Basic to any acquisition and its financing are the projections of the target’s future performance. These play a key role in setting the price for the target as well as on the availability of acquisition financing. Projections prepared by the target will likely influence projections prepared by others as well, such as those of potential acquirors and financiers.
The integrity of a set of projections may be challenged in a number of different contexts. A successful challenge can sometimes yield dramatic results. Projections designed to mislead can give rise to charges of fraud and intentional fraudulent transfer. Projections that mislead not by design, but on account of negligence in their preparation, may also lead to striking outcomes. If asset valuations were inflated based on faulty revenue projections, e.g., so as to mask an actual deficiency of asset values versus liabilities, then the hidden insolvency could give rise to disgorgement claims against beneficiaries of asset transfers from the insolvent entity. Such claims could seek to avoid liens granted to lenders that provided the related acquisition financing, or to claw back payments made from acquisition loan proceeds to former owners of the target in payment of the purchase price for the acquisition.
Would it be reasonable for a target to update its previously furnished projections in light of a new or renewed indication of interest from a potential acquiror? What if the updating were done in an expedited manner, even in just the course of a few days, when the prior projections had been prepared over the course of many months in an elaborate corporate process? What are the relevant standards a court may use in considering these and related questions?
A recent bankruptcy court decision dealt with some of these issues, and sheds light on how a court considering them may think about them. The decision in In re Lyondell Chemical Company1 includes an elaborate discussion about when it may be appropriate for a target’s management, in the course of negotiating acquisition terms with a potential acquiror, to hurriedly update financial projections for use by the acquiror and by those providing the acquisition financing. The reasonableness of and business justification for the updates wound up playing a key role in the court’s analysis of certain claims of the bankruptcy trustee in Lyondell’s Chapter 11 case. It had brought claims against certain affiliates of the sponsor-acquiror for disgorgement, on the basis of intentional and constructive fraudulent transfer. The trustee’s claims arose from a contention that the updates to the projections were effectively ordered by the target Lyondell’s CEO to artificially support an inflated purchase price for its shares.
The case also provides a cautionary note for revolving lenders about over-reliance on a “no material adverse change” draw condition, as a basis on which to decline to fund an advance requested by the borrower.
Lyondell-Basell Merger – Background
In December 2007, Basell AF S.C.A., a Luxembourg entity (Basell), acquired Lyondell Chemical Company, a Delaware corporation (Lyondell), via merger. The merger consideration consisted of US$48 cash per Lyondell common share, which was payable as well for the nearly 10% of outstanding Lyondell common shares held by or on behalf of Basell affiliates as their “toehold” position in the target Lyondell, acquired about two months before execution of the merger agreement (Toehold Position). The merger closed in December 2007 with the acquisition financing totaling about US$21 billion, secured by substantially all of the assets of the combined companies.
About a week after the Toehold Position in Lyondell was established, Lyondell’s CEO asked a member of its corporate development team to update the 5-year projections in Lyondell’s long-range plan (Long Range Plan) issued in December 2006. The Long Range Plan and its accompanying projections had taken the better part of a year to prepare, in a deliberate and comprehensive process that incorporated input from heads of its business segments, board members and corporate development team members. In contrast, the updating of those projections was done in only a few days, and primarily by the single member of the corporate development team who had been asked to prepare the updates. The updated or “refreshed” projections resulted in a substantial boost to most of the 5-year EBITDA projections that were reflected in the Long Range Plan. About six weeks after the updated projections were produced, Basell increased its offer price to Lyondell by US$10 a share, to the eventual merger price of US$48 per share, and the merger agreement was signed up a week later.
In the first quarter of 2008, the combined companies started facing liquidity issues due to volatile oil prices. To address them, by the spring of 2008 they had entered into a US$750 million unsecured revolving credit facility with a sponsor-affiliated lender and, in addition, had exercised a US$600 million accordion under one of their bank credit facilities, together providing an additional US$1.35 billion in liquidity. However, a “perfect storm” of unforeseeable negative events hit them through the summer of 2008, from which they never recovered. The confluence of negative events in this period included oil hitting record prices, a major crane collapse at the principal refinery, two hurricanes in the refinery’s vicinity, and the onset of the Great Recession and sharply reduced demand for the company’s products. In January 2009, less than thirteen months after the merger, Lyondell filed for Chapter 11 protection.
Trustee’s Claims to Claw Back the Toehold Payments
The trustee (Trustee) for the estate in the chapter 11 case asserted, among other things, claims of actual and constructive fraudulent transfer, in order to avoid and thus claw back into the estate certain payments that had been made to sponsor affiliates. These payments, totaling in excess of US$1 billion, represented the purchase price for the Toehold Position that had been held by the affiliates, paid on the acquisition closing date as part of the merger consideration and funded from proceeds of the acquisition financing. The Trustee’s claim for actual fraudulent transfer was based on the contention that the Lyondell projection updates were ordered by Lyondell for the express purpose of inflating them and thus inflating the acquisition price for its shares, which wrongful intention, the Trustee argued, should be imputed to the sponsor on account of its alleged knowledge of or complicity in the scheme.
