Slip Opinion at 66-67.

Vice Chancellor Lamb puts the nail in the coffin by quoting trial testimony from Hexion’s CEO where he admitted that providing the lenders with a copy of the lawsuit and a copy of the Duff & Phelps insolvency opinion would kill the financing, and that he, the CEO, knew that doing so would kill the financing notwithstanding his awareness of Hexion’s obligation, under Section 5.12(b) of the merger agreement, not to take any action that would be reasonably expected to materially impair, delay or prevent the financing. See Slip Opinion at 67. These are witness examinations trial lawyers dream about.

In reaching his conclusion that Hexion knowingly and intentionally breached the merger agreement, the Vice Chancellor first sets aside Hexion’s claim that Huntsman had to show not only that Hexion knowingly and intentionally took actions that in fact breached the agreement, but also that Hexion had actual knowledge that its actions breached the agreement. Not so, concluded Vice Chancellor Lamb:

“In other words, a ‘knowing and intentional’ breach, as used in the merger agreement, is the taking of a deliberate act, which act constitutes in and of itself a breach of the merger agreement, even if breaching was not the conscious object of the act.”

Slip Opinion at 59-60.

Hexion argued that, notwithstanding its obligation to use its reasonable best efforts to secure the financing, that covenant did not prevent the company or its board from seeking expert advice to rely upon in assessing its own future insolvency, or from taking actions to avoid insolvency. True, responded the Vice Chancellor, but irrelevant. Again, he returns to Hexion’s utter failure to confer with Huntsman:

“… [Hexion’s] contention from the outset of this lawsuit has been that once it determined that the combined entity would be insolvent, its obligations to Huntsman were at an end. The fact that a conference with Huntsman management to discuss these concerns would have been virtually costless only underscores the fact that Hexion made no attempts to seek out its available options. … Hexion’s utter failure to make any attempt to confer with Huntsman when Hexion first became concerned with the potential issue of insolvency, both constitutes a failure to use reasonable best efforts to consummate the merger and shows a lack of good faith.”

Slip Opinion at 74.

In my post on this case of August 4, 2008, I addressed Huntsman’s answer and counterclaim and the action it had filed in Texas against Apollo and its two principals, Leon Black and Joshua Harris. In its Texas petition, Huntsman referred to Apollo’s securing the Duff & Phelps insolvency opinion without first conferring with Huntsman “an absurdity.” “It is inconceivable,” complained Huntsman, “that if Apollo wanted to proceed with the transaction, it would not seek Huntsman’s help with the solvency opinion. But, without consulting Huntsman, Apollo delivered the report to its banks and released it to the public.”

Those were prescient comments. Given the Vice Chancellor’s finding that Hexion knowingly and intentionally breached the merger agreement, the cap on its damages for breach is blown away. Even worse for Hexion, the Vice Chancellor, in note 96 to his opinion, cites other actions taken by Hexion that damaged the deal prospects, including the effect of the lawsuit on dissuading the three highest bidders for assets of Hexion to be divested for antitrust reasons from pursuing the acquisitions, and its advertising to U.S. and U.K. pension authorities by the filing of this lawsuit the potential shortfalls in its obligation to fund future pension liabilities. Both of these consequences increased the “funding gap” cited by Hexion as one reason the financing, even if secured, would not be sufficient to do the deal, by some $200 million to $600 million. “Further, to the extent that any of the above increases in the funding gap proximately results in a failure to consummate the financing and the merger, that failure will be the result of Hexion’s knowing and intentional breach in taking the course of action that resulted in those increases.” (Emphasis added.)

And this in a footnote!

B. Huntsman Suffered No MAE

Vice Chancellor Lamb’s failure to find a MAE in Huntsman’s performance is no great surprise, given the high bar set by Vice Chancellor Strine’s 2001 decision in the IBP case (789 A.2d 14). As noted by Vice Chancellor Lamb:

“A buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close. Many commentators have noted that Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement. This is not a coincidence. The ubiquitous material adverse effect clause should be seen as providing a ‘backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term hiccup in earnings should not suffice; rather [an adverse change] should be material when viewed from the longer-term perspective of a reasonable acquirer’ [quoting IBP].”

Slip Opinion at 39-40 (citations to IBP omitted).

What is somewhat surprising is that the Vice Chancellor didn’t even get to the chemical industry carve-outs in the definition of MAE; rather, he found no MAE to have occurred in the first place, meaning no “occurrence, condition, change, event or effect that is materially adverse to the financial condition, business, or results of operations of the Company [Huntsman] and its Subsidiaries, taken as a whole; …” Merger Agreement § 3.1(a)(ii). Finding no such MAE, the Vice Chancellor had no reason to delve into the carve-outs, excusing a MAE, as so defined, except for such having a “disproportionate” effect on Huntsman compared to other chemical industry players.

Vice Chancellor Lamb engages in a detailed analysis of Huntsman’s performance in concluding that no MAE had occurred. He first concludes that, in this declaratory judgment action, the burden was on Hexion to establish a MAE, not on Huntsman to disprove one, Slip Opinion at 40-42, and this is true regardless of whether the MAE is relevant in a bring-down certificate affirming reps and warranties or as a condition to closing. He also concludes that the relevant measure is EBIDTA, and not earnings per share, at least in the context of a cash-out merger.

