The Big Fall
Wachtell was supremely confident of its strategy in the Hexion busted-merger litigation with Huntsman. How did it all go so wrong?
The American Lawyer
By Amy Kolz
April 01, 2009
The lawyers at Wachtell, Lipton, Rosen & Katz aren't often embarrassed. So there was a distinct tremor last September in the M&A world when a Delaware Chancery Court judge issued a 91-page opinion that amounted to a complete repudiation of Wachtell's strategy in one of the highest-profile cases of the year. Vice-Chancellor Stephen Lamb declared that Wachtell's client, an Apollo Management, L.P., portfolio company called Hexion Specialty Chemicals, Inc., had "knowingly and intentionally breached" its merger agreement with Huntsman Corporation in a deliberate effort to walk away from their $10.6 billion deal. The judge--an 11-year veteran of Chancery Court and a former partner at Skadden, Arps, Slate, Meagher & Flom--not only rejected Wachtell's legal arguments, but also railed against "the carefully designed plan" the firm and its client had constructed to support them.
Lamb's ruling could not have been worse for Hexion and Apollo. His finding of an intentional breach left Wachtell's client liable for uncapped--i.e., billions--in damages if it couldn't complete the Huntsman acquisition, a virtually impossible feat given Huntsman's deteriorating financial condition, the meltdown of the credit markets, and Hexion's own arguments in Delaware, which gave the banks more than enough justification to back out of their original financing commitment. At the same time, Apollo's founders were facing the prospect of a jury trial in Texas on Huntsman's $3 billion tort claim, filed as a response to Hexion's suit in Delaware; Lamb's ruling certainly didn't help their chances on Huntsman's home turf.
Eleven weeks later, after a flurry of new filings and tense negotiations, Apollo and Hexion settled the Huntsman mess for $1 billion, a painful breakup fee that resulted from misplaced corporate judgment and a seriously flawed legal strategy. With broken deals raining on Lower Manhattan like ticker tape, Apollo's errors were expensive, though hardly unique. But how did Wachtell, a firm widely viewed as one of the savviest players in the Delaware courts, muff this case?
It wasn't easy. Wachtell, Apollo, and Hexion have all declined to comment for this story, with Wachtell citing the settlement's nondisparagement provision and its obligation to maintain client confidences. But a close reading of the record and interviews with more than a dozen people in the case reveal an almost operatic series of bad decisions and miscalculations.
The Delaware landscape is littered with litigation consultants and bankruptcy experts, yet Wachtell chose to hire two from the same firm who were then expected to work separately. Except when they didn't. That commingling led to an unflattering exposure of litigation prep work-edited expert opinions and massaged economic models-that infuriated Vice-Chancellor Lamb.
Though the merger agreement required Hexion to discuss financing concerns with its putative merger partner and to make its best efforts to consummate the deal, Apollo and Wachtell operated in secret, never giving Huntsman notice. And when it was time to walk away, Hexion's CEO waited until an hour after filing suit in Delaware Chancery Court to drop the bad news on Huntsman's CEO. Adding insult to injury was a litigation strategy for Hexion in the Huntsman case. It just wasn't a very good one.
In the spring of 2007, with the private equity boom at its peak, Hexion was fighting to get into a deal with Huntsman, not out. Merger discussions between the two had fallen apart the year before, after Huntsman missed an earnings target. In May 2007 Huntsman put itself up for sale. The Dutch chemical giant Basell AF reached a $9.6 billion agreement with Huntsman in late June-only to see Apollo/Hexion bid up the price three times over a fortnight. Apollo/Hexion, which was advised by Wachtell and O'Melveny & Myers, ultimately agreed to pay $28 per share for Huntsman. That was 11 percent more than Basell's offer and 12 percent more than the price Hexion had proposed in 2006.
Huntsman and its lawyers at Shearman & Sterling and Vinson & Elkins were able to negotiate a merger agreement that all but locked Hexion into the acquisition. There was no "financing out," which meant that Hexion would have to pay a $325 million termination fee if it failed-despite using best efforts-to obtain debt financing. The material adverse effect clause, as Lamb would later remark, was also "narrowly tailored." And though one of the parties had to deliver a solvency letter to the banks funding the deal, there was no "solvency out" for Hexion.
The deal also included a provision that later proved harmful to Apollo. Though the agreement capped Hexion's liability at $325 million if it couldn't complete the deal despite making "best efforts," it allowed for uncapped damages in the event of a "knowing and intentional breach of any covenant" by Hexion, a provision more often seen in deals with strategic acquirors.
