In a decision that amplifies how Delaware courts analyze material adverse effect clauses in merger agreements and examines what constitutes bad faith by a buyer, the Delaware Court of Chancery in Hexion Specialty Chemicals, Inc. v. Huntsman Corp., C.A. No. 3841-VCL, 2008 WL 4457544 (Del. Ch. Sept. 29, 2008), dealt the buyer, Hexion Specialty Chemicals, Inc., a stunning blow. The court found that the seller, chemical company Huntsman Corporation, had not experienced a material adverse effect that excused Hexion's performance of a merger agreement and that Hexion had knowingly and intentionally breached the agreement. Although the court did not order specific performance of Hexion's obligation to actually consummate the merger, it required Hexion to specifically perform its covenants related to financing and antitrust compliance and ruled that, if Hexion should fail to close, Huntsman's potential damages would not be limited to the break-up fee.

Hexion Wins Bidding Contest, Then Seeks to Avoid Its Contract Obligations

The case grew out of the successful bid by Hexion, a portfolio company of Apollo Global Management, LLC, a private equity investor to buy Huntsman in July 2007. To induce Huntsman to terminate an announced transaction with another buyer, Hexion not only offered a better price in a cash merger, but agreed to seller-favorable terms, including a narrowly tailored material adverse effect clause, no financing out, an obligation to use its reasonable best efforts to obtain the financing, a "hell or high water" antitrust compliance provision and the possibility of essentially uncapped damages if the transaction should fail to close as a result of Hexion's knowing and intentional breach.

Following announcement of the transaction, Huntsman reported several disappointing quarters. Without informing Huntsman, Hexion began laying the groundwork for excusing its performance under the merger agreement, including obtaining an opinion from an outside appraiser that following the merger, the combined company would be insolvent. In June 2008, Hexion filed suit in Delaware seeking a declaratory judgment that Hexion was not obligated to consummate the merger if the combined company would be insolvent and that Huntsman had suffered a material adverse effect. Hexion simultaneously published the insolvency opinion through a press release. Huntsman counterclaimed for a declaratory judgment that Hexion had knowingly and intentionally breached the merger agreement, that Huntsman had not suffered a material adverse effect and that Hexion had no right to terminate the merger agreement, and sought an order that Hexion specifically perform its obligations under the merger agreement.

Vice Chancellor Lamb carefully reviewed Hexion's performance in relation to the terms of the merger agreement and found for Huntsman on nearly all claims.

This Update provides key highlights of the Hexion decision and offers practical advice.

Huntsman Did Not Suffer a Material Adverse Effect

In the opinion, Vice Chancellor Lamb observed 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 court cited both In re IBP, Inc. S'holders Litig., 789 A.2d 14 (Del. Ch. 2001), and Frontier Oil v. Holly Corp., No. Civ.A. 20502, 2005 WL 1039027 (Del. Ch. Apr. 29, 2005), and added to these precedents interpretative guidance that underscores the extremely high bar faced by buyers who seek to terminate merger agreements based on the assertion of a material adverse effect.

Material Adverse Effect Carve-Outs Do Not Apply if a Material Adverse Effect Has Not Occurred. The merger agreement had a relatively standard definition of a material adverse effect: "any occurrence, condition, change, event or effect that is materially adverse to the financial condition, business, or results of operations of [Huntsman], taken as a whole." This definition had carve-outs for, among other things, changes in the chemical industry generally, other than those that would have a disproportionate effect on Huntsman as a whole compared to others in the chemical industry. Finding that the purpose of the carve-out was to prevent events that would otherwise be a material adverse effect from constituting a material adverse effect, the court adopted Huntsman's view that the carve-out requiring comparison with the chemical industry did not apply unless the court first found that Huntsman had suffered a material adverse effect.

