One of the lessons coming out of the string of failed acquisitions in 2007 and 2008 is that debt commitment letters may not be as firm as you think.
When a lender breaches a commitment to finance an acquisition, a borrower traditionally obtains a substitute loan and recovers as damages the incremental costs of the new capital. But in a down market like the prevailing one, a substitute loan cannot always be found. In such circumstances, can banks be compelled to fund the acquisition? Although little case law directly addresses this question, the answer appears to be “no,” and that may leave a borrower with little legal recourse against a defaulting lender, save for recovering its out-of-pocket expenses. The lesson, as discussed further below, is to expressly address and allocate substitute financing risk in debt commitment letters.
The effects of the slackening economy on the buyout market are obvious. Just as tightening credit has increased lenders’ costs of capital, hindered their ability to sell loans and changed their risk appetite, inflation and other adverse market conditions have hurt the performance of targets. These factors (and others) have contributed both to failed acquisitions (Cumulus Media, Myers Industries, NIBC Holdings) and to stalled and renegotiated ones (Clear Channel, BCE).
Less obvious is what a sponsor can do when a lender pulls the plug on a deal. These days, it is frequently the sponsor that bears the risk of securing financing for a transaction, a marked change from the past when that risk was primarily borne by sellers. This change largely came about in 2005, a result of competition among buyout firms for limited acquisition opportunities. As a result of now bearing the financing contingency risk (typically in the form of liquidated break-up fees equal to two to three percent of the purchase price), and their inability to find substitute capital, sponsors are focusing ever greater attention on their remedies when a lender defaults on a debt commitment.
Deteriorating economics, unavailable replacement capital, and newly assumed acquirer risk are the very factors that precipitated the widely-watched Clear Channel case, where a consortium of lenders refused to fund a $22 billion buyout on the basis that financing conditions had not been satisfied. Seeking an order of “specific performance”—an order requiring the lenders to advance capital in accordance with the commitment letter—the sponsors argued that substitute capital was not available and that only specific performance could provide an adequate remedy. The case settled on restructured loan and acquisition terms without a judicial decision shedding light on what remedy the sponsors could have obtained if the lenders had been found to be in breach. The issue remains an open one.
In contract cases, the remedy for breach is usually a monetary award, unless damages are inadequate either because (a) the subject of the contract is unique (as with a work of art) or (b) the loss cannot be reliably monetized (as with lost profits for a start-up company). In either case, specific performance may be obtained only if the non-breaching party can demonstrate its ability fully to perform.
The law favors damages over specific performance for several reasons. Compelling parties to perform may require a court to engage in continued supervision of the relationship. The judiciary is not similarly taxed when it gives a damages award. Damages also provide a more efficient remedy than specific performance. Under a damages regime, all contract parties have an option either to perform or to breach and pay damages. A party will elect the latter when it can both make the non-breaching party whole through the payment of damages, and still fare better than if the deal had advanced. Damages thus provide a means for redeploying contracted-for goods or services so that they end up with the user that values them most, while leaving neither contract party (in theory) worse off than full performance.
Notwithstanding the law’s preference for damages, borrowers unable to secure alternative financing will likely argue (as did the Clear Channel sponsors) that the lenders should have to make the loan. By seeking specific performance, a plaintiff threatens not only to secure the benefit of its bargain, but also to deprive the breaching party of any perceived gains from the breach. It thereby obtains negotiating leverage. Apart from strategic considerations, borrowers also have a compelling legal case to make: Since they cannot secure a damages award covering the heightened costs of capital, as no adequate substitute loan can be obtained, and since commitment letters usually bar the recovery of consequential damages (the lost value of the acquisition), a borrower may contend that damages simply cannot be quantified. As a result, only specific performance can provide an adequate remedy, or so the argument goes.
A Tough Sell
In the end, however, the borrower’s argument will probably not prevail. While not resolving the issue, the Clear Channel judge noted that New York courts ordinarily “will not order specific performance of a contract to lend money” and that “very few exceptions have been made to this general rule.” There are several reasons for this. First, the very fact that a borrower cannot obtain a substitute loan strongly suggests that the marketplace perceives such a loan to be too risky. This fact seriously undercuts a borrower’s ability to demonstrate that it can perform under the loan, a prerequisite to a specific performance order.
Second, the exclusion of consequential damages in the commitment letter also may foreclose specific performance. For instance, in the Clear Channel case, the commitment letter barred any claims for “any special, indirect, consequential or punitive damages in connection with the Credit Facilities,” a fairly standard exclusion. By seeking to require the lender to make the loan, the borrower is attempting to capture its anticipated profits and thereby shift to the lender a risk that the borrower explicitly assumed.
