February 19, 2008
Content originally posted on MGLAW.net
Buyer's remorse is not just an individual emotion—corporations feel it, too. Someone who purchases an expensive, but popular, pair of shoes might later regret it. But such regret is no doubt magnified exponentially when the purchase is of a shoe company rather than a pair of shoes, and the retail price is $1.5 billion. Tennessee's leading case on corporate buyer's remorse, Genesco v. The Finish Line et al., teaches that a corporation ridden with buyer's remorse may in fact get out of its purchase—but only on the terms specified in the contract.
In April and May 2007, Foot Locker and Finish Line, retail competitors in the athletic footwear and apparel arena, engaged in a bidding war to purchase Nashville-based Genesco, Inc., a large, more diverse retailer of footwear and apparel. In June, Genesco and Finish Line signed a Merger Agreement whereby Finish Line agreed to acquire Genesco for approximately $1.5 billion in a highly leveraged deal financed by UBS. As the summer progressed, Genesco's Q2 and Q3 earnings proved significantly lower than projected, and by September, Genesco anxiously sought to close the deal, but Finish Line and UBS refused, citing concerns about Genesco's drop in earnings.
On September 24, 2007, Genesco filed suit in Davidson County Chancery Court in Nashville, asking the Court to order Finish Line to specifically perform its obligations under the Merger Agreement and to close the deal before the Agreement expired on December 31. Finish Line and subsequently UBS defended their refusal to close the merger by asserting, among other things,1 that Finish Line's performance was excused due to the occurrence of a Material Adverse Effect ("MAE") under the terms of the contract.2 The Merger Agreement specified that a prerequisite to Genesco's right of specific performance was to demonstrate the absence of an MAE. The Merger Agreement also contained a number of "carve-outs" negotiated by the parties, which specified certain circumstances that would ordinarily rise to the level an MAE but which the parties agreed would not constitute an MAE in this case.
The leading case on MAE clauses, In re IBP, Inc. v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch. 2001), supplied the framework upon which the Genesco parties structured their arguments and the Court ultimately rendered its decision. In Tyson, the Delaware Court of Chancery held that contracts such as the merger agreement in the Genesco case should be read in the larger context in which the parties transacted. For example, a company's failure to meet analysts' projected earnings for a single quarter could be highly material to a short-term speculator but much less important to a strategic buyer with a long-term view. For the strategic buyer, the important thing was whether the company suffered an MAE that negatively impacted the company's earnings power over a "commercially reasonable period," which the Tyson Court surmised would be measured in "years rather than months." The Court concluded that it would be "odd to think that a strategic buyer would view a short-term blip in earnings as material, so long as the target's earnings-generating potential [was] not materially affected by that blip or the blip's cause."3
According to Tyson, a buyer's avoidance of its obligation to close under an MAE provision in a merger agreement should be the exception rather than the rule. Tyson reasoned that because merger contracts are heavily negotiated and explicitly cover a large number of specific risks, MAE provisions are "best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner." The Court reiterated that the aforementioned "blip" or "short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror."4
II. Finish Line and USB's MAE Arguments
Against this backdrop, at trial, Finish Line and UBS asserted that Genesco's decline in Q2 and Q3 performance constituted an MAE that did not fit within one of the Merger Agreement's MAE carve-outs. Finish Line and UBS also asserted that a securities investigation of Genesco by federal authorities constituted an MAE. UBS argued in its pretrial brief and at trial that under the terms of the Merger Agreement, the earnings drop suffered by Genesco in Q2 and Q3 was of sufficient magnitude to constitute an MAE because it fell outside normal earnings volatility and Genesco's explanations for the decline were both inconsistent and insufficient. UBS argued that the earnings drop was of sufficient duration to constitute an MAE because the Merger Agreement permitted Genesco to cure any MAE prior to December 31, thus setting a time frame of months, rather than years, for determining whether an MAE had occurred. UBS argued that the general economic conditions carve-out relied on by Genesco did not apply because that carve-out applied only to stock market crashes and the like.5
