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LBOs in the UK
"Nasty traps" await the unwary
Competition to secure the trophy LBO deals in Europe has never been more intense. The rules of engagement are all too familiar. The vendor appoints an investment bank to auction the target business. Data rooms are established, pro-forma contracts are drafted, due-diligence reports commissioned and information memoranda prepared. Round 1 bids are invited. Preference will be given to bidders who mark-up the contract lightly, can complete quickly (subject to the fewest conditions) and, of course, offer the highest price. Round 2 will see perhaps three bidders through the gate, each being allowed access to the more commercially sensitive due diligence. Negotiation of the main commercial points on the legal contracts commences. Final bids are submitted. Round 3 will see the lucky winner given one- or two-weeks' exclusivity to reach the finishing tape and sign on the dotted line. The whole process can take many months and involve numerous professional firms and financial institutions.
In round 1 everyone is jockeying for position and listening hard to pick up market rumors. Who's interested and who's not? Are bidders predominantly trade buyers, predominantly financial buyers, or a mix of both? Is anyone close to management? Does anyone have an inside track? During this period financial buyers (and, in certain cases, trade buyers) invite banks to bid for the mandate to provide the debt facilities. Substantial fees and market profile are at stake--especially for a trophy deal and especially if there is a high-yield bond. A future IPO mandate also beckons.
Types of Commitment Letter
So what are the ramifications for banks in signing up to the different types of commitment letter? What obligations do they assume? Are they putting balance sheets or reputations or both at risk? Do they actually deliver (in legal terms) what financial buyers and vendors anticipate? Put another way, do commitment letters bind up offers of finance in legal or merely reputational knots?
The problem is that commitments come in all shapes and sizes. The legal consequences will turn on the particular words used. Indeed, everything can turn on a single word.1 However, we can identify some common components and features and look at the legal implications of adopting particular formulations.
The commitment: a statement recording what the bank is agreeing or committing to do. We will look at three common formulations:
The conditions: the conditions which must be satisfied before the bank's obligations are triggered. These typically comprise:
The engagement provisions--the terms governing the bank's appointment including:
The commitment letter will usually attach term sheets summarizing the essential terms of the facilities offered by the bank. See page 22 for a typical U.K.-style commitment letter and page 24 for a sample of a short-form term sheet. To keep things simple we have assumed only senior facilities are involved.
Some Preliminary Points
Form--U.K.-style commitment letters tend to be more concise than their U.S. equivalent. The U.S.-style commitment letter will usually describe the transaction which is to be funded in greater detail and include more narrative. A U.K.-style letter will often include only the commitment component and the conditions component summarized in the paragraph above. The engagement terms will either not be addressed at all or left until the deal has been secured. This reflects the greater maturity of the U.S. financing market, the use of high-yield bonds and other capital markets instruments in U.S. financings and a voracious appetite for litigating every commercial mishap and dented corporate ego. High-yield and similar instruments are now established features of the larger European transactions. As a result U.S.-style engagement terms have been adopted on those transactions and are achieving more general currency.
Contracting party--this point is easily overlooked. The financial buyer will be making an offer to buy the business on behalf of a Newco which, at the time of making the offer, may not even exist. If it exists, it will be a pure shell of no value. Indeed, even if a financial buyer's bid is the winning bid, Newco will stay as a shell until the moment of closing. The financial buyer may resist taking on any obligations in the commitment letter in its own right. At most it may agree to procure that Newco (when formed) becomes a party to the commitment letter. Any indemnity or agreement to reimburse expenses recorded in the engagement terms is therefore economically meaningless unless and until the transaction actually completes.
Signatures--it is not uncommon for a commitment letter signed off by the bank immediately prior to submission of a round 1 bid to remain unsigned by the venture capitalists until some time during round 3. This can leave the bank in the uncomfortable position of having its "commitment" out supporting the bid but with no written confirmation from the bidder that it is exclusively mandated.
Capital cost--banks should be aware that delivering a commitment letter which constitutes a "firm offer" of finance will trigger a capital cost (for those regulated by the Financial Services Authority) after 30 days (60 days if the facilities are to be syndicated). Indeed, the note to regulation BC 4.2.6 makes it clear that the Financial Services Authority will regard an offer as firm even if it is subject to documentation and/or no material adverse change.
The commitment: The commitment is the section of the letter which records what the bank is agreeing or committing to do. There are a host of different variations. Broadly speaking, they divide into three categories:
We will look at each of these in turn.
Highly Confident: When a bank writes a highly confident letter the key paragraph usually reads something like this:
"We are highly confident that we will be able to arrange and underwrite these facilities."
