ONLINE EXCLUSIVE: To read a Q&A with Genesco’s GC, click here.
As is typical with doomed relationships, the Genesco-Finish Line deal started with a honeymoon period that quickly went sour. Athletic footwear retailer Finish Line Inc., after emerging victorious from a bidding war with competitor Foot Locker and six private equity firms, announced in June 2007 that it would buy Genesco Inc., the Nashville, Tenn.-based retailer that operates stores including Journeys Shoes and Hat World. UBS was to provide financing for the heavily leveraged deal.
Then, in August, Genesco reported a second quarter loss of $4.2 million–a year earlier it had reported a $5.9 million profit. In response, Finish Line issued a statement: “The company is disappointed with Genesco’s second quarter fiscal 2008 financial results … [and] is evaluating its options in accordance with the terms of the merger agreement.”
The honeymoon was over. As Genesco shareholders approved the deal, Finish Line and UBS tried to either renegotiate or terminate the agreement. They both began exploring material adverse change, or MAC, clauses in the agreement. On Sept. 21, Genesco sued Finish Line in Tennessee state court, seeking enforcement of the merger agreement.
As the parties prepared for a December trial, UBS filed a suit of its own, against both Genesco and Finish Line, in Federal District Court in New York. The suit claimed that a company formed by combining the two retailers would be insolvent, and solvency was a condition of UBS’ agreement.
On Dec. 27, the Tennessee court agreed with Genesco that a material adverse effect had not occurred and ordered the deal to proceed, pending a ruling in the New York case. As UBS and Finish Line plan for an appeal and the New York case is still up in the air, the whole deal has spiraled into a mess of unforeseen proportions.
“The Genesco case is just a flat-out brawl,” says Steven Davidoff, an assistant professor at Wayne State University Law School who blogs for The New York Times as The Deal Professor. “UBS and perhaps Finish Line are really doing anything they can to not close. It’s probably the worst case of buyer’s remorse I’ve ever seen.”
The Genesco-Finish Line deal is one of several troubled M&A agreements made before the credit crisis began to take hold of the market in August 2007. And of those deals, Genesco is far from the only company to see its buyout collapse.
“The current stress in the credit markets is raising the cost of capital and changing the economic assumptions of deals that were modeled a year or so ago,” says Dan Brown, a partner in Mayer Brown who spearheaded the firm’s Subprime Lending Response Team. “That’s going to make potential buyers consider the option of trying to … walk away from or renegotiate a deal.”
Even when these broken deals result in lawsuits, few go all the way through trial. Many companies renegotiate to avoid the cost of litigation, so the Tennessee trial was rare. The fact that the providers of the funding also wanted to pull out of the deal may have propelled the case to trial.
“To actually go through the whole [litigation] process is unusual,” Brown says. “It may be a deal [where] the perception was it really couldn’t be salvaged by a renegotiated price.”
If the Tennessee trial was unusual, the judge’s order of specific performance was even more so. A court order of specific performance forces a party to carry out a specific act, usually the completion of a transaction, and courts tend to be hesitant to force an action if they believe money can recompense the party injured by the breach.
“Generally, specific performance in a garden-variety contract case is rare, because the default damages for a breach of contract is money,” Brown says. “But here, it’s something that doesn’t really produce a dollar amount to make up for the failure to consummate the transaction.”
In other words, it would make little sense for the court to order Finish Line to pay Genesco the amount it would have received and then not acquire it.
Some broken deals go away relatively easily with reverse termination provisions, which give private equity buyers the right to abandon the transaction by paying a dollar figure–no matter the cause.
“That’s what you saw in [Cerberus Capital's abandoned plan to take United Rentals Inc. public] for instance, where the private equity buyers just want to be rid of the company,” Davidoff says.
It’s likely that M&As being negotiated in today’s economic climate won’t include this type of option. “To the extent that sellers are still negotiating these types of provisions in such a shaky credit market, they really have only themselves to blame if the buyers back out,” Davidoff says.
Since Genesco wasn’t being acquired by a private equity buyer, a reverse transaction fee wasn’t in play. In addition, its agreement with Finish Line contained no financing out.
Thus, the Tennessee case hinged on the merger agreement’s MAC clause, a typical part of an M&A deal that buyers can use to escape the deal in case the expected economic results change in a sufficiently detrimental way. That change is the “material adverse effect” which triggers the clause. A MAC clause is basically a return policy of sorts. Of course, creating and invoking a MAC claim is more complicated than, say, returning a pair of shoes to the store because they don’t fit. For one, MAC clauses vary from agreement to agreement.
“You can’t say there’s a standard language in a standard MAC clause that’s essentially boilerplate in each agreement,” Brown says. In the definition of material adverse effect, parties will include and exclude certain things. “There can be exclusions to exclusions. It’s that level of detail in material adverse effect that really provides the uniqueness to each agreement,” Brown says.
When it came to Genesco and Finish Line’s MAC clause, Genesco had a seemingly airtight deal, which Jim Denvir, Genesco’s lead trial counsel and a partner in Boies, Schiller & Flexner, attributes to the company’s considerable leverage during the drafting of the agreement. “Finish Line really desperately wanted to do this deal because they were in a bidding contest against Foot Locker,” he says. “And UBS very much wanted to be the financer for this deal.”
That came into play in the Tennessee court. Finish Line, Genesco claimed, was just trying to get out of a deal it regretted because of growing concerns it had overpaid coupled with a “general gradual decline” in the retail footwear industry and trouble in the debt securities market. “To put it simply,” Genesco’s complaint read, “a deal is a deal.”
“If the applicability of a MAC clause and the definition of material adverse effect are at issue before a court, the court is going to try to discern what the parties’ intentions were,” Brown says. “Courts aren’t going to let out of a deal a side that just basically got a bad deal but got what they negotiated and what they should have expected.”
That may have helped Genesco in Tennessee, but now the case moves to New York, where already motions have been flying. If UBS succeeds in showing a Genesco-Finish Line merger would be insolvent, the whole deal could fall through. Denvir says that as in Tennessee the New York case will likely play out in court. And, he says, expect to see similar cases in the near future.
“My sense is there are a lot of deals that have been affected by the credit market crunch and economic downturn, so I would expect that we will see more of this,” he says. “We litigated the first case I know about, but I wouldn’t be surprised to see more of them.”