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v. HOLLY CORPORATION, a Delaware corporation, Defendant. HOLLY CORPORATION, a Delaware corporation, Counterclaim Plaintiff, v. FRONTIER OIL CORPORATION, a Wyoming corporation, Counterclaim Defendant. 
Stephen E. Herrmann, Esquire, Gregory V. Varallo, Esquire, C. Malcolm Cochran, IV, Esquire, Daniel A. Dreisbach, Esquire, Steven J. Fineman, Esquire, Dawn N. Zubrick, Esquire, and Lisa M. Zwally, Esquire of Richards, Layton & Finger, P.A., Wilmington, Delaware; David J. Margules, Esquire of Bouchard Margules & Friedlander, P.A., Wilmington, Delaware; Richard H. Caldwell, Esquire, Kent W. Robinson, Esquire, J. Wiley George, Esquire, John Clutterbuck, Esquire, and Charles B. Hampton, Esquire of Andrews Kurth, L.L.P., Houston, Texas, Attorneys for Plaintiff and Counterclaim Defendant Frontier Oil Corporation. A. Gilchrist Sparks, III, Esquire, Kenneth J. Nachbar, Esquire, and Patricia R. Uhlenbrock, Esquire of Morris, Nichols, Arsht & Tunnell, Wilmington, Delaware; Bruce L. Silverstein, Esquire, Rolin P. Bissell, Esquire, and Christian D. Wright, Esquire of Young Conaway Stargatt & Taylor, LLP, Wilmington, Delaware; Michael McKool, Jr., Esquire, Lewis T. LeClair, Esquire, and Gary J. Cruciani, Esquire of McKool Smith, P.C., Dallas, Texas, Attorneys for Defendant and Counterclaim Plaintiff Holly Corporation. NOBLE, Vice Chancellor. Plaintiff and Counterclaim Defendant Frontier Oil Corporation ("Frontier") and Defendant and Counterclaim Plaintiff Holly Corporation ("Holly") on March 30, 2003, agreed to merge.1 On August 19, 2003, Frontier concluded that Holly had repudiated the Merger Agreement and brought this action the next day. In this post-trial memorandum opinion, the Court explores how and why the transaction fell apart and determines the consequences of the parties' conduct. Frontier, a Wyoming corporation, and Holly, a Delaware corporation, are both mid-sized petroleum refiners. Frontier, headquartered in Houston, Texas, operates in a market that lies primarily on the eastern slope of the Rocky Mountains; Holly, with its headquarters in Dallas, Texas, focuses on the western slope of the Rockies. In addition, Holly owned and operated approximately 1,600 miles of pipeline with support facilities to transport crude oil and refined products. Page 2 For several years, Frontier had recognized the benefits of a combination with Holly. James R. Gibbs, Frontier's chief executive officer, predicted that Frontier and Holly together would be "one incredible company" which would be "either the largest or second largest refiner" in the Rocky Mountain region. C. Lamar Norsworthy, IIII, Holly's chief executive officer, also saw the advantages that could result from joining with Frontier. Serious efforts to bring Frontier and Holly together were frustrated for several years because of Holly's role as a defendant in a lawsuit brought in a Texas court by an entity controlled by major national petroleum companies.3 Holly was accused of having engaged in anticompetitive conduct by opposing (and surreptitiously supporting the opposition to) the Longhorn pipeline, proposed by the plaintiff in that action. The Longhorn pipeline would have been competitive with Holly's pipeline facilities. Although Holly considered the Longhorn Litigation to be without merit, the plaintiff claimed damages in excess of $1 billion. W. John Glancy, Holly's general counsel, said that the litigation made him feel as if "he was in jail." More specifically, Glancy understood that the Longhorn Litigation severely Page 3 impaired Holly's ability to borrow, tied up management time and energy, and "walled off [Holly] from the whole M&A field."4 For Gibbs, the "uncertainty" and "risk" associated with the litigation deterred him from pursuing Holly. Eventually, Holly was able to negotiate a settlement under which it agreed to provide approximately $25 million worth of refined petroleum product transportation services. The settlement was announced on November 15, 2002. A few days later, Gibbs called Norsworthy to propose negotiations that would lead to a merger between Holly and Frontier. Merger negotiations commenced in late November, but, by the end of January 2003, the parties had reached an impasse. Holly then turned its attention to enhancing shareholder value through creating (and sale to the public of a portion of) a master limited partnership ("MLP") into which it would contribute its pipeline assets.5 Holly retained Lehman Brothers to assist in the MLP effort. Page 4 C. The Merger Agreement is Negotiated In February 2003, merger negotiations resumed. By March 3, 2003, the parties had agreed upon the basic terms of a merger. For each share of Holly common stock, its shareholders would receive one share of Frontier and $11.11 in cash.6 No protection, such as ceilings, floors, or