Once Upon an M&A

Suellen W. Bergman, Powell Goldstein LLP

Oil and water don't mix. But how about oil and oil? Not always.

Two mid-sized petroleum refiners, Frontier Oil Corp. and Holly Corp., began merger discussions. They shared a vision for their future combined business and tremendous enthusiasm for the merger, and soon the parties agreed to merge. Under the terms of the merger, the Holly Corp. shareholders were entitled to receive shares of Frontier Oil's stock plus approximately $11 per share in cash. The aggregate purchase price was $450 million.

However, before the deal could close, Wainoco, a Frontier Oil subsidiary, was sued several times. These lawsuits, initiated by activist Erin Brockovich, alleged that Wainoco's oil wells caused cancer in people living near the wells.

Holly Corp. became concerned about the effect that the Wainoco litigation might have on Frontier Oil's stock price. Holly believed that the lawsuits against Wainoco created so much risk and uncertainty that it could substantially weaken Frontier's financial condition. In other words, the lawsuits would have a material adverse effect on Frontier Oil's prospects.

Efforts to negotiate a restructured transaction to avoid the effects of the California litigation ended when Frontier Oil initiated a lawsuit against Holly Corp. alleging that Holly had reneged on the deal. Frontier alleged that Holly had sought to renegotiate the deal to obtain better economic terms and not as a result of any effect that the toxic tort litigation might have on Frontier Oil's stock price.

After months of renegotiations, Holly Corp.'s chairman called Frontier and stated that Holly would not proceed with the merger under the terms and conditions set forth in the merger agreement; Frontier Oil claimed that this phone call constituted an anticipatory breach.

Delaware's Court of Chancery ruled that Frontier Oil had breached the merger agreement by ceasing all efforts to merge, by declaring that Holly Corp. had repudiated the contract, and by filing the lawsuit. The court also ruled, however, that Holly was not damaged as a result of Frontier's actions and was entitled to only nominal damages.

The court also addressed Holly's position that the potential effect on Frontier Oil of the toxic tort litigation would have excused Holly Corp.'s performance under the merger agreement.

A key reason the parties did not merge was the risk and uncertainty inherent in the environmental class action litigation. The court thus examined whether this litigation constituted a material adverse effect so that it would trigger a "material adverse effect" clause present in the merger agreement and permit Holly Corp. to walk away from the merger.

The court first noted that the parties had defined "material adverse effect" in the merger agreement: "'Material adverse effect' with respect to Holly Corp. or Frontier Oil shall mean a material adverse effect with respect to (A) the business, assets and liabilities (taken together), results of operations, conditions (financial or otherwise) or prospects of a party and its subsidiaries on a consolidated basis . . . ." The court determined that this language was merely a starting point for determining if something is a material adverse effect.

The lawyers who drafted the merger agreement had the benefit of the analysis in In re IBP Inc. Shareholders Litigation (IBP), 789 A.2d 14 (Del. Ch. 2001), a Delaware case applying New York law. The court concluded that there was no reason why the law of Delaware should be different from the New York law applied in IBP, which held that "Material adverse effect [provisions] should be material when viewed from the longer-term perspective of a reasonable acquirer."

The court applied the IBP standard in the Frontier Oil case and concluded that Holly Corp. had not shown that the toxic tort claims and the costs associated with them would have had a material adverse effect on Frontier Oil if viewed over a longer term.

In applying IBP'sreasoning, the Delaware court determined that pending environmental mass tort litigation is not necessarily a material adverse effect. The court found that Holly Corp. did not meet its burden of proving that the environmental litigation would have or would reasonably be expected to have a material adverse effect. The court acknowledged that the outcome of the environmental litigation could be catastrophic for Frontier Oil, but held that Holly Corp. had not even tried to demonstrate the likelihood of that outcome.

The court further found that, although Holly Corp. argued that the estimated $15-$20 million defense costs alone for the claims in this environmental litigation constituted a material adverse effect, Holly did not show that Frontier Oil would be unable to absorb the projected defense costs without experiencing a material adverse effect.

There are many lessons to learn from the negotiations, the written agreement, and the parties' dealings in the protracted negotiations and this failed transaction. The most obvious lesson relates to the definition of "material adverse effect." One would think that a company's exposure to a massive class action toxic tort litigation case with potentially devastating consequences would constitute a material adverse effect on the company - such a material adverse effect that it would permit another party to terminate its merger with or acquisition of the company. That is not necessarily the case, as the court found here.

Consequently, if you want to include exposure to such litigation as a material adverse effect, you should carefully draft the material adverse effect provisions in the acquisition documents to specifically identify these types of mass toxic tort litigation as something that would constitute a material adverse effect. Furthermore, one may want to include some industry-specific terms and risks in a material adverse effect clause.