Moreover, courts are far more likely to order specific performance when it results in the severing of a relationship (such as one partner buying out another) or a one-time transaction (such as in an acquisition of closely-held shares). Courts are reluctant to order parties to specifically perform a long-term contract because if one party is an unwilling participant, the relationship will likely require substantial court supervision. The one noteworthy exception is when a borrower, in reliance on a commitment, has partially undertaken a project that will lie fallow in the absence of specific performance—for example, when a developer starts construction in reliance on milestone financing. In that situation, there will be both continued losses suffered by the borrower and adverse third-party effects (such as an abandoned building in the middle of town), both of which can be alleviated only by a specific performance order because replacement capital can seldom be raised in the midst of a failed development. The case of a lender failing to provide acquisition financing does not fall within this exception.
If specific performance cannot be obtained, what should the damages be? As noted above, most commitment letters permit a non-breaching borrower to recover “direct damages,” but not “consequential damage.” Direct damages measure the value of that which was to be delivered under the contract (here, a loan), either in terms of (a) the cost of its replacement or (b) its market value on the expected date of delivery. Consequential damages, by contrast, measure the income that a non-breaching party could have earned in a transaction with a third-party (here, the profits of the target) had it received the goods or services promised. The problem is that many losses do not fit neatly into these categories, as is the case with damages arising from broken debt commitments.
We have assumed that the first measure of direct damages, the cost of a substitute loan, is inapplicable. To be sure, while a borrower might be able to obtain a loan at a price that does not make sense in terms of the expected return on the acquisition, and then seek to recover the higher loan costs from the defaulting lender, that would be both inefficient and highly unlikely to occur. For such a borrower would be undertaking an acquisition based on a gamble that it might prevail in a later lawsuit against the original lender.
Consider an example: If a sponsor’s expected cost of capital is $6, and the expected profit of the target is $8, the sponsor’s return on its investment would be $2. A sponsor able to find a substitute loan at a $9 would have negative return of minus $1. While such a sponsor could, in theory, eventually be made whole by recovering the additional costs of capital, $3, from its original lender, few sponsors would obviously risk a negative return in the hopes of prevailing in such a suit.
The second measure of direct damages is the market value of the loan—the price that a third-party would be willing to pay to step into the borrower’s shoes. That value would be based on the expected rate of return on the acquisition, or the projected profits of the target less the costs of capital. The problem here is that the direct damages measure converges with the consequential damages measure—both focus on the lost profits of the acquisition—and most commitment letters, as we have seen, expressly preclude awards based on consequential damages.
Confronted with no obvious means to measure direct damages, no ability to recoup consequential damages, and unlikely to secure specific performance, a borrower might next argue that the consequential damages exclusion should be stricken. More specifically, a borrower might contend that the quid-pro-quo for its agreement to exclude its right to claim consequential damages was the lender’s agreement to pay all incremental costs of a substitute loan. Since no substitute loan can be found, a borrower could argue that the premise for the deal (or in lawyer parlance, the “consideration”) has not materialized and thus, that the damages exclusion should not be enforced.
Courts will, in fact, strike damages exclusions that leave non-breaching parties with no remedy, but are very reluctant to do so when sophisticated parties are involved. Most courts, particularly in New York, do not want to be in the business of rewriting deals. Rather, courts in this situation tend to default to the “reliance measure of damages,” that is, damages that place the non-breaching party in the position it was in prior to executing the agreement (as opposed to the position it would have been in after full performance). The borrower’s commitment fees to the lender and break-up fees to the seller—its out-of-pocket expenses—would thus likely form the basis of any award.
Contract parties often leave default provisions vague on the theory that the parties will not be able to reach agreement on such clauses and that a breach is unlikely to occur. There is nothing wrong with that approach, provided parties understand that contractual uncertainty often leads to litigation. If, however, lenders and borrowers intend to clarify remedies in advance of a breach, then they would be well-advised not simply to rely upon a generic exclusions of “consequential” damages, but to specify whether specific performance, break-up fees, lost profits, or other remedies can be awarded, whether such remedies are exclusive, and what happens if such remedies fail. Only then will parties truly understand what lenders do and do not commit to when they issue a commitment letter.
Eric Fishman is a litigation partner in the New York office of Pillsbury Winthrop Shaw Pittman LLP. His practice focuses on contract disputes in the financial services sector and large construction and engineering disputes. He can be reached at firstname.lastname@example.org