Hexion relied heavily upon Huntsman’s EBIDTA results versus projections. Here Hexion was, once again, slammed against the text of the merger agreement, which explicitly disclaimed any rep or warranty with respect to projections or forecasts. The Hexion/Huntsman merger agreement contained a standard limitation of reps and warranties to those expressly set forth in the merger agreement (as modified by the disclosure schedule or as disclosed in SEC-filed documents or in certificates delivered under the merger agreement), but expanded the typical language to include an express disclaimer of any representation or warranty as to the following:

“(i) any projections, forecasts or other estimates, plans or budgets of future revenues, expenses or expenditures, future results of operations (or any component thereof), future cash flows (or any component thereof) or future financial condition (or any component thereof) of the Company or any of its Subsidiaries or the future business, operations or affairs of the Company or any of its Subsidiaries heretofore or hereafter delivered to or made available to Parent, Merger Sub or their respective representatives or Affiliates; (ii) any other information, statement or documents heretofore or hereafter delivered to or made available to Parent, Merger Sub or their respective representatives or Affiliates, except to the extent and as expressly covered by a representation and warranty made by the Company and contained in Section 3.1 of this Agreement.”

Merger Agreement § 5.11(b), quoted in the Slip Opinion at page 45.

All deal lawyers should, after this decision, include such language in their deal document as a matter of course.

With this language, the Vice Chancellor refused to consider Huntsman’s purported failures to meet projections in his MAE analysis: “To now allow the MAE analysis to hinge on Huntsman’s failure to hit its forecast targets during the period leading up to closing would eviscerate, if not render altogether void, the meaning of section 5.11(b).” Slip Opinion at 46.

Another interesting aspect of the Vice Chancellor’s analysis is his reliance upon Regulation S-X, item 7, to interpret “financial condition, business, results of operations” in the definition of MAE. There terms are “terms of art, to be understood with reference to their meaning in Reg. S-X and Item 7, . . .” Slip Opinion at 47. The result of this reliance was to direct the focus upon comparable fiscal periods, i.e., year-end 2007 results to year-end 2006 results, first-quarter 2005 results to first-quarter 2004 results, and so forth.

Once this lens is used, “it becomes clear that no MAE has occurred.” Slip Opinion at 48. Using this “lens,” Huntsman’s EBIDTA shortfalls ranged from 3% to 7%, using Hexion’s numbers, and 11% using Hexion’s numbers.

Vice Chancellor Lamb also carefully analyzed and rejected Hexion’s claims that Huntsman’s increase in net debt and the asserted declines in its textile effects and pigments divisions constituted a MAE.

All in all, given that the burden was on Hexion to establish an MAE, it could not, on the record before the Vice Chancellor, do so.

C. Where Do the Parties Go from Here?

As I began my post of June 28, “[c]orporate civil litigation is all about positioning and leverage.” Huntsman has all the position and leverage now. Because of some odd and convoluted language in the merger agreement, Vice Chancellor Lamb did not specifically order Hexion to close, but rather to comply with its obligations under the merger agreement to pursue financing for the deal and to confer and cooperate with Huntsman in doing so, as well as to pursue all antitrust clearances.

So the focus will now shift to convincing Credit Suisse and Deutsche Bank to provide financing under their commitment letter, notwithstanding the Duff & Phelps insolvency opinion. In addition, Hexion will undoubtedly have to make up any “funding gap” that arises due to the breaches the Vice Chancellor found Hexion to have committed under the merger agreement.

The banks will obviously be put in a difficult position, since if they refuse to fund, that will trigger another round of litigation. This possibility is addressed in The Deal’s article on the decision of October 1. Given the likelihood of a Hexion appeal of the Vice Chancellor’s decision, delays are inevitable.

Apollo’s principals, Leon Black and Joshua Harris, must also now be concerned about the Texas case, in which they are sued for tortious interference and other misdeeds. (I would think they would also be concerned about exposure to their investors in the Apollo funds.) As the author of The Deal article speculates:

“Some arbs think Apollo has good reason to settle. If Apollo loses against the banks and does not close the deal, it faces billions of damages for the breach — probably loses Hexion — and faces damages in Texas, an arb said. So it makes sense for Apollo to try to cut a deal wherein the banks take some hit on the debt, Apollo adds some equity to the deal, and Huntsman takes a price cut, an arb said.”

Given that Huntsman is currently trading at some $8.50, obviously the market is not confident of a deal closing anytime soon at $28.

D. Kudos to the Delaware Chancery Court

Vice Chancellor Lamb oversaw a six-day trial, from September 8 through Monday, September 15. The case was submitted Friday, September 19, and the Vice Chancellor delivered his opinion and decision on September 29, ten days later. The decision is a remarkable piece of work, well written and meticulous. It really is a tour de force, and only enhances the reputation of the Delaware Court of Chancery as the forum for the resolution of business disputes.