Huntsman hit a downturn almost immediately after the $10.6 billion merger was announced in July 2007. The company repeatedly lowered its 2008 forecasts over late 2007 and early 2008-the same time frame in which many of the private equity deals struck during the boom faltered as the credit markets seized up and cheap debt disappeared.
Apollo was clearly feeling pressure on multiple fronts. In April 2008 its portfolio company Linens n' Things, Inc., was facing imminent bankruptcy. Moreover, Credit Suisse (USA), Inc., and Deutsche Bank AG, the lenders financing the Huntsman buyout, were pressing the private equity shop to restructure the chemical deal, citing potentially large losses on the $15.3 billion debt package that would fund the $10.6 billion acquisition and refinance existing debt. On April 22 the situation reached a crisis: Huntsman e-mailed Apollo its first-quarter results, which showed a rising debt level and a 20 percent drop from 2007 in the key financial metric of EBITDA.
It was at this point that Apollo officials turned to Wachtell for help in exploring their options, setting up a meeting with Wachtell partner Marc Wolinsky, who would head Wachtell's Hexion team of about 12 lawyers. Wolinsky, then 52, was a star in the M&A litigation world, having recently obtained a favorable settlement for a set of private equity buyers looking to exit their $25 billion buyout of SLM Corporation. His May 9 meeting with Apollo marked the genesis of the "carefully designed plan" that Vice-Chancellor Lamb would later cite in finding that Hexion had intentionally breached its merger agreement with Hunstman.
Apollo arrived at the meeting, according to testimony from Apollo partner Jordan Zaken, focused on the contract's material adverse effect clause: If Huntsman's declining numbers constituted an MAE, Hexion could walk away without even paying the deal's $325 million termination fee. But Wolinsky had to know that was a long shot. Delaware courts have never found a MAE in the context of a merger agreement, and Wolinsky himself helped to litigate the precedent-setting case on the issue, IBP, Inc. v. Tyson Foods, Inc., in 2001.
Instead, Apollo and Wachtell began to consider the combined company's potential insolvency as a possible way out of the merger. The strategy was certainly intriguing. If the merger would result in an insolvent company, the banks could refuse to finance it, leaving Hexion with no choice but to abandon the deal. And if it were the banks-not Hexion-scuttling the deal, Hexion would be liable for, at most, the breakup fee.
But could Wachtell and its client demonstrate insolvency? Records from the subsequent litigation suggest that that was an open question. Apollo had prepared three financial models for the May 9 meeting. The models showed "tight liquidity" at the merged companies but not necessarily insolvency. Apollo's profits would clearly suffer-one analysis showed the firm's return on the investment would drop by an average of 50 percent. But another Apollo analysis listed over $1 billion in "potential opportunities" to improve the combined company's liquidity.
A week after the May 9 meeting, Wolinksy called two managing directors--a litigation consultant and a transactions opinion expert--at the valuation and litigation consulting firm Duff & Phelps Corporation. Wolinsky explained that Wachtell was potentially interested in a formal solvency opinion, but also wanted to hire Duff in a "consultative arrangement to assess the solvency analysis," according to testimony from Duff's Philip Wisler. The firm would use Duff & Phelps, in other words, for two roles: a litigation consulting team that would provide various financial analyses to assess the possibility of deal litigation, and an opinion team that would be engaged if Hexion decided "to go forward with a particular course of action," namely litigation to end the merger.
The May 23 engagement letter between Duff and Wachtell memorialized this dual engagement. Wisler would lead the opinion team; his colleague Allen Pfeiffer would lead the consulting team. (Duff & Phelps declined to comment on the matter, other than to state that it "stands behind all the work we did for Hexion and Wachtell.")
From the beginning, Duff's efforts to separate the consulting and opinion teams were imperfect, at best. Wisler, for instance, attended the May 20 kickoff meeting for the litigation consulting team at Apollo's New York offices, even though he was to be the author of the insolvency opinion. The same Duff expert performed modeling work for both teams. And litigation team leader Pfeiffer, at Wachtell's request, e-mailed Wisler various deal models for the opinion analysis; Wisler later testified that he was unaware he was supposed to be walled off from Pfeiffer's work.