In its closing at trial, UBS argued that Genesco's 64% decline in performance in Q2 and Q3 was greater than in other cases, such as the 63% decline in Tyson. With regard to general economic conditions, UBS argued that Genesco's performance was poor despite generally favorable economic conditions, noting Genesco's 4.5% decline in sales in Q2 and Q3 when over that same period GDP was up 2.8 %, retail sales were up 3.5% and footwear sales were up 2.4 %.6
III. Genesco's MAE Arguments
Genesco asserted that its performance beginning in May 2007 was a "blip" in line with similar short-term declines in Genesco's history and thus no MAE had occurred. Genesco also asserted that this blip was due to general economic conditions affecting the entire retail industry, such as high gas prices, housing and mortgage issues, and consumer debt, and thus fit within one of its bargained-for MAE carve-outs. In its pretrial brief, Genesco emphasized the "backstop" nature of MAE provisions generally, and Genesco's powerful bargaining position as reflected in the carve-outs. Genesco also asserted that its Q2 and Q3 performance was not indicative of a "fundamental operations failure" by Genesco and was ultimately immaterial in light of Finish Line's long-term, strategic reasons for the purchase.7
In its trial closing, Genesco highlighted Tyson's reasoning that MAE provisions were designed to protect the buyer from the occurrence of "unknown events." At the time Finish Line signed the Merger Agreement, it knew that Genesco's performance, historically, was like a "roller coaster" in which "periods of decline were always followed by extended periods of recovery." Finish Line's own performance suffered similar ups and downs. With regard to the purpose of the merger, as late as September 21, 2007, Finish Line's CEO touted the benefits of the merger, namely strong market position and brand name recognition, and cost-savings due to diversified and improved operations, purchasing, inventory, and distribution.8 With respect to MAE carve-outs, Genesco cited recent comments from the chairman of the Federal Reserve as well as its own experts to support its argument that "there ought not to be any serious dispute in this case that Genesco and Finish Line and retailers generally have been adversely affected by changes in economic conditions."9 Genesco argued that, despite the difficulties in the general economy, its Q3 performance was better than that of other retailers in the footwear industry.10
IV. Chancellor Lyle's Decision
The Davidson County Chancery Court, Chancellor Ellen Hobbs Lyle presiding, found one fact dispositive of the MAE issue, specifically, that general economic conditions such as higher gasoline, heating oil and food prices, housing and mortgage issues, and increased consumer debt loads, caused Genesco's decline in performance.11 In doing so, the Court attached great weight to the testimony of a Genesco expert witness, who, in addition to academic and professional expertise, had 26 years' retail experience as president and director of Payless Shoe Stores.12 This expert cited numerous and wide-ranging sources, including a September 2007 presentation by Finish Line to equity investors that cited macroeconomic conditions on consumer spending, quotes from other footwear retailers, industry analysts, and journalists who cited these same macroeconomic conditions as responsible for Genesco's weaker earnings.13 UBS's own 2007 performance was down due to significant adjustments in the housing and mortgage and credit industries which had a ripple effect on consumer spending and created poor general economic conditions. 14
Chancellor Lyle concluded that Genesco's decline in performance fit within the general economic conditions MAE carve-out for which it had bargained and that it was not necessary for the Court to determine whether an MAE had occurred. Nevertheless, the Court included an MAE analysis "for completeness," and determined that, absent the carve-out, Genesco had in fact suffered an MAE.