collars, was afforded the shareholders to guard against fluctuation in market price. The merger terms were finalized on March 24, 2003. As to corporate governance, Norsworthy would become chairman of the board of the "new" Frontier; Gibbs would be its chief executive officer; and all directors of both constituent corporations would become directors of the "new" board. One adjustment to merger consideration was through a "contingent value right" ("CVR") that Holly shareholders would receive.7 The contingent value right represented the potential value of a litigation claim asserted by Holly against the United States with respect to the sale of jet aviation fuel. The value of the claim was uncertain. Page 5 During March 2003, in advance of a definitive merger agreement, the parties proceeded with their due diligence efforts. On March 15, Frontier delivered due diligence materials to Vinson & Elkins ("V&E"), the law firm representing Holly in the transaction. One of the items provided was an article from the February 22, 2003, edition of the Los Angeles Times, entitled "Cancer Cluster Alleged."8 The article described plans by activist Erin Brockovich and the Masry & Vititoe law firm to bring a mass toxic tort suit against Beverly Hills (California) High School, the Beverly Hills municipality, and three oil companies. An oilrig had been in operation for decades on the campus of Beverly Hills High School, next to the athletic field. Brockovich claimed that the students attending the high school suffered from a disproportionately high incidence of various cancers, which she attributed to exposure to air contaminants released during the drilling and on-site processing activities. The crude oil production activities were carried out, at that time, by Venoco, Inc. ("Venoco"), which had acquired its interest in the Beverly Hills site from Wainoco Oil & Gas Company ("Wainoco") in 1995. Wainoco had obtained its interest in 1985 from Waverly Oil Company, an assignee of Chevron USA, Inc. The article, Page 6 however, failed to set forth one fact that would become critical to the Merger: Wainoco is a wholly-owned subsidiary of Frontier. E. Due Dilligence I: Holly Becomes Concerned About Beverly Hills V&E, following receipt of Frontier's due diligence materials, ascertained that Frontier had made no public disclosure regarding the threatened Beverly Hills litigation and realized that only limited information regarding the potential litigation was readily available. On March 27, 2003, as the final details of the Merger documents were being worked out, V&E informed Glancy about the possibility of a toxic tort suit involving prior operations of a Frontier subsidiary. Glancy promptly informed other senior Holly executives. With their sensitivity to complex litigation having been heightened by their unhappy experience in the Longhorn Litigation, Holly management decided to seek additional information from Frontier regarding Beverly Hills. In addition, Holly retained Gibson, Dunn & Crutcher ("Gibson Dunn"), a national law firm headquartered in Los Angeles, to provide advice and guidance with respect to toxic tort litigation in California. As Glancy phrased it in an e-mail to Currie Bechtol, Frontier's general counsel, Holly's management needed to know whether the Beverly Hills problem was "a gnat or an elephant."9 Page 7 F. Frontier Describes the Potential Litigation as a "Bunch of Hooey" Frontier attempted to assuage Holly's concerns in several ways. Gibbs told Norsworthy that the Beverly Hills problem "was likely to be a nuisance claim."10 Similarly, Julie H. Edwards, Frontier's chief financial officer, in talking to Matthew Clifton, Holly's president, characterized the claim as a "bunch of hooey" and a "Hollywood stunt."11 Frontier was most persuasive, not in attacking Brockovich's motivations or her science, but with its argument that Frontier was protected from liability because of the separate and distinct corporate structure of Wainoco. In short, Frontier assured Holly that any liability could be confined to the subsidiary Wainoco and would not reach the parent Frontier. Frontier bolstered this argument by producing a Canadian tax ruling which, it claimed, demonstrated that the manner in which Frontier operated its subsidiaries would minimize the risk of any successful veil-piercing effort by toxic tort plaintiffs. On March 28, at a special meeting, Frontier's Board unanimously approved the Merger Agreement, authorized Frontier's management to execute the Merger Agreement and related documents, and established a Page 8 special committee to which it delegated the power to approve changes to the Merger Agreement. Holly's Board also met on March 28. That meeting did not go as well as Frontier's. Holly's Board was informed of the potential for litigation arising out of the Beverly Hills problem. Alan Bogdanow, who