Anatomy of a Merger

April 13, 2008, 9:56 pm

On Friday, JPMorgan Chase filed its registration statement on Form S-4 with the Securities and Exchange Commission related to its acquisition of Bear Stearns. This is the document JPMorgan is using to register the securities it is issuing to the Bear Stearns shareholders and will also function as the proxy statement for the Bear Stearns shareholder vote.

It is interesting reading, but it is quite clear that this deal has very little to do with corporate law. Still, here are a couple of highlights from the section on the background to the transaction:

1. It was over for Bear on the evening of Friday, March 14. That was when the New York Federal Reserve informed Bear that on Monday morning it was pulling its secured lending facility agreed to earlier that day. This was the stick for the carrot another “unnamed” government official gave Bear – find a “stabilizing” transaction by the end of the weekend.

Without any liquidity on Monday morning, Bear had no choice but to take the carrot. The question here is what led the Fed to do an about-face and force Bear into a transaction – was it Treasury lobbying? Regardless, someone in the federal government decided that Bear was no longer going to go it alone. I haven’t read the congressional testimony so if it is explained there please let me know in the comments below.

2. “Bidder A” never had a chance. It is being reported in the media that the alternative bidder described in the filing is the private equity group J.C. Flowers & Company. According to the filing, a Bidder A (i.e., Flowers) gave a preliminary indication of interest for a transaction involving a capital infusion of $3 billion for 90 percent of Bear’s equity. By mid-afternoon on Sunday, however, Flowers had to withdraw, given the Fed’s refusal to support the proposal and the consequent refusal of other financial institutions to provide financing for Flowers’ bid. The filing discloses that Lazard was able to find other interested bidders, but the required timeframe made things unworkable for them.

3. The end of the affair. After Bidder A’s withdrawal and with no other savior or bidder in sight, JPMorgan lowered its $10-to-$12 initial offer to $2, refusing Bear’s request for some form of contingent consideration. The filing states that this move was done in consultation with yet again “unnamed” government officials. I would have loved to hear that conversation. Nonetheless, it appears clear that by this time with no Fed lending facility, no other bidders, and the Japanese markets about to open, Bear’s only other alternative to the JPMorgan transaction was bankruptcy. JPMorgan lowered the price leveraging off this fact with some level of government support/ “persuasion”?

4. Bankruptcy alternative. Here, Bear’s broker-dealer subsidiary would have been required to file a Chapter 7 liquidation, but the Bear holding company and non-broker-dealer entities could still file for Chapter 11 reorganization selling operations along the way through the bankruptcy process. This alternative is mentioned but the parties say that it was not considered a realistic possibility because of the lack of cash at the Bear holding company. Here, bankruptcy may have been harder since the broker-dealer entities at this point were relying on collateralized overnight borrowing, and the concern and the Bear holding company debtor would not have the right to put a hold on collateral seizures and forced liquidations or otherwise the assets to get debtor-in-possession financing.

5. There is a weird dynamic in the bankruptcy analysis. The board of directors was advised by Lazard, their legal advisors and management that it was their collective view that in bankruptcy “the holders of Bear Stearns common stock likely would receive no value and there likely would be losses incurred by certain creditors of Bear Stearns.” But in their fairness opinion Lazard assumes that the stockholders will receive nothing. Hard to see if there was any real financial valuation done of the bankruptcy alternative other than the usual mantra of we’ll lose everything, but likely such analysis was impossible given the timeline imposed by the Fed.

6. The Lazard opinion is a waste of paper. The Lazard opinion assumes a Chapter 7 filing (without a valuation thereof and based on the stockholders receiving nothing) as the only alternative. The opinion notes that the consideration was set with the participation of the government, and unusually caveats the opinion as excluding anything with respect to the deal protection mechanisms or any compensation agreements with Bear employees. But Lazard shouldn’t be blamed here — no other investment bank would have given an opinion on anything more. Lazard is getting $20 million for their services, a large dollar fee relative to my salary, but a relatively appropriate sum for their services in this deal outside of the fairness opinion. Still – I’d be curious to see their fee letter to see if it too was renegotiated to take into account the first version of the deal and comparatively low consideration.

7. The deal renegotiation is the most interesting part. The filing makes a case that Bear was continuing to face liquidity issues and a possible bankruptcy despite the Fed loan and JPMorgan guaranty. More importantly, the filing details a scenario where JPMorgan was getting pressure from the New York Fed to further guarantee Bear’s loans from the Fed and rework the transaction to in the filings word’s “achieve a greater degree of stability at Bear Stearns.”

8. Here it is worth going through the disclosure a bit. The filing states:

On Friday, March 21, 2008, discussions continued between Bear Stearns and JPMorgan Chase regarding the revised transaction terms proposed by JPMorgan Chase. Representatives of JPMorgan Chase informed Bear Stearns that during the week the New York Fed had repeatedly requested that JPMorgan Chase guaranty Bear Stearns’ borrowings from the New York Fed, and that JPMorgan Chase was at this time unwilling to do so.