Party Asserting the Material Adverse Effect Has the Burden of Proof. Hexion argued that Huntsman bore the burden of proof since the absence of a material adverse effect was a condition to closing rather than a representation or warranty that no material adverse effect had occurred. The court found that the burden rests with the party seeking to excuse its performance under the contract, absent clear language to the contrary. The court, in a footnote, suggested that since the allocation of the burden of proof is often dispositive, parties should contractually "allocate explicitly the burden of proof with respect to material adverse effect clauses."

Material Adverse Effect Must Generally Be Based on a Long-Term View. The court reaffirmed prior case law in holding that, in the absence of contrary evidence, "a corporate acquirer may be assumed to be purchasing the target as part of a long-term strategy." As a result, the relevant question is "whether there has been an adverse change in the target's business that is consequential to the company's long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months." "[P]oor earnings results must be expected to persist significantly into the future" to constitute a material adverse effect.

Missed Forecasts Alone Are Not a Material Adverse Effect. Hexion argued that Huntsman's shortfalls from its 2007 and partial 2008 EBITDA forecasts evidenced a material adverse effect. But the court noted that the merger agreement "explicitly disclaims any representation or warranty by Huntsman" with respect to any projections, forecasts or other estimates. Because the parties had "specifically allocated the risk to Hexion that Huntsman's performance would not live up to management's expectations at the time," Huntsman's failure to meet projections did not constitute a material adverse effect.

Regulation S-X Interpretation of "Financial Condition, Business, or Results of Operations Determines Material Adverse Effect. To interpret the terms "financial condition, business, or results of operations" in the material adverse effect definition, the court turned to Securities and Exchange Commission Regulation S-X, Item 7, and concluded that the magnitude of period-to-period changes should be measured by comparison with the prior year's equivalent quarter or year.

Huntsman's 2007 EBITDA was only 3% below its 2006 EBITDA, and 2008 would only be 7% below its 2007 EBITDA, neither of which evidenced a material adverse effect. The court found that future performance was likely to fall somewhere between Hexion's pessimistic projections and Huntsman's somewhat optimistic ones, which was consistent with analysts' expectations. Finally, the court found that Huntsman's net debt expansion of approximately 5%-6% was not large enough to establish a material adverse effect and was, in any event, consistent with Hexion's own projections, and that disappointing results at two key Huntsman businesses were either part of normal cyclicality or likely to be reversed in future periods.

Hexion Knowingly and Intentionally Breached Its Obligations

The court then methodically reviewed Hexion's actions following Huntsman's poor results to document a pattern of bad faith activity that amounted to a knowing and intentional breach of Hexion's general obligation to use its reasonable best efforts to consummate the merger and its specific obligations to obtain antitrust approvals and to use its reasonable best efforts to consummate the financing.

"Knowing and Intentional" Breach Is a Deliberate Act That Constitutes a Breach. The court rejected Hexion's argument that it could not "knowingly" breach a covenant unless it both knew of its actions and had "actual knowledge that such actions breach the covenant." The court found that a "knowing and intentional" breach is "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."

Solvency Is Irrelevant Where There Is Neither a Solvency Out Nor a Financing Out. Hexion claimed that it would be unable to consummate the merger because the combined company would be insolvent, making it impossible for Hexion to fulfill the terms of the commitment letter with its lenders and obtain financing. The court pointed out that, in Hexion's "ardor" to acquire Huntsman, it negotiated neither a financing out nor a solvency out, and could not now benefit from a comparable "out" by arguing impossibility of performance.

Hexion Committed to Use "Reasonable Best Efforts" to Obtain Financing and to Notify Huntsman of Financing Status. Instead of a financing out, Hexion agreed to "use its reasonable best efforts to take ... all actions and to do, or cause to be done, all things necessary, proper or advisable to arrange and consummate" the financing. For the court, this meant that "to the extent that an act was both commercially reasonable and advisable to enhance the likelihood of consummation of the financing, the onus was on Hexion to take that act" and that Hexion had to show that "there were no viable options it could exercise to allow it to perform without disastrous financial consequences."