Consider the industry of the target company and include the occurrence of specific events where the final outcome, if resolved in a worse case scenario against the target company, is or could reasonably be expected to have a material adverse effect on the target company. Some industry-specific risks one should consider - especially in regulated industries - would be adverse regulatory developments, a material change in applicable regulations or authoritative interpretations thereof, of licensing or re-licensing criteria, or a change in entitlement to, or amount of, reimbursement for services. An example of language one could use is:

Either party may terminate this agreement at any time within three months after the enactment of new laws or regulations applicable to this agreement or the activities of the parties hereunder, or the adoption or promulgation by the courts or a regulatory agency of interpretations of existing laws or regulations, which enactment, adoption or promulgation would have the effect of rendering unlawful any material activity of that party contemplated hereby, materially altering the rights and obligations of the terminating party (vis-^-vis either the other party, the public, or any regulatory agency), substantially increasing the costs of that party's regulatory compliance in connection with the activities contemplated hereby, or granting material additional rights to the other party.

Another lesson comes from the recent removal of the painkiller Vioxx from the market. All the similar painkiller drugs were hurt when Vioxx was withdrawn, so if one is acquiring a drug company one should write the material adverse effect clause to be sensitive to regulatory events that occur with respect to any member of a class of drugs, where the target company produces a member of that class.

In addition, the court cautioned that "magic words" do not necessarily create a repudiation of an agreement. While Frontier Oil concluded that, during a phone call with Holly Corp., Holly "clearly and unequivocally" stated that its board of directors was not willing to proceed or support the merger under the existing terms, the court held that merely stating that a board is not recommending a transaction - even if such a statement is clear, unambiguous and unequivocal, cannot, in this (although fact-specific) context, be considered a repudiation of the merger agreement. The court also noted that a phone call is a curious method to conclude protracted negotiations; the court stated that written notice is not required, but a "written demand is preferable, especially for a transaction of the complexity and sophistication of the one anticipated by the merger agreement."

The merger agreement was a well thought-out document, and the parties' dealings with each other were also professional. For example, C. Lamar Norsworthy III, Holly CEO, acted prudently and properly with respect to his company's shareholders. The court noted that during negotiations, Norsworthy realized that by considering making the Denver Agreement [one of the many creative proposals the parties considered to make the merger work], he had shirked his fiduciary responsibilities to his shareholders - he was concerned about his personal liability if the transaction were to close on these terms.

Under the terms of the Denver Agreement, Norsworthy and his associates had intended to take the cash option, in essence, hoping that enough of the other (that is less-informed) Holly Corp. shareholders would take Frontier Oil stock. (2005 Del. Ch. LEXIS 57 at *74-*75). Ultimately, Norsworthy did not recommend the Denver Agreement to the Holly Corp. board of directors. Norsworthy's conscience, or at least fear of personal liability, helped him do the right thing by Holly shareholders.

Finally, as lawyers know, with every case, one must do the best one can with the facts at hand. In the Frontier Oil-Holly Corp. situation, the environmental litigation was a huge problem that both parties had to work with. The environmental litigation created hurdles in the negotiations between Frontier Oil and Holly as well as in the lawsuit between these former merger hopefuls.

The negotiations hurdle for Frontier Oil and Holly in trying to restructure the merger was to estimate the costs of the mass tort litigation, which is very difficult to do. Complex class action cases are challenging to assess; the parties attempted to ascertain the potential liability and set forth a few estimates. The court developed some estimates, too, and came up with a very different ballpark figure.

One way to avoid uncertainty in determining the costs of litigation do this is to get insurance coverage. The parties in Frontier Oil were looking into that possibility when Frontier initiated the lawsuit against Holly. Another method to avoid such a situation is to seek a "clean" company as a merger partner. For the oil industry, that may mean negotiating with potential merger partners who have already settled with the Environmental Protection Agency (though one could still be at risk for class actions).

Once negotiations fell apart and the lawsuit between Frontier Oil and Holly was at bar, the problem with the environmental litigation took a new twist. Holly would have to demonstrate that it was damaged in order to receive damages from the court for the failed merger. This put Holly Corp. in a tight spot. Holly would have to argue that the environmental litigation was more than tenuous, that the cancer-victim plaintiffs' claims were strong, that there was causation between oil companies' and refineries' activities and the illnesses, and that the plaintiff's damages were high, foreseeable and devastating - essentially, Holly Corp. would have to prove the plaintiffs' case. This is not something Holly Corp. would want to allege against any company in its own industry, let alone a potential merger partner.

The judge acknowledged Holly's predicament in footnote 221: "It might not be in Holly Corp.'s self-interest, as a participant in the petroleum industry, to champion the cause of linking exposure to petroleum (or petroleum products) to cancer." Nevertheless, the court held Holly Corp. to the requirement that a party must present evidence of damages in order for a judge to award them, and declined to so award Holly any since Holly did not present substantive evidence of damages.

In the end, the parties were not able to close on their merger agreement, but others can learn much from this agreement and the parties' negotiations.

First, carefully draft a merger agreement so that it includes this kind of mass toxic tort litigation in the definition of a material adverse effect. Second, do not use repudiation as a negotiating technique. Third, do the right thing by your company's shareholders.

Finally - and here is the catch for those who are seeking a merger party in their same industry - you must be willing and able to argue that a lawsuit would be successful, in order to take advantage of a "material adverse effect" clause.