The Court first set out the essential elements of an MAE as provided in the Merger Agreement, namely, "a change to the assets, liabilities or result of operations at Genesco (1) taken as a whole, that is (2) material and (3) adverse." The Court found that these elements indicated that a significant change in the company's business was required to constitute an MAE. To measure this, the Court identified "[c]ommon sense considerations such as the duration of the change, the measure of the change and whether the change relates to an essential purpose or purposes the parties sought to achieve by entering into the merger" as significant to courts faced with the decision of whether an MAE has occurred.15
First, with respect to the extent of the decline in Genesco's earnings and performance, the Court found the change to be material. The May 2007 loss in earnings sparked, over the remaining months of 2007, what appeared to be Genesco's lowest earnings in 10 years.16
Next, with respect to duration, the Court rejected Genesco's contention that the May and June declines were a mere "blip" under Tyson. Accrediting Finish Line/UBS's argument and hewing closely to the terms of the Merger Agreement, Chancellor Lyle found significant the Merger Agreement provision that an MAE could be cured "prior to the Termination Date" of December 31, 2007. Reasoning that the agreement thereby contemplated that an MAE could occur in three or four months' time, Chancellor Lyle held that because Genesco's earnings over the remainder of 2007 did not increase at a pace sufficient to offset the May decline, it was of sufficient durational significance with respect to the MAE analysis in this case.17
Last with regard to whether the change affected the essential purposes the parties sought to achieve through the merger, the Court found that, in addition to Finish Line's primary long-term strategic goals for the merger—diversification, synergies from reduced costs, and opportunities for growth—Finish Line had a secondary purpose of using Genesco earnings to contribute a substantial sum to payment of the financing for the highly leveraged deal.18 Genesco's decline in earnings negatively affected the ability of the combined company to pay its financing and have money left over to grow the company. In the Court's view, this material, durationally significant change constituted an MAE.19
The Court then ordered Finish Line to close the transaction with Genesco. Finish Line and UBS have sought an expedited appeal. The Court of Appeals has, to date, refused to expedite the process and is still considering whether to grant an appeal.20 The issue of whether UBS will be ordered to fund the transaction is the subject of litigation pending before the U.S. District Court for the Southern District of New York.
As the Genesco case shows, corporate buyer's remorse is an issue to be dealt with in both the drafting and litigation stages. Although parties expend great time and energy drafting MAE provisions and related carve-outs, the meaning of those contract terms are subject to competing interpretations, and therefore are likely to spawn litigation. As with any contract, careful drafting may not be enough. Whether the contract involves thousands of dollars, a few billion, or somewhere in between, the help of experienced legal counsel and the ultimate guidance of a knowledgeable and capable trial judge may be one's only recourse for deciding whether corporate buyer's remorse is temporary or permanent.
1Finish Line and UBS also asserted tort defenses to Finish Line's performance under the Agreement, namely, alleged securities fraud and fraudulent inducement on the part of Genesco. The Court ultimately ruled there was no securities fraud or fraudulent inducement by Genesco. There were also allegations by UBS that the continued company would be insolvent and that this relieved UBS of any obligation to fund the merger. The insolvency claim is the subject of a separate action pending in New York. A full discussion of these claims is outside the scope of this article.
2Modern merger agreements typically contain "Material Adverse Change" or "Material Adverse Effect" provisions, and the respective acronyms, "MAC" and "MAE," are used interchangeably in relevant literature and case law. This article employs the term MAE in accord with the Genesco Merger Agreement and resulting memorandum and order filed by the Davidson County Chancery Court.
3Tyson 789 A.2d at 67.
4Id. at 68.
5UBS's Pretrial Br. at 7-9, 13-15; see Finish Line's Pretrial Br. at 27-31, 37-41.
6Transcript of Proceedings on Dec. 18, 2007 (hereinafter, "Record"), at 2153-60.
7Genesco's Pretrial Br. at 35-50.
8Record at 2040-46.
9Id. at 2050.
10Id. at 2050-52.
11Trial Court's Memorandum and Order filed Dec. 27, 2007, at 31.
14Id. at 32.
15Id. at 34.
16Id. at 35.
17Id. at 35-36.
18Id. at 36-37.
19Id. at 37.
20On January 18, 2008, Finish Line and UBS filed a motion for permission to seek an interlocutory appeal under Rule 9 and also filed a notice of appeal under Rule 3 of the Tennessee Rules of Appellate Procedure. On January 30, 2008, Chancellor Lyle granted the Rule 9 motion due to the potential for irreparable injury to the parties in light of the uncertainty surrounding the merger. (As of the date of publication of this article, the Court of Appeals has not yet decided whether to grant Finish Line and UBS's Rule 9 application.) On February 13, 2008, the appeals court dismissed as untimely Finish Line and UBS's Rule 3 appeal as of right.