Even Wachtell lawyers conflated the teams. When Wachtell counsel Elaine Golin e-mailed Pfeiffer on June 5, she asked to "talk about the weak spots in the Apollo model" and "what variables would need to be changed and by how much" so that the entity wouldn't be insolvent. At the same time, she specifically noted that she didn't want this discussion "to interfere with getting the opinion ready"-even though Pfeiffer was not supposed to have anything to do with the preparation of the formal solvency opinion.
The blurry line between Duff's consulting and opinion work would later come back to haunt Wachtell in Delaware. Vice-Chancellor Lamb ultimately concluded that Duff's consulting assignment cast doubt on the objectivity of its solvency opinion. Moreover, the dual role destroyed any potential work-product privilege claim over the Hexion team's communications with both the Duff litigation consultants and solvency experts. Duff had to provide comprehensive discovery to Huntsman, which was a huge gift to Huntsman's Vinson & Elkins litigators.
In fact, some of the documents Duff produced directly contradicted Wachtell's claim that Duff was retained to provide objective advice on solvency. Pfeiffer's handwritten notes from May 16, for instance, stated: "Get out. 1) Notice that insufficient capital to close. 2) hiring D&P to support that notion." (Pfeiffer would later testify at a deposition that he meant "to get out of a deal, Hexion would have to provide notice...to Huntsman that they have insufficient capital to close.") A senior Duff associate e-mailed Pfeiffer three days later, saying that he would "see what if any loophole [sic] were used by those [other private equity] firms for walking away."
Other Duff documents showed Wachtell's involvement in the solvency evaluation. Wisler submitted a draft opinion to Wachtell three days before his June 18 presentation to the Hexion board. Two days later, when Pfeiffer sent Wisler Wachtell's suggestions for "revised language for deficit funding," Wisler replied: "They really need to stop now." (At trial Wisler would dismiss these communications as debating over "minutiae.") Wachtell argued that there was no evidence showing "any attempt by counsel to change the substance of Duff's opinion work." But it didn't look good.
Wachtell's close work with experts who consulted on the merger's pension costs--a significant part of Duff's solvency analysis--was also cited in Lamb's opinion. Wachtell replaced Hexion's long-standing adviser on the transaction's U.K. pension costs, PricewaterhouseCoopers International Limited, with a new expert, Punter Southall Ltd. PwC had opined that a one-time change-of-control cost of approximately $45 million was "the most likely outcome" for the U.K. pension liability of the merged company. Wachtell counsel Golin asked Punter consultant Richard Jones to reexamine the issue in early June, alerting him that there was a potential for litigation.
Five days later, without having talked to anyone from Huntsman, PwC, or even Hexion, Jones sent Wachtell an e-mail in which he stated that the U.K. pension cost would be "at least $175 million up front (with a further $175 million over the coming three years)." Over the next week, Golin would e-mail Jones her comments on his draft report for the Hexion board, asking him to delete certain qualifiers, such as the caveat that his estimates were based on the "limited" information provided and could be "considerably" refined if more data became available.
Hexion executives would later testify that they hired Punter because of a conflict: PwC also represented trustees in the Huntsman pension plan. But this conflict was discussed and resolved at the beginning of the merger talks. Lamb concluded it was reasonable to infer that Hexion stopped using PwC to maintain confidentiality as it obtained the insolvency opinion-and because it wanted an expert that answered only to Hexion.
Wachtell's dealings with the U.S. pension consultant, Fiduciary Counselors, followed a similar pattern. In deal models created before the crisis meeting on May 9, Hexion and Apollo didn't project any U.S. pension costs at closing. Even in late May, the Pension Benefit Guaranty Corporation suggested four approaches to handling pension obligations that would not require Hexion to provide funding at the close. Nonetheless, Wachtell engaged Fiduciary Counselors to evaluate the cost. And again, the firm was involved in supplying an answer. After the Fiduciary Counselors expert circulated an initial draft of an opinion, Wachtell's Golin responded with comments that included a note about a cash payment at closing of $200 million. "If anything doesn't sound right to you, go ahead and change it," Golin wrote. The pension expert later testified that counsel's comments did not alter her opinion, but Lamb said that her conclusion "appears to have been influenced by the suggestions from Wachtell, Lipton."
On June 13 Golin e-mailed both Duff teams a revised deal model that estimated the U.S. and U.K pension funds would each require a $195 million cash payment at the close of the merger--a cumulative $390 million that dwarfed the $30-50 million pension cost projected in pre-May deal models. Lamb would later find this disparity so striking that on the fourth day of trial he questioned Wisler directly about it. Some courtroom observers cited those questions as the first indication that Hexion's case was unraveling.
