The Art of Walking Away from the DealPublished: January 11, 2006 in Knowledge@Wharton
On December 15, 2004, New Brunswick, N.J.-based Johnson & Johnson announced an agreement to acquire cardiovascular device maker Guidant for $25.4 billion. As with most M&As, both sides spoke of synergy -- in this case, J&J's goal of strengthening its position in the cardiac devices market -- and set about the task of closing the deal.
Ten months later, the press had a different story to report. After Indianapolis-based Guidant recalled thousands of defibrillators and pacemakers in June and announced it had received subpoenas from U. S. Attorneys' offices in Boston and Minneapolis, J&J hinted that it might walk out of the deal. Soon after, it decided instead to try and renegotiate the purchase price lower. Guidant followed up with a lawsuit to force J&J to follow through on its original commitment. On November 15, the two companies agreed on a new price -- $21.5 billion.
What Guidant experienced in the course of these negotiations is a "material adverse change," a legal term that offers buyers an "out" and gives sellers heartburn, and refers to events that happen between the time a deal is announced and the day it closes. In J&J's case, that change referred to revelations of Guidant's product defects and regulatory problems, all of which caused its stock price to lose more than 20% of its value over the last 12 months.
"Material Adverse Change"
While the J&J case has recently been complicated by a counteroffer from medical device maker Boston Scientific to buy Guidant for $25 billion, the use of the material adverse change clause remains the contentious issue. The clause is an integral part of a preliminary deal agreement between two parties stipulating, among other things, that if the due diligence process digs up anything that would materially alter the value of the company, or if subsequent events relating to the target company adversely impact its long-term value, then the parties can renegotiate the price or walk away from the deal, says Richard Shell, Wharton professor of legal studies and business ethics. "When you hear parties talking about this clause, a lawsuit is usually not far behind."
Experts observe that while deals seldom break up because of material adverse change, companies often use it as a bargaining chip to renegotiate the deal price if the situation changes substantially.
Another company that successfully used the material adverse change clause to lower the original purchase price was Pittsburgh-based PNC Financial Services Group during its bid to purchase D.C.-based Riggs National. In July 2004, PNC had agreed to buy Riggs, which was already under a regulatory cloud, for $729 million -- a deal that would allow PNC to enter the desirable Washington, D.C., market with one of the largest banking franchises in the region. In the months that followed, however, Riggs was investigated for lax anti-laundering controls and alleged violation of the Bank Secrecy Act, as well as for its dealings with former Chilean dictator Augusto Pinochet and the government of Equatorial Guinea.
PNC's management, initially upbeat about the deal, began publicly stating that they were watching the developments, and reminded investors that the bank could walk out under the "material adverse change" clause. Riggs, for its part, sued PNC for undermining the deal. Eventually, PNC renegotiated a lower price -- $654 million --but also agreed to drop its demand that Riggs settle or set aside reserves against private litigation before the deal was completed. The PNC-Riggs deal closed in May: PNC entered the D.C. market and the embattled Riggs found a savior.
A key reason why many public deals, such as J&J's, get renegotiated instead of breaking up in light of new adverse developments is that both parties have too much at stake strategically to back out, says Wharton management professor Saikat Chaudhuri. "I am not surprised at the J&J-Guidant renegotiation," he notes. In going after Guidant, J&J had been hoping to expand its product portfolio into heart devices. "J&J would have needed to fill that gap anyhow," and trying to find another target would result in significantly more time and effort. "It is unusual for deals to completely fall though," he adds, because both sides have already invested so much in the final outcome.
Renegotiation of a deal because of new facts is not uncommon, adds Jeffrey Robards, a vice president at Downer & Company, an investment banking firm in Boston. In fact, "in the last two years, companies are paying more attention to the adverse material change clause. In addition, we are seeing more specific language in the contract, narrowing it down to the company itself as opposed to allowing for broader things such as changes in the industry or the economy."
Dynegy's Close Call
While a majority of the deals between public companies that make strategic and economic sense end up being consummated -- even if new facts emerge -- some do fall apart if the situation turns dramatic.