Highly confident letters are a relatively recent phenomenon in Europe. They are, however, well established in the U.S. In U.S. transactions it is not unusual to sign up to an acquisition agreement which is itself subject to financing. The purchaser obtains a highly confident letter to give the vendor some assurance that the purchaser will be able to obtain the necessary bank finance to complete on the transaction. But what obligations does a bank assume if it writes such a letter?
There is no record of this issue having come before the English courts. However, its legal effect has been considered by the U.S. courts. In McKinley Allsopp Inc. v. Jetborne International Inc. (1990) the judge indicated that:
"Although a highly confident letter is not a contractual commitment to secure financing, it does represent a commitment to devote efforts to secure financing (unless the entity issuing the 'highly confident' undertaking expects to provide the financing itself).... The obligations (with respect to efforts) undertaken by an investment bank by issuance of a 'highly confident' letter are at least as onerous as those undertaken by issuance of a 'best efforts' undertaking (once again, unless the issuer expects to provide the financing itself)."
The judge concluded that "best efforts to obtain financing implies multifaceted obligations, which include learning the business to be financed, performing due diligence functions, authorizing a descriptive memorandum, creating and generating financial models, identifying potential investors, contacting and screening potential investors, working with the potential investors in an effort to convince them of the merits of the transaction."
This case tells us two things. First, that the highly confident letter does not constitute a contractual obligation to provide the financing. Second, where the bank is to act as the arranger of the financing (which is normally the case) it assumes an obligation to use best efforts to secure the financing.
There can be little doubt that the English courts will also take the view that a highly confident letter does not amount to a contractual commitment to provide funds. Whether they will similarly take the view that it imposes an obligation to use best efforts to arrange a financing (where the bank is assuming that role) is more doubtful.
However, that is not an end to the matter. The issue of a highly confident letter is not without legal consequences. The letter will be used by the bidder to convince the vendor that the bidder can raise the necessary finance to complete the transaction. The bank will be aware of this. The bank will know that the seller is relying upon the letter in making its judgment as to whether it accepts the bidder's offer. It is therefore most likely that the bank is making a representation which--if proved to be false--could entitle the bidder (and indeed the seller)4 to claim damages for any loss they suffer as a result of relying upon the representation. If, therefore, the bank has not undertaken the necessary research, investigated the bidder and the target business, or produced the necessary financial models etc., a legal action against it could well succeed.5
Commitment: a more traditional form of commitment letter might include the following statement:
" We commit to provide the facilities."
What does "commit" mean for these purposes? The only judicial authority we have on this side of the pond is a Scottish case--Bank of Scotland v 3i, decided in 1993. Bank of Scotland lent money to a company--IPS. It did so on the basis of an assurance given to it by an executive of 3i (over the telephone) that 3i had "commitments" from equity investors to invest an extra £1.1 million in IPS to repay Bank of Scotland. This was short of the £1.25 million needed by the business but the 3i executive indicated that if the investors did not provide the balance, 3i would make up the difference. A stock-market crash followed and the equity investors withdrew. Bank of Scotland lost its money and sued 3i. The court received extensive expert evidence of what the word "commitment" means in the venture-capital world. The court concluded that the use of the word "commitment" in the telephone conversation did not signify any legal obligation to subscribe. It meant no more than an expression of serious interest and that internal approvals had been obtained. Bank of Scotland therefore failed in its action for damages against 3i.
Whatever your views of the outcome of the Bank of Scotland v 3i case, the formulation "we commit to provide facilities" recorded in a commitment letter is a different matter to stating on the telephone that "we have commitments."
Until recently, the English courts have construed documents according to the grammatical and ordinary sense of the words (unless that would lead to some absurdity or inconsistency). More recently, they have adopted a more flexible approach. If the words used are capable of more than one construction, they choose the construction which seems most likely to give effect to the commercial purpose of the agreement.
Against this background, how should we construe the phrase "we commit to provide facilities"? If you look at the commercial purpose of obtaining the commitment letter, a court could conclude that the very purpose for which the commitment letter was given was to assure both the financial buyer and the seller that the funds would be available. It must be probable that an English court will construe the phrase "we commit to provide the necessary facilities" to mean the bank has assumed a legal obligation to provide the facilities.6
1. See "Quadrex Risk" page 21. See also Kleinwort Benson v Malaysia Mining (1988) where the use of the word 'policy' in the sentence "it is our policy to ensure that the business of [our subsidiary] is at all times in a position to meet its liabilities to you" was held to be a statement of present intention and to impose only a moral--not a legal--obligation to support the subsidiary.
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