No MAE Occurred Based on Merger Agreement Carve-Out
On December 27, 2007 the Tennessee Chancery Court ordered sportswear retailer Finish Line, Inc. (FINL.O), to complete its purchase of Tennessee-based shoe and hat retailer Genesco, Inc. (GCO.N), as contemplated by a merger agreement offering $54.50 per share for a total purchase price of $1.5 billion.
Finish Line and UBS, which had proposed to finance the deal, cited events amounting to a Materially Adverse Effect ("MAE"), as well as fraudulent inducement and securities fraud by Genesco, in an attempt to back out of a deal that was looking increasingly like a losing proposition for the acquirers. Chancellor Lyle found that there was an MAE that was excepted from excusing performance by the general economic and general industry conditions carve-outs in the merger agreement. She ordered specific performance in reliance solely on Tennessee principles of equity rather than citing the merger agreement provision requiring it.
The MAE provision in the merger agreement contained several carve-outs, including exceptions for a downturn due to general economic conditions or general industry conditions:
"’Company Material Adverse Effect" shall mean any event, circumstance, change or effect that, individually or in the aggregate, is materially adverse to the business, condition (financial or otherwise), assets, liabilities or results of operations of the Company and the Company Subsidiaries, taken as a whole; provided however, that none of the following shall constitute, or shall be considered in determining whether there has occurred, and no event, circumstance, change or effect resulting from or arising out of any of the following shall constitute, a Company Material Adverse Effect: … changes in the national or world economy or financial markets as a whole or changes in the general economic conditions that affect the industries in which the Company and Company Subsidiaries conduct their business, so long as such changes or conditions do not adversely affect the Company and the Company Subsidiaries, taken as a whole, in a materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate…"
Relying on expert testimony regarding the downward turn of Genesco’s 2007 financial performance, including analysis from expert M&A attorneys testifying as to professional customs, standards and interpretation in drafting MAE provisions, Chancellor Ellen Hobbs Lyle stated that the analyses were "dispositive of the MAE issue," because Genesco’s decline was due to "general economic conditions such as higher gasoline, heating oil and food prices, housing and mortgage issues, and increased consumer debt loads," and therefore came within the MAE carve-outs of changes in general economic conditions and industry conditions.
The court found that Finish Line and UBS ailed to prove that Genesco had fraudulently induced Finish Line to enter into the merger agreement or that Genesco had committed securities fraud. With expressions of interest in Genesco from Foot Locker and six private equity firms in its back pocket, Genesco negotiated a provision (Section 3.24) of the merger agreement effectively stating that it had no affirmative contractual duty to provide information, even that relating to its financial performance, nor did it have liability with respect to information not specified in its representations and warranties. The court found that Section 3.24 and the parties’ due diligence procedures put the onus on Finish Line to renew all requests for information until such information was provided.
To make the determination that specific performance of the merger was warranted, Chancellor Lyle’s opinion relied on Tennessee principles of equity and did not cite to the clause in the merger agreement requiring it (Section 9.9). The court concluded that the merger "has a reasonable chance of succeeding" based again on expert testimony, and that "specific performance is not a futile, harsh result."
On December 21, the Chancery Court came to an opposite conclusion, denying specific performance in the Cerberus-United Rentals decision ("URI"). Chancellor William Chandler found that the Cerberus affiliates had made clear that they understood the agreement to eliminate any right to specific performance. URI either knew or should have known of their understanding, and had an affirmative duty to rectify the understanding. There was another remedy available: a $100 million reverse termination fee.
Hit particularly hard by the credit industry woes, UBS sued both Finish Line and Genesco in New York in October for relief from its obligation to fund the deal. Chancellor Lyle stated in her opinion that if the New York court finds the merger would result in an insolvent entity, the merger will be halted. In the meantime, Finish Line is considering an appeal of the Tennessee court order.
Companies finding themselves in Finish Line’s shoes are not likely to agree with Chancellor Lyle that specific performance is not a futile, harsh result. Specific performance can create an unhappy, unprofitable business combination and is often treated by courts reviewing troubled M&A deals as an "extraordinary remedy," as Delaware’s Vice Chancellor Noble described it in a recent case, to be awarded only if there is no other adequate remedy.
In light of recent decisions such as the URI decision and the prevailing view that specific performance is an extraordinary, and perhaps even harsh, remedy, the Genesco decision may not indicate an increased likelihood that specific performance will be awarded for M&A deals outside of Tennessee. The decision does serve as a reminder that choice of law and forum clauses do matter and should be carefully negotiated and considered when a merger agreement is drafted. Skilled M&A counsel should be aware of the implications of choice of law and forum and be prepared to raise the issue with clients.
Another way to possibly avoid the imposition of what could be an untenable business combination is to engage skilled M&A legal counsel to draft the merger agreement, including provisions providing for remedies other than specific performance when specific adverse circumstances arise, as in URI, thereby narrowing the instances in which specific performance can be sought and making it more difficult to prove there can be no adequate remedy at law.
Finally, the Genesco case shows that nothing can take the place of conducting detailed and thorough due diligence to identify potential risks, and of responding to those risks by including effective contractual protections in MAE and other merger agreement provisions.