But the most damaging aspect of Hexion's litigation strategy was the decision to completely exclude Huntsman from the solvency analysis. Though it's impossible, looking at the court record, to isolate Wachtell's role in this decision, the firm was, of course, aware of its client's notice obligations under the merger agreement and closely advised its client during the litigation. Yet Hexion and Apollo said nothing to Huntsman about solvency concerns during their more than a dozen meetings and calls with Huntsman in May and June. Duff was instructed not to contact Huntsman management, and was told instead to rely on Apollo's May 23 estimates for the combined company--estimates that Lamb later called "pessimistic." Some were 20 percent lower than two of Apollo's models for the May 9 meeting that had taken place only 14 days before. (Duff was also instructed to include some new closing costs in its solvency analysis, including a $102 million advisory fee to Apollo.)
The failure to consult Huntsman became more dangerous in early June, when Wachtell's client made a decision that Lamb would later call a critical turning point. Pfeiffer's litigation consulting team informally concluded at the end of May that the postmerger company would be insolvent. On June 2 Pfeiffer told Wisler that Hexion now wanted a formal opinion from Wisler's team of solvency analysts. At this point, Hexion had "a good faith belief" that the combined company would be insolvent, and that the bank financing might be "imperiled." The merger agreement required Hexion to notify Huntsman within two business days if it no longer believed that it would be able to draw upon the committed financing. When Hexion and Apollo first became concerned about solvency, contacting Huntsman would have been "reasonable," said Lamb. After receiving the analysis from the Duff consultants, their obligation was "absolute." But Hexion continued its silence, breaching the merger agreement.
Over the next 16 days, Wisler's team-working with Apollo, Hexion, Wachtell, Wachtell's experts, and, it seems, Pfeiffer-scrambled to complete the formal insolvency opinion. On June 18 the Hexion board heard and approved Wisler's opinion. The combined company, this analysis projected, would be worth $11.35 billion-$4.25 billion less than Apollo had concluded in March 2008. The opinion estimated an $858 million funding gap at closing.
The board also approved the immediate filing of a lawsuit in Delaware Chancery Court. The suit would seek to put an end to the merger, arguing both that an MAE had occurred and that the insolvency of the merged company would render the deal impossible to finance.
This was the point of no return in the Hexion and Apollo litigation strategy. Lamb would later say that if Wachtell's clients had contacted Huntsman to discuss strategies to address their insolvency concerns-even after the board had approved the Duff opinion without notifying Huntsman-Hexion could have "cured" any prior breach of the merger contract.
Instead, shortly before four o'clock that afternoon, Hexion filed a sealed complaint in Delaware Chancery Court with the Duff insolvency opinion attached. About an hour later, Hexion CEO Craig Morrison called his Huntsman counterpart, Peter Huntsman, to inform him of the insolvency report from Duff & Phelps and Hexion's belief that the transaction could not go forward. He didn't mention the litigation. A stunned and tired Huntsman--still in Europe after a business meeting in Belgium--asked Morrison who Duff & Phelps was. Around the same time, Hexion filed an 8-K, attaching the public complaint, a press release, and the Duff opinion.
Hexion's suit asserted that the merger was impossible because the banks would refuse to fund the insolvent combined company, and alternative funding would be impossible to obtain. But in fact, according to later testimony, Hexion's suit was the first the banks had heard of the potential insolvency. Indeed, shortly after news of Hexion's filing went out on June 18, Apollo partner Scott Kleinman called a banker at Credit Suisse, telling him to check the news on Huntsman.
The next day Hexion sent a letter to Credit Suisse and Deutsche Bank that included a copy of the Delaware complaint and the insolvency opinion. Hexion's Morrison would later agree at trial that he knew that the publication of the opinion and the suit "effectively kill[ed] the financing" and "[made] it virtually impossible for the [banks] to go forward with the financing." This was a troublesome admission for Apollo and Hexion: The merger agreement not only required Hexion's best efforts to consummate the financing and give Huntsman notice of any concerns in doing so, it also required that Hexion do nothing that might harm the likelihood or timing of the financing. Morrison's testimony made it clear, Vice-Chancellor Lamb later wrote, that a knowing and intentional breach of that covenant had occurred by June 19.