The Trustee’s action for constructive fraudulent transfer was based on the claim that the US$48 per share payment for the Toehold Position did not represent “reasonably equivalent value” and that Lyondell, as well as the combined companies, were insolvent on the date on which the merger closed and the merger consideration paid. The Trustee attempted to prove such insolvency on such date by demonstrating that the updated Lyondell projections were unreasonable, incorporating inflated revenue projections that implied significantly overstated asset valuations, and that liabilities actually exceeded assets when correctly valued, yielding insolvency. Alternatively, the Trustee asserted that, without the exaggerations in the updated projections on both the cost and revenue sides, both Lyondell and the combined companies on the closing date of the merger had been left with an unreasonably small amount of capital with which to conduct their business, confirmed by the subsequent liquidity crises that led to the chapter 11 filing. Such a finding would suffice for purposes of a claim of constructive fraudulent transfer, in lieu of a finding of balance-sheet insolvency.2
Court Finds Updated Projections to be Reasonable
The court frowned on judging the updated projections based on unforeseeable future events, or with the benefit of 20/20 hindsight: “[Lyondell’s expert] presented unrebutted analysis showing the consensus outlook in 2007 that demand growth for petrochemicals and refined products would remain positive and robust . . . and that the projected upcoming petrochemical trough would be ‘mild’ and ‘entirely supply-driven.’. . . Likewise, [he] explained that the confluence of events that actually caused [the company] to miss its 2008 projections—including rapidly rising and then plummeting oil prices . . . and unprecedented negative demand growth for petrochemicals in the fourth quarter of 2008—were not, and could not reasonably have been anticipated as of the Merger Closing Date.”3 The court insisted that market consensus at the time the updates were prepared was the right benchmark to be used in determining the reasonableness of the updates.
Further, the court recognized that different types of projections or projection updates may be prepared for different purposes, and that a particular set of projections or updates can be reasonable for the specific context in which it was prepared and for which it was used, though potentially inappropriate or unreasonable in different contexts: “With respect to the refresh process itself, [Lyondell’s expert] testified regarding different types of corporate planning that are utilized by companies in different scenarios, and sought to contextualize the refresh process employed by Lyondell when revising its projections in May 2007. . . . [He] identified three categories of corporate planning: long range planning, short term planning, and event driven planning. [He] noted that Lyondell’s [Long Range Plan] . . . involved a detailed and thorough process that encompassed strategic considerations, entailed a “bottoms-up” review, macroeconomic analysis and industry trends. . . . [T]he refresh process began following [the sponsor’s] acquisition of the Toehold Position, and [its] filing of the 13D with the Securities and Exchange Commission . . . [representing] a typical “event driven” planning that came in response to a potential merger opportunity, and required swift execution.... The actions . . . in updating EBITDA projections in connection with a potential merger opportunity were reasonable and appropriate given the circumstances. . . .”4 The court found this evidence persuasive.
The court understood the reasonableness of a given set of projections as capable of being established by specifically identified and justifiable business factors, and not merely by conclusory statements or cherry-picking from available market data: “[Lyondell’s expert] also determined that the refreshed projections themselves were reasonable…. In the context of ‘gathering optimism in the performance of the Houston Refinery,’ [he] . . . analyzed each business segment’s historical performance and industry outlook, and concluded that the alterations to the EBITDA projections ‘were based on identifiable and justifiable business factors….‘ [The Trustee’s expert, however,] did not closely analyze any of the valuations prepared by the Banks . . ., but testified at trial that these valuations should be disregarded as not credible, despite the fact that the Banks were putting billions at risk, and the projected valuations prepared by the Banks were all approved by the Banks’ credit committees…. Specifically, [he] testified that the Banks’ projections and valuations were not credible based on his insistence that [other] reports were superior, and referenced scholarship on the supposedly ‘perverted motivations’ of commercial banks in underwriting loans…. The Court finds that [his] opinions were not credible…. He seemed to believe (unreasonably) that banks were willing to risk billions of dollars and their own reputations without undertaking any serious analysis….”5
36 Sets of Projections, But Who’s Counting?
The court also was swayed by the fact that 36 different sets of projections for the target and the combined companies had been prepared in all, including those from the target, the sponsor, investment bankers, and arrangers providing the acquisition financing, together demonstrating a contemporaneous market consensus. The court highlighted that the transactions in question were among sophisticated parties that had run their own projection models and financial analyses, and that it had not been only the target’s projections supporting the pricing of the deal or the amount of the acquisition financing: “[I]n lieu of taking the average of the 36 sets of projections [the Trustee’s expert] identified, or identifying some other method to blend the full set of projections, [he instead] chose three of the lowest projections, each of them downside or stress test cases, and found that these projections failed his cash flow adequacy test.”6 The court disapproved of such an approach that did not consider all of the available data.
