Legal Briefs: Stuck In A Feedback Loop

As the carnage of failed deals piled up last year, industry participants widely predicted big changes in merger agreements. Specifically, these changes were supposed to tilt the balance of contractual power toward the seller.

Well, that hasn’t happened. Reverse break-up fees have gone up, but not by much, and sellers haven’t reacted to scotched deals from LBO shops by demanding “specific performance” in contracts, which would help guarantee a deal’s closure. Of course, there haven’t been all that many take-privates in the last year, thinning the size of the sample, but a few trends seem to be appearing.

The Blackstone Group, for instance, last month inked a $1.6 billion deal to buy Apria Healthcare Group Inc. The merger agreement is little different from the kind of contract that was standard before August 2007. Blackstone Group’s liability tops out at $38 million, and the firm can walk away from the transaction at any time and simply pay the fee, according to an analysis by Stephen Davidoff, a former M&A lawyer turned University of Connecticut Law School professor. Apria Healthcare, on the other hand, is more or less helpless and at the whim of Blackstone Group.

This baffles Davidoff, who keeps a close eye on LBO merger agreements. In fact, it more than baffles him. He considers this non-change in contract language to be nothing short of a breakdown by M&A attorneys. At the end of June, he published a paper called “The Failure of Private Equity,” in which he argued that deal attorneys are stuck in a closed system. This feedback loop rarely incorporates new concepts and ideas.

Over the years, attorneys have come to rely on the fact that buyout firms have a nearly existential obligation to close deals. This is what LBO shops do, after all, and their merger contracts are therefore ambiguous in some spots and incomplete in others. Parties to a deal are counting on forces outside the four corners of a contract to prevail. As Davidoff points out, this explains in part why Peter Huntsman, the eponymous CEO of Huntsman Corp., said LBO shop Apollo Management should be “disgraced” after suing Huntsman to back out of its deal to buy the chemical company. Huntsman’s outrage suggests that he views Apollo Management’s move as almost contrary to nature, yet Huntsman may not have much recourse under the terms of its contract.

Especially now that buyout firms have suffered such reputational damage from broken deals, and shown they’re willing to violate their words, it would stand to reason that contracts would have correspondingly changed. But deal lawyers lack incentives to make any changes. “By negotiating within the prior structure and instead relying upon externalized forces, lawyers allow the burden of failure to be assumed by the companies rather than lawyers themselves,” Davidoff writes. Lawyers, in other wrods, are counting on drivers outside the merger agreement to come to bear on a deal, and if the deal breaks down, it’s not because the contract itself is flawed.

Davidoff predicts this mode of thinking will persist until the market makes such a commotion that attorneys will have little choice but to make big changes. If the market keeps sputtering, and deals keep going south, that day may come soon.