Equity Commitment Letters – are they enforceable?
This blog examines a recent High Court decision relating to the construction of an equity commitment letter and asks just how committed is an equity commitment letter?
Why is this interesting? In a word – "rarity" – this case is the first case of its kind on this subject. Although it is a decision on preliminary issues only, it is interesting to see how an English court interprets an equity commitment letter.
Background: this case relates to: (i) the conditional purchase of a Spanish company that owned a hotel in Gran Canaria (the Hotel) for €93m pursuant to a sale and purchase agreement (the SPA) between private equity funds (the PE Funds), a newco acquisition company (the Buyer) and the owner of the Hotel (the Seller); and (ii) the construction of an equity commitment letter (the ECL). The ECL is governed by English law and the SPA is governed by Spanish law. The SPA was subject to EU merger clearance which was subsequently obtained.
COVID Affect: the PE Funds' case was that the consequences of the COVID-19 pandemic on the Hotel were catastrophic during the period between signing of the SPA and the obtaining of EU merger clearance: the Hotel was forced to close; tourists were prohibited from entering Spain; and restrictions on freedom of movement meant that Spanish residents could not visit the Hotel either. The Hotel's principal source of revenue dried up completely; and the Hotel faced severe disruption to its relationship with (among others) its customers, suppliers and employees.
The Dispute: Against this COVID backdrop, the PE Funds contended that the SPA terminated, the principal reason being that the representations and warranties in the SPA, following the pandemic, could not truthfully be repeated at Completion. On the other hand, the Seller contended that the Buyer remained obligated to complete under the SPA and therefore sought to enforce the ECL against the PE Funds.
What exactly is an ECL and why is it needed?
Because a private equity buyer tends to use a new company structure on an acquisition, the buyer entity is often a newly formed company with little economic substance to it, because it will not receive its equity (and if applicable, debt) funding until just before completion occurs. Therefore, in transactions requiring regulatory clearance, where there is likely to be a period of several months between signing and completion, it is important for the seller to receive some form of comfort that the buyer will be able to meet its completion obligations to pay the purchase price to the seller. As it will be the individual private equity funds that will be funding the buyer, the current market practice is that those funds will sign an equity commitment letter addressed to the buyer agreeing (subject to the detailed terms of the ECL) to provide the funds before the date set for completion. The seller is then granted specific third-party legal rights to enforce the terms of this letter (sometimes, the seller can be a specific party to the ECL, although this is much less common in the US). In circumstances where there is also acquisition financing being provided to fund the purchase price obligation, then a debt commitment letter is usually also provided.
Whilst a much shorter document in comparison to the SPA, the ECL is nevertheless a really important document in the terms of the transaction, because without it, the seller would only have recourse to a shell company with no meaningful assets.
So, what did the court decide?
Because the SPA was governed by Spanish law, the key issues of when the completion date actually was and whether the SPA had been lawfully terminated fell to be decided under Spanish law. At the time of the judgement in the English proceedings, that issue had not been determined. However, the English courts were able to make preliminary findings in relation to certain key issues as follows:
1. When does the PE Funds' obligation to fund arise?
The PE Funds' obligation under the ECL to provide the completion funds arose when the Buyer became unconditionally obligated to complete the SPA. In the court's judgement, that moment came when the condition precedent under the SPA was satisfied (the obtaining of EU merger clearance). Accordingly, the PE Funds became obliged to provide the completion funds by no later than 11:59 on the date prior to the date fixed for completion, unless the SPA was validly terminated prior to that date.
2. Could the PE Funds argue that a fixed termination date (which fell after EU merger clearance being obtained) set out in the ECL meant that they were no longer obliged to provide the completion funds under the ECL as, due to ongoing litigation, that date had now passed?
The court construed the fixed termination date as being the date for determining whether the obligation to fund had arisen. If the obligation to fund had arisen prior to the termination date, then the mere effluxion of time would not bring those obligations to an end. "It will not apply so as to bring to an end to the obligation where completion should have taken place but has not". (The court also made clear that any attempt by the PE Funds to deliberately delay and run down the clock – "the lapse argument" - would not result in the PE Funds being released from their funding obligations).
3. Are the PE Funds required to provide the completion funds in circumstances where there is a dispute between the Buyer and the Seller under the SPA relating to completion?
Yes, "[the PE Funds are] not able to justify a failure to comply with their obligation by reference to the fact that the buyer has raised a dispute as to its obligation to complete on the Completion Date. Instead, [the PE Funds] must put the buyer in funds to enable the buyer to complete prior to that date; and if in fact, the buyer can establish that it is not obliged to complete, then it will have to return those funds to [the PE Funds], since those funds are not to be used for any purpose other than completion."
The English Court considered seven issues relating to the construction of the ECL and found for the Seller on six of those issues, with the crucial findings being that the key funding terms of the ECL were held to be valid and binding on the PE Funds. Given the importance of the purpose of an equity commitment letter to a seller, this is a welcome decision.
Case referenced in this article: Lopesan Touristik S.A. V Apollo European Principal Finance Fund III (Dollar A) L.P, Apollo European Principal Finance Fund III (Master Dollar B) L.P, Apollo European Principal Finance Fund (Master Euro B) L.P, Apollo EPF III Capital Management LLC  EWHC 2141 (Comm)