The Court thus rejected the Trustee’s assertion that there was something inherently improper about target’s management providing updated projections in the context of a specific transaction on a timetable tailored to the potential deal, even though the target ordinarily updated its projections only annually as part of its next top-down strategic review and preparation of its next long-term plan: “The Trustee’s challenge to the refreshed projections presented a good headline for the Trustee’s theory of the case. But credible trial evidence did not support that headline.”7
Because the updated projections were found by the court to have been reasonable under the circumstances, the Trustee’s attempted demonstration of insolvency on the merger date failed, along with the claim of constructive fraudulent transfer that hinged on that finding. In addition, the court found no wrongful intent in the preparation of the updates by Lyondell and thus no basis for imputing any wrongful intent to the sponsor in connection with the Trustee’s claim of intentional fraudulent transfer, which failed as well.
What This Means for Sponsors
This decision supports the notion that revisions or updates to projections in response to identifiable business changes, whose timing may be dictated by the requirements of a particular deal or potential deal, will not be deemed flawed just because they turned out in the end to be wrong, so long as their preparation was reasonable in light of the circumstances and context for which they were prepared and used. The decision also highlights how deal professionals can provide valuable support for contemporaneous market views of valuations and projections in respect of a transaction. Having a sponsor’s model, e.g., supporting certain acquisition synergies, investment banking models supporting a given merger price for the buyer’s or seller’s board, and financing arranger models prepared for their own credit committee approvals, although each produced for its own purposes, together can constitute a credible snapshot of market consensus at the time of a deal and provide additional support for projection updates such as were at issue in this case.
MAC, Can You Loan Me Some Dough?
As noted above, in order to address liquidity issues it was facing in 2008, the combined company entered into a US$750 million unsecured revolving credit facility with a sponsor-affiliated lender (Affiliate Revolver). In October 2008, the company drew US$300 million under the Affiliate Revolver and then fully repaid such amount over the course of just the following few days as its liquidity improved. Then, in late December 2008, just days before Lyondell’s chapter 11 filing, it made a borrowing request under the Affiliate Revolver for a draw equal to the full US$750 million commitment amount under the facility. The sponsor-affiliate declined to honor the draw request, asserting that a “material adverse change” had occurred since the original date of the facility, due to the company’s insolvency on the date of the requested borrowing.
The Affiliate Revolver had included, as a condition to each borrowing, that since the inception of the facility there had occurred no “material adverse effect,” defined in the agreement as “a material adverse effect on the business, operations, assets, liabilities (actual or contingent) or financial condition”8 of the company. The sponsor-affiliated lender asserted that the company’s insolvency was such an event, and that due to failure of the borrowing condition, the loan need not be extended. The Trustee asserted that the failure to lend on the part of the sponsor-affiliate was a breach of contract, inasmuch as the facility contained no express solvency condition for each borrowing, and that it was improper to read a solvency condition into the no-material adverse change condition.
The court noted that the Affiliate Revolver had required an express representation by the borrower as to solvency at the initial closing of the facility, but not in connection each subsequent advance. The court also noted that, when the Affiliate Revolver was first entered into, the company had already been facing severe liquidity issues, and the parties thus had every reason not to require a solvency representation at the time of each later borrowing. The court also observed that the parties clearly had the ability to incorporate into the agreement, if they had so intended, an express solvency condition for each borrowing. But they had not done so: “The Defendants cannot now stretch the MAC clause to include [solvency]. Accordingly, this Court finds that the MAC clause does not create a solvency requirement at the time of the loan draw request”.9
While holding that the affiliated lender had thus breached its contract when it refused to honor the borrowing request, it also enforced a clause in the Affiliate Revolver limiting the lender’s damages in cases of breach. The common clause provided that the lender would not be liable for indirect, special, consequential or punitive damages in connection with its breach. The court therefore awarded, as damages for the breach, only a portion of the commitment fees that had been paid by the borrower to the affiliated lender at the time of entry into the agreement, as “restitutionary” damages. This equaled US$7.2 million, or 60% of the US$12 million commitment fee previously paid, rather than the billions of dollars in damages for such breach the Trustee had estimated and sought.
What This Means for Sponsors
In the context of a liquidity line of credit provided for a portfolio company or other affiliate, a sponsor should address specific concerns upfront. It is beneficial in such cases to add a specific solvency condition for each extension of credit, which condition can be waived at the later time if so desired. Often there will be no other lender willing to make the credit available on similar terms, so there is ample justification for such a funding condition. The relatively small amount of damages awarded in the case for the breach is also a reminder in such cases to include a limitation of damages provision for the sponsor’s benefit.
We look forward to updating you on additional developments in the next issue.