Hexion was also obligated to keep Huntsman informed of "all material activity concerning the status of" the financing, and specifically whether Hexion "no longer believes in good faith that it will be able to obtain all or any portion" of the financing on the commitment letter terms. In the court's view, Hexion's failure to communicate to Huntsman its solvency concerns "both constitutes a failure to use reasonable best efforts to consummate the merger and shows a lack of good faith."

Rather than keeping Huntsman informed of its financing concerns, Hexion acted in secret to have an appraisal firm prepare the insolvency opinion. The court criticized Hexion for failing to insulate the opinion team from knowledge that Hexion was preparing for litigation, biasing its objectivity. The court enumerated the many ways Hexion skewed the facts presented to the appraisal firm: reducing Huntsman's EBITDA estimates without consulting Huntsman, adding a $102,000,000 Apollo advisory fee that had not been included in prior deal models, and factoring in nearly $400,000,000 of U.S. and U.K. pension liability payable at closing despite discussions with pension authorities suggesting such payments would be unnecessary. The skewed input resulted in a flawed document that the court ultimately found "unreliable."

Hexion Deliberately Scuttled the Financing by Publicizing the Insolvency Opinion. Hexion's most damning action was the public release of the insolvency opinion which, according to the court, Hexion "knew, or reasonably should have known, would frustrate the financing." Predictably, the lending banks conducted their own solvency analysis and agreed with Hexion that the combined company would be insolvent. Release of the opinion had the collateral negative effects of causing the three highest bidders for the assets to be divested for antitrust purposes to drop out of the bidding process, tainting the pension regulatory negotiation process by independently estimating significantly higher pension obligations and prejudicing Federal Trade Commission negotiations.

Hexion Breached Its Antitrust Obligations. Hexion agreed to "take any and all action necessary" to obtain antitrust approval for the merger, and not to take actions that "could reasonably be expected to hinder or delay the obtaining" of such approval—a "come hell or high water" obligation. Nevertheless, by the time of trial, Hexion had not received antitrust clearance, despite having agreed in principle with the FTC staff on a divestiture plan. Although Huntsman had certified its compliance with a second request from the FTC, Hexion had failed to respond to interrogatories relating to the second request. The court concluded that Hexion had been "dragging its feet" on obtaining antitrust clearance, despite its "hell or high water" commitment.

Damages Caused by Knowing and Intentional Breach Not Capped by Termination Fee. The bottom line penalty for Hexion's knowing and intentional breach was that all damages proximately caused by that breach will be "uncapped and determined on the basis of standard contract damages or any special provision in the merger agreement." Here the merger agreement provided that damages may be "based on the consideration that would have otherwise been payable to the stockholders," so Hexion's exposure could include the drop in the market price of Huntsman's stock from the merger price. The court placed the burden of determining that damages were not proximately caused by Hexion's breach on Hexion.

Huntsman Entitled to Specific Performance of All Merger Agreement Obligations Except Obligation to Consummate Merger.

The more extraordinary ruling was the court's sweeping grant of Huntsman's request for specific performance of all Hexion's covenants precedent to closing and indefinite extension of the merger agreement termination date to permit Hexion to comply with its order. The court concluded that the merger agreement "somewhat unusually" prohibited the issuance of an order specifically directing Hexion to comply with its duty to close the transaction. But the court ordered Hexion to perform all its obligations short of consummating the closing, including using its reasonable best efforts to satisfy the terms of the commitment letter and consummate the financing and enjoined Hexion and its affiliates from taking any further action "that could reasonably be expected to materially impair, delay or prevent consummation" of the financing (emphasis omitted). Finally, the court extended the termination date until five business days after the date when the court should determine that Hexion had fully complied with the terms of its order.

Following the ruling, Hexion obtained approvals for the merger from both the Federal Trade Commission and the European Union. Hexion has also received from Apollo a commitment for a $540 million capital infusion contingent on the merger and an agreement to waive its transaction fee and other fees following the merger, both of which should facilitate obtaining a solvency opinion for the combined entity.