Wachtell lawyers would later submit several defenses for their client's ongoing silence. Initially, they argued, Apollo was just being prudent, enlisting an expert before approaching Huntsman. The private equity shop was also concerned that if Huntsman got wind of Hexion's solvency concerns, it would rush to file a lawsuit in Texas; Hexion and Apollo, Wachtell argued, were concerned with keeping any merger-related litigation in Delaware. And finally, Wachtell asserted that if Hexion had spoken to Huntsman about solvency, it would have been obligated to notify the banks at the same time. Lamb rejected all of these arguments. The merger agreement explicitly gave exclusive jurisdiction to Delaware, he noted. And Hexion's obligations to the banks, Lamb said, were not based on its communications with Huntsman.
Lamb's opinion makes it clear that Wachtell's client was so focused on insolvency-particularly as a means of getting out of the merger-that it missed the big picture: Hexion was contractually obliged to make its best efforts to close the deal. It didn't, Lamb concluded. In addition to castigating Hexion for its failure to keep Huntsman informed, Lamb's opinion also questioned Hexion's foot-dragging over antitrust approval and its limited search for alternative financing. It was all part of the same pattern of behavior, Lamb concluded. Hexion believed that Duff's insolvency opinion would rescue it from the merger.
Did this deep faith in the insolvency argument come from Wachtell? Lawyers and other people who are familiar with Wachtell's thinking in the litigation say the legal team, and Wolinsky in particular, was very confident in the insolvency strategy. He must have been: Hexion and Apollo had no Plan B. The decision to assert insolvency via a public suit meant that Hexion was letting the banks off the hook and badly wounding Huntsman at the same time. Wachtell and its client may have been betting that Huntsman would settle quietly for the $325 million termination fee instead of facing the uncertainty of litigation. (And perhaps they were emboldened by the settlement between retailers Genesco Inc. and The Finish Line, Inc., in March 2008: Even after a Tennessee judge ordered The Finish Line to proceed with the deal, dismissing claims that Genesco hid declining results, the merger wasn't completed, and Genesco settled for a paltry amount.) Any concerns that the litigation strategy could be seen as a "knowing and intentional breach" were apparently swept aside. Wachtell would later argue in Hexion's pretrial brief that a "knowing" breach requires "actual knowledge that such actions breach the covenant," and that an "intentional" breach requires acting "purposely" with the "conscious object of breaching." Lamb dismissed such circular analysis.
"Litigators tend to fall in love with their arguments," says one lawyer involved in the matter. "Sometimes you get a little too close."
Wachtell remained confident in its strategy throughout the trial last fall. Even after the trial concluded, as the two sides waited for Lamb's ruling, Wachtell's Martin Lipton personally guaranteed victory to Apollo cofounder Leon Black, according to individuals familiar with the matter. So when Vice-Chancellor Lamb issued his opinion on September 29, Apollo and Hexion were shocked. Not only had the judge ruled against Hexion on the material adverse effect clause and found Hexion liable for uncapped damages, he had declined to rule at all on Wachtell's primary argument of insolvency, saying the issue was not ripe for judgment.
Two weeks later, Apollo hired Paul, Weiss, Rifkind, Wharton & Garrison to handle the appeal of Lamb's ruling. Wachtell's name remained on the docket, but it was clear that the firm would take a back seat. In January, a month after the $1 billion settlement was announced, Apollo's general counsel, John Suydam, claimed that all was well with Wachtell. "[We] continue to hold Wachtell, Lipton in the highest regard, and we are working with the firm on a number of new matters," he said. But a line in Hexion's notice of appeal suggests that Apollo was more than ready to blame Wachtell for the failed litigation strategy when the stakes were higher: "All of these actions were taken while Hexion was advised, at every step of the way, by Wachtell, experienced corporate counsel."
Wachtell Certainly isn't shying away from aggressive tactics. At the end of January, several lawyers on the Hexion team-Wolinsky, Paul Rowe, and Golin-filed a suit against The Dow Chemical Company on behalf of their client Rohm and Haas Company, seeking to force the chemical giant to complete its $15.3 billion merger. Dow had sought to delay the deal, arguing that the combined company could be insolvent-a position Wachtell should have been all too familiar with. After six weeks of hard-fought litigation and accusation-trading, the two companies reached a last-minute settlement in mid-March. Dow agreed to proceed with the merger and pay Rohm and Haas shareholders the original purchase price, plus penalties, while two large Rohm and Haas shareholders agreed to loan Dow $2.5 billion in preferred stock. Looks like Wachtell did a little better on the other side.
E-mail: amy.kolz@incisivemedia.com.