In addition to the New York Fed borrowings, representatives of JPMorgan Chase also noted that they did not see how JPMorgan Chase would be able to continue to extend credit to Bear Stearns or provide an enhanced guaranty in the face of the market’s concerns regarding Bear Stearns’ viability and the risk that the merger might not be completed. In light of these factors, JPMorgan Chase expressed its view that the previously discussed transaction revisions would not be sufficient to provide the stability to Bear Stearns or certainty to JPMorgan Chase necessary for JPMorgan Chase to continue its exposure to Bear Stearns.

This appears to be carefully choreographed language to put Bear back into a bankruptcy scenario and justify the deal protections imposed. It may indeed be true. But I just don’t understand this. Didn’t Bear just sign a contract to be acquired at $2 a share with no outs (question – under the deal would even bankruptcy have qualified)? And didn’t they have a guarantee to provide them some operational coverage. Would the Fed at this point have really just let JPMorgan walk? I interpret this last sentence in this disclosure to mean that JPMorgan was threatening to terminate the merger agreement and perhaps the guarantee and address this in litigation with a $2 a share cap on liability to Bear’s shareholders. The disclosure then continues:

Bear Stearns senior management believed that, in light of the deterioration in Bear Stearns’ liquidity and the absence of any other source of additional funding, if the New York Fed and JPMorgan Chase were unwilling to maintain their funding of Bear Stearns and JPMorgan Chase was unwilling to assure Bear Stearns’ customers, counterparties and lenders by clarifying and enhancing its guaranty of Bear Stearns’ obligations, Bear Stearns would not be able to open for business on Monday, March 24, 2008 and would have no choice but to file for bankruptcy by that morning. Bear Stearns’ bankruptcy advisors were instructed to be prepared for this contingency by the end of the weekend.

Again, am I missing something about the original deal? I read the original guarantee to provide a relatively broad guarantee of Bear’s revolving credit and term facilities for a year. Was it really not enough?

The rest is history — over the weekend, JPMorgan recut the deal and received the deal protection devices it wanted. These included a change in the guaranty termination mechanism from effectively a one-year arrangement to a guarantee which expired 120 days after a negative shareholder vote. JPMorgan gave the Bear board a reason to support these changes: a four-fold increase in the consideration and continued director indemnification provisions possibly unavailable in a bankruptcy scenario.

JPMorgan and Bear paint this as necessary to again avert bankruptcy. But I have more questions than answers about this:

• Why wasn’t JPM buying stock that week at $3.75 to $7 (and getting the Fed and the Treasury to lean on the FTC for even earlier termination than April 1 to go up above the $50 million threshold)? Who was to stop them from buying for the next month? Would even the FTC have done so? I don’t see any provision under the original merger agreement prohibiting them from doing so. And what about all those creditors who were supposedly buying Bear stock to vote the shares? Furthermore who was at risk if Bear continued to face liquidity issues that week? Not Bear shareholders.

• Why a fourfold increase? Why not just two or three times? What gave the Bear board leverage now if they were indeed facing bankruptcy? On Friday, March 21, JPMorgan asked for 2/3 of the company vote to be locked up through a stock purchase, and it would increase the merger consideration to an undisclosed amount. On Saturday, Bear countered for $12 and offered to sell 19.9 percent of its shares. On Sunday they came up with an unexplained compromise of $10 a share, a 39.5 percent stock issuance to JPMorgan, an apparent implicit understanding that JPMorgan would purchase more shares up to 49.5 percent of Bear in the open market, and a guaranty that got “clarified and enhanced.” The Fed also got its direct guaranty from JPMorgan of Bear’s Fed borrowings.

• I’m still most troubled by the actions of the Bear board members who subsequently sold their shares in the market after the deal recut. The disclosure talks of Bear offering “to obtain the agreement of Bear Stearns’ directors to vote their stock in favor of the merger.” This turned into a commitment in the press release, and at least two sales so far (James Cayne, Bear’s chairman, and director Paul A. Novelly). What were the conversations that led to this? How did the Bear directors justify refusing to give a contractual commitment.

So what explains all this? What explains the deal change from Saturday to Sunday? Did the Bear board think they were again in a bankruptcy scenario? The disclosure implies this if not out rightly states it.

But I am thinking JPMorgan was one month pregnant (after one week) and the guaranty terms looked increasingly inappropriate. JPMorgan also got some pressure from the Fed because the Fed was being criticized for a bailout. For some reason they weren’t buying Bear stock in the market. And no doubt it was impossible for JPMorgan to lock up the Bear human assets they wanted during that week, particularly after Jamie Dimon’s reception at Bear. And one week into the deal, they liked it more and were willing to resolve the Fed’s guaranty issue. It gave the Bear board some leverage, of approximately $8 a share.

And back to that corporate law. The document describes a situation where the parties felt that they had no risk in stretching ordinary corporate laws. And it is probably the correct assumption. JPMorgan and Bear have already won a stay of the Delaware proceedings. They have a good chance of winning in New York at least as to holding the shareholder vote and getting a positive outcome and from there it’s any easy close – JPMorgan is still buying stock in the market this past week. The New York Court will likely refuse to enjoin and at best say monetary damages are sufficient – if so, this will be quietly settled in a few years with the class action attorneys.

This may explain the negative spread right now (to the extent the class period is stretched or people are derivatively hedging class period plays), but it doesn’t explain Joseph C. Lewis’s continuing absence.