For instance, Dynegy walked away from its deal to buy the beleaguered energy giant Enron four years ago. When Dynegy agreed to purchase the company on November 9, 2001, Enron was already in trouble over its earnings restatement, although the full extent of the misdeeds by Enron's management didn't surface until after the due diligence process. Within weeks of the deal's announcement, Enron's shares had fallen more than 50% and the company announced it couldn't meet its debt repayment obligations.
Dynegy scrapped the deal, essentially pushing Enron toward bankruptcy. Dynegy's chief executive Chuck Watson said the company was forced to walk away and cited the material adverse change clause in the deal contract. "If you have extreme circumstances of this sort, those are good reasons to walk away," says Chaudhuri.
Of course many deals also fall apart if the parties mutually agree that it is better not to proceed -- a scenario different from one where one of the two gets into trouble. On November 14, Pitney Bowes called off its $50.3 million acquisition of privately held FirstLogic because of a request for information regarding the deal by the Federal Trade Commission. Both companies had agreed that either could terminate the deal without any penalty if the deal was not closed by a certain date. Similarly, Microsoft and SAP, two software giants, called off their merger talks last year because the merger and integration process would have been too complex.
Negotiating Through the Media
Typically, if the parties involved are large public companies, such as J&J, then the stakes are higher as investors and the media begin to closely follow the developments. On occasion, the parties themselves fight the battle through the media before arriving at a new agreement.
For example, in October, J&J first said publicly to analysts and investors that it might have to review the deal or walk away as a result of the developments at Guidant. When J&J warned again that it might walk away after regulatory probes came to light, Guidant sued J&J to force it to complete the deal. Similarly, PNC, too, had to comment publicly when the investor community started questioning the deal once Riggs' troubles began to surface.
"One of the unfortunate aspects in some of these deals is that a lot of signaling and messaging is done through the media on both sides," says Chaudhuri. It might have been more beneficial if J&J and Guidant had been able to negotiate more privately, so that the first statement to the media would have been the renegotiated contract, "instead of statements that were more hostile in nature."
Being a publicly listed company sometimes forces negotiating parties to come out in the open about the renegotiation process, says Robards. Opportunities for renegotiations are much more common in deals between private companies, where public scrutiny is avoided.
Risks of Renegotiation
While pushing for a lower price because of adverse developments in the target company can be successful and even justified, it can sometimes bring unwanted attention, such as a new bidder. On December 11, Paramount Pictures acted quickly to buy DreamWorks SKG after General Electric's NBC Universal Studio stretched the negotiations over many months and eventually lowered its initial bid. By dragging its feet for so long, Universal alienated DreamWorks' owners and opened the door to a quick deal with Paramount.
Similarly, in the J&J case, Boston Scientific's offer of a higher price for Guidant could mean the deal might slip away from J&J. Guidant's board has said it will consider Boston Scientific's bid even as J&J issued a statement saying its renegotiated price was fair. If J&J does decide to increase its bid, it could be a difficult sell to shareholders, especially since J&J has already taken such a tough stance on the negative impact of Guidant's troubles. "Whenever you renegotiate a deal, you give other parties a chance to get into the process and complicate the outcome," says Shell. "At the end of the day, what J&J has to decide is what Guidant is worth to it." Competition from another bidder, he adds, might tempt the original bidder to overpay -- always a danger in the renegotiating process.
This turn of events has worked well for Guidant, says Chaudhuri. The fact that another company made a serious offer gives Guidant a certain legitimacy and credibility, he adds. It could also signal that its current problems are immaterial in the long run, and that its value lies in its product portfolio and the pipeline it brings with it.
J&J might still clinch the deal, as has happened in other instances where the lower bidder ended up winning. In February, MCI-WorldCom agreed to be acquired by Verizon Communications although Verizon's bid, at $6.75 billion, was lower than Qwest Communication's reported $7.3 billion offer. Verizon, as the market leader, was the stronger player of the two.
In many cases, the final decision is not based on price alone, says Chaudhuri. Instead, it might depend on the kind of post-merger company the target wants to be. He anticipates that if Guidant's goal is to operate as a subsidiary supported by the resources of a large company, then J&J would probably be the choice. With Boston Scientific, he would expect a lot more integration to take place. Another important consideration is which acquirer can provide the kinds of resources the target company needs most, such as access to broader markets and distribution systems.