Back in April, private equity fund J.C. Flowers, along with JP Morgan Chase and Bank of America, agreed to acquire Sallie Mae, the largest provider of student loans in the United States. Between then and now, Congress passed the College Cost Reduction and Access Act of 2007 (CCRAA), which reduced in various ways the subsidies the federal government provides the education loan industry. J.C. Flowers and the other buyers have declared that the passage of the CCRAA (either taken alone or in conjunction with other events not here relevant) has caused a Material Adverse Effect on Sallie Mae (as defined in the merger agreement). If this is correct, then the buyers are entitled to walk away from the deal. If not, they may still walk away (the contract expressly excludes a specific performance remedy), but only by paying Sallie Mae a reverse breakup fee of $900 million. The parties are currently litigating the matter before Vice Chancellor Leo Strine of the Delaware Court of Chancery.
At the time the merger agreement was negotiated, other legislation, also adverse to Sallie Mae, was pending before Congress, and the agreement’s definition of “Material Adverse Effect” expressly excludes the effects of certain proposed legislation described in the company’s 10-K. The parties generally agree that the CCRAA is even more adverse to Sallie Mae than such proposed legislation. A central issue in dispute in the litigation is this: assuming that the CCRAA is more adverse to Sallie Mae than the proposed legislation described in the 10-K, in determining whether an MAE has occurred, is it only the incremental effect of the actual legislation over the proposed legislation that counts, or is it the entire effect of the actual legislation? Naturally, Sallie Mae says the former, the buyers the latter.
According to the buyers, they agreed in the contract to accept a certain level of risk, including the risk of the legislation described in the 10-K, but not more. Hence, if the actual legislation is more adverse than the legislation described in the 10-K, the question is whether such legislation in its entirety causes an MAE. Sallie Mae points out that, if this view is correct, then if the actual legislation is just one dollar more adverse than that contemplated at the time of the agreement, the existence of an MAE could turn on this one additional dollar of adverse impact, which seems ridiculous. According to Sallie Mae, the incremental impact in itself should have to be material, i.e., cause a MAE, if the buyers are to get out of the deal without paying the reverse breakup free.
The buyers are right here. Imagine that, at the time of the agreement, the buyers valued the company at V, but were willing to buy the company at the purchase price even if it were worth as little at rV, where r is some percentage reflecting a diminution in value of the company to the buyers from whatever causes (e.g., r = .80, meaning that the buyers would have been willing to buy the company even if it were worth only 80% of its value at the time of the agreement). The intuition here is that rV is lowest value of the company at which it still has not suffered an MAE; if the company is worth less than rV, then it has suffered an MAE.
Since the buyers were willing to bear the risk of the proposed legislation, we have to conclude that they thought that the proposed legislation, if enacted, would reduce the value of the company to, say, xV for some discount factor x such that xV > rV (e.g., perhaps x = .85, meaning that the proposed legislation would reduce the value of the company to .85V, which is still above the .80V threshold of an MAE).
Now, what happens when Congress passes legislation even more adverse to Sallie Mae than that which was being considered at the time of the agreement? Well, the value of the company is reduced to some value yV such that y < x. Has the legislation caused an MAE? It depends. All we know is that y < x. It could be that r < y < x, in which case rV < yV, and there has been no MAE. On the other hand, it could also be that y < r < x, in which case yV < rV, and there has been an MAE. Hence, the buyers’ view makes perfect sense: if the actual legislation is more adverse to Sallie Mae than the proposed legislation (if y < x), then the issue should be whether y < r, i.e., whether the legislation taken as a whole reduces the value of the company to the point that it has suffered an MAE.
Sallie Mae’s view, on the other hand, is incoherent. According to Sallie Mae, there is an MAE only if the incremental effect of the legislation (which is (x – y)V), taken alone, causes an MAE, i.e., only if V – (x – y)V < rV or, what amounts to the same thing, 1 – (x – y) < r. But this means that the buyers can be obligated to buy the company or pay the breakup fee in some cases when the company has suffered an MAE. For example, let r = .80, so that a 20% diminution in the value of the company causes an MAE, and let x = .85, so that the proposed legislation would have caused only a 15% diminution. According to Sallie Mae, if the actual legislation causes a diminution in the value of the company of more than 15% but less than 15% + 20% = 35%, e.g., say y = .70 for a 30% diminution, then the buyers have to buy the company or pay the breakup fee, even though the diminution exceeds 20% and causes an MAE. This, as I say, has to be wrong.
What about Sallie Mae’s argument that the buyers’ interpretation implies that legislation that is even one-dollar more adverse to the company than the proposed legislation could cause an MAE and so the existence of an MAE could turn on one dollar, which seems absurd? To this, I think, there are two responses.
First, all Sallie Mae is doing here is noting what philosophers call the Sorites Paradox—the idea that if you have a heap of sand and remove one grain, you still have a heap, and so by iterating this process you can prove that no matter how few grains of sand you have, even zero, you still have a heap. Analogously, if the proposed legislation doesn’t cause an MAE, then neither does legislation just one dollar more adverse. Iterating this argument, we can show that no legislation, no matter how adverse, causes an MAE. As to why sorites arguments fail, philosophers disagree (there’s a large literature on the philosophy of vagueness), but that such arguments are fallacious is clear enough.
Second and more important, Sallie Mae is right that, since the buyers were willing to accept the risk of the proposed legislation described in the 10-K, if the actual legislation is to cause an MAE, the actual legislation must be materially more adverse to Sallie Mae than the proposed legislation. But saying that the incremental impact of the actual legislation over the proposed legislation is material is not the same as saying that the incremental impact, taken alone, would have an MAE. To pursue the point from above, saying the incremental impact is material amounts to saying that (x – y) ≠0, or, more accurately, that (x – y) is not de minimis. But (x – y) can be significantly greater than zero even though (x – y) < r, i.e., even though the incremental impact, taken alone, does not cause an MAE. For example, if x = .85 and y = .70, the difference (x – y) = .15, or 15% of the value of the company, which is surely material, even if only a 20% diminution in value would cause an MAE on the company because r = .80. Put yet another way, the actual legislation could be materially different from the proposed legislation not because the incremental impact taken alone causes an MAE but because the actual legislation, in its entirety, causes an MAE whereas the proposed legislation did not.