led V&E's merger efforts for Holly, told the Board what was known about Beverly Hills and reviewed its potential consequences. Holly's Board minutes reflect Bogdanow's concerns: In respect of the potential California litigation, Mr. Bogdanow informed the Board that a recent article stated that Erin Brockovich and Ed Masry were preparing a lawsuit against the city of Beverly Hills, Beverly Hills Unified School District and three oil companies, alleging that there was an abnormally high rate of cancer, or a "cancer cluster," among former Beverly Hills High School students due to polluted air caused by oil wells operating in the area. Mr. Bogdanow noted that this raised the issue of a potential toxic tort claim against the Frontier subsidiary which once owned oil and gas wells in the Beverly Hills area that were sold in 1995 to Venoco, Inc. . . . Mr. Bogdanow, among other things, noted that (i) Frontier had not publicly disclosed the potential claim in its Securities and Exchange Commission filings, (ii) Frontier had a strong indemnity right against Venoco, but Venoco may not have the financial ability to satisfy all of its indemnification obligations, (iii) Frontier probably did not have insurance coverage that would cover such potential claim, (iv) potential legal defenses that might be available to Frontier, including expiration of the applicable statute of limitations period, whether any potential liability could be limited to Frontier's subsidiary, whether California has damage caps, and burden of proof issues were being looked at, (v) the Company was assessing whether the potential claim was a substantial practical risk, but there was no Page 9 assurance as to whether a more meaningful assessment could be made in any particular time frame, (vi) Mr. Gibbs, the Chief Executive Office of Frontier, had stated that Frontier was not concerned about this matter becoming significant and that the previous Longhorn litigation against the Company had been much worse than this potential claim, which was considered by Frontier to be only a nuisance claim, . . . and (vii) he did not know if the potential claim might raise a financing issue for Frontier.12 Thus, the Board concluded that it would need additional information before deciding to proceed with the Merger. Holly's desire to take the time necessary to acquire the additional information was tempered by Frontier's concern that the plans for the Merger might be leaked to the public or that stock might be traded based on nonpublic information regarding the transaction.13 Nonetheless, Holly's Board directed its management to pursue various options regarding the threatened litigation, including: (i) strengthening Frontier's representations and warranties, (ii) strengthening the definition of material adverse effect, (iii) determining whether Frontier had any obvious legal defenses if a claim were made against it, (iv) clarifying the Board's rights under the merger agreement to terminate the merger in exercise of the Board's fiduciary duties, and (v) performing additional analysis of the potential claim over the weekend so that the Board could better evaluate the issue.14 Page 10 The Board then decided to reconvene on Sunday, March 30, to evaluate any new information and to decide on a course of action. H. The Merger Agreement is Renegotiated The confluence of Holly's concerns about the risks associated with the potential Beverly Hills litigation and Frontier's desire to reach an agreement as quickly as possible resulted in several modifications to the Merger Agreement. These modifications were negotiated over a very short period of time. First, Section 4.8 of the Merger Agreement was changed to read as follows:15 Except as set forth on Schedule 4.8 of the Frontier Disclosure Letter, there are no actions, suits or proceedings pending against Frontier or any of its Subsidiaries or, to Frontier's knowledge, threatened against Frontier or any of its Subsidiaries, at law or in equity, or before or by any federal, state or foreign commission, court, board, bureau, agency or instrumentality, other than those that would not have or reasonably be expected to have, individually or in the aggregate, a Frontier Material Adverse Effect.16 Second, the Definition of "Material Adverse Effect" was modified to read as follows: "Material Adverse Effect"
with respect to Holly or Frontier shall mean
a material adverse effect with respect to
(A) the business, assets and liabilities
(taken together), results of operations,
