Shell companies prove tough to crack

The Delaware Chancery Court recently ruled that Blackstone doesn’t owe Alliance a termination fee – sticking to a strict interpretation of the language in the merger agreement.

After the collapse of The Blackstone Group’s planned merger of portfolio company Aladdin Solutions with Alliance Data Systems, Alliance sued to force Blackstone to pay the $170 million reverse termination fee associated with the deal. After months of deliberation, the Delaware Chancery Court recently decided the language in the merger agreement does not indicate that Blackstone owes the fee.

The decision is a victory for the common private equity deal structure known as a “shell” acquisition subsidiary, says David Grinberg, chair of the mergers and acquisitions practice group at law firm Manatt, Phelps & Phillips. In a typical private equity deal a “shell” acquisition subsidiary is the entity that actually buys the target company, while the private equity sponsor agrees to provide a reverse termination fee but is not liable for any other obligations under the merger agreement.

“[The decision] showed that the typical private equity structure of forming shell companies to make offers for public companies will be upheld, and that absent extenuating facts and circumstances, you’re not going to be able to pierce the veil of the shell to get at the assets of the private equity fund itself,” Grinberg says.

In the Alliance suit, the target claimed that Blackstone and Aladdin failed to make their “reasonable best efforts” to close the deal, that Blackstone had actually impeded the merger, because Blackstone failed to provide the Office of the Comptroller of the Currency with a guarantee of financial support for the banking subsidiary of Alliance. Finally, Alliance argued that Aladdin represented that it had the power to execute the merger agreement and, therefore, that it implicitly controlled Blackstone.  

The court stuck to a strict interpretation of the language of the merger agreement, which only bound Aladdin to use “best efforts” to close the deal, not Blackstone. Blackstone, meanwhile, didn’t actually take any active steps to derail the deal, and therefore the second accusation didn’t hold. In addition, the court found that the argument that Aladdin had misrepresented its control over Blackstone didn’t stand up to scrutiny either, because the argument “distorts the plain meaning of a common term in acquisition agreements”, and found that Aladdin’s representation that it had the power and authority to honour its agreements in the merger agreement was not tantamount to Aladdin claiming it could control its parent company.

Ultimately, because Blackstone was not a signatory to the merger agreement, the court ruled that Alliance could not come after Blackstone for the fee.

“If anything it’s an eye opener for companies thinking of doing deals with private equity firms in that you’d better understand what the merger agreement and the related agreements say and mean, because the court is going to going give effect to what the plain meaning of the agreement is,” Grinberg says.

He points out that reverse termination fees have been controversial essentially since the beginning of their use in merger agreements. At first they seemed like a boon for targets: previously only the target company had to pay fees if a deal didn’t close. But it became clear in the last few years that first of all, the fees were so small compared to the overall deal sizes that private equity firms were using them as option contracts rather than regarding them as punitive measures, and second, that it’s difficult to actually force a private equity firm to pay a termination fee. In almost all of the notable cases where a target has sued a private equity firm for the fee, the parties have reached some other settlement, or the target has lost.

There are certain things a seller can do to improve its standing in these situations, Grinberg says.

“One is to make the reverse termination fee so large that it makes it extremely painful for a private equity fund to walk away, or at least give them pause before they do,” he says. “Another is not to have a termination fee at all, just have specific performance requirements. Make the buyer close on the deal. Targets aren’t in the business of collecting termination fees; they want the deal to get done because that’s in the best interest of their shareholders. There are a variety of things to do to strengthen the contract, but the overall question is, does the seller have the correct leverage in order to implement those things?”

Both buyers and sellers can take one lesson away from this decision: make sure you know exactly what your merger agreement says.