Page 11 prospects of a party and its Subsidiaries on a consolidated basis . . ."17 Third, Schedule 4.8, referenced in Section 4.8, was added to the Frontier Disclosure Letter: Wainoco Oil & Gas Company ("Wainoco") owned an interest in an oil field from 1985 until early 1995 in the area where the Beverly Hills High School is located. News articles in February 2003 indicated that the Brockovich and Masry law firm were preparing a lawsuit involving that site. Wainoco sold its interest to Venoco, Inc. by a Purchase and Sale Agreement dated February 9, 1995. Frontier has not been contacted by anyone concerning a possible lawsuit, and does not have any knowledge of any litigation being filed. For avoidance of doubt and only for the limited purpose of the Agreement, Frontier agrees with, and for the sole benefit of, Holly that this potential litigation will be considered as "threatened" (as such term is used in Section 4.8 of the Agreement) and that the disclosure of the existence of this "threatened" litigation herein is not an exception to Section 4.8, 4.9 or 4.13 of the Agreement and despite being known by Holly, will have no effect with respect to, or have any limitation on, any rights of Holly pursuant to the Agreement. When the Holly Board reconvened on March 30, Glancy presented (indeed, he read aloud) to the Board a six-page memorandum prepared by Jeffrey D. Dintzer of Gibson Dunn. In his memorandum, Dintzer summarized what was known about the anticipated Beverly Hills claim and he attempted to gauge its likely effects.18 Page 12 I. Gibson Dunn Explains the Risks Dintzer's memorandum informed the Board that the potential for litigation was first reported by a local Los Angeles television station on February 10, 2003. The report indicated that Brockovich and the law firm of Masry & Vititoe were preparing a lawsuit on behalf of at least twenty Beverly Hills High School students who had been diagnosed with one of three types of cancer: Hodgkin's disease, non-Hodgkins lymphoma, and thyroid cancer. Brockovich had identified the oil wells at the High School as the potential cause. According to an "environmental specialist" from Masry & Vititoe, tests of the area conducted seven times over five months revealed "abnormally high levels of benzene, methane and n-hexaneall by-products of the oil industry."19 This report also noted that while benzene is a known carcinogen, a recent test conducted by the South Coast Air Quality Management District ("SCAQMD") had found nothing abnormal, except for elevated levels of toluene. Dintzer also discussed subsequent reports. For instance, one report noted that the current owner of the oil wells, Venoco, had acquired its ownership interest from Wainoco in 1995 and that "Wainoco has since Page 13 changed its name to Frontier Oil Corporation."20 This report also quoted a Frontier representative as having said, "Anything to do with those sites and royalties would have been transferred to Venoco when they bought our assets."21 From this report, Holly's Board also learned that Brockovich had hosted a dinner for 600 alumni of, and parents of students attending, Beverly Hills High School and that 170 graduates and staff had developed one of the three cancer types over the last decade. Masry was quoted as having stated that the ratio of these cancers was eighteen times the national average. Dintzer's memorandum, however, was not devoid of good news. For example, it described a March 25, 2003, release by the Superintendent of the Beverly Hills Unified School District which noted that tests conducted by SCAQMD on three separate occasions in February 2003 did not show "readings of benzene, hexane and other air toxic levels that are considered abnormal."22 In fact, the Superintendent was quoted as having said that the levels were "well below" what the California Environmental Protection Agency deemed to be the minimum exposure risk for public health. Moreover, the release observed that there was no "consistent evidence" that benzene exposure caused any cancer other than acute myelogenous leukemia Page 14 and that "there is a threshold below which the risk of cancer from benzene exposure is negligible."23 Holly's Board was warned that the lawsuit would be prosecuted by a "highly-organized, well-funded group of law firms."24 In addition to Masry and Brockovich, the memo noted that the "lawsuit will likely be funded in part by the well-known and highly successful plaintiffs' law firm Girardi & Keese, who prosecuted the famous Anderson chrome case against PG&E which is the subject of the Brockovich film."25 It noted that "Girardi and its partner law firms have the resources to vigorously and aggressively prosecute any lawsuits filed and have the wherewithal to go to great lengths to bring these lawsuits to a successful conclusion."26 Dintzer's memorandum also advised Holly's Board that since "[t]he science of connecting human exposures to chemicals, such as those released from oil and gas production, to serious disease outcomes is complicated and often difficult to explain . . ., the plaintiffs' storyvery sick plaintiffs exposed to chemicals, fighting large corporations[would be] attractive to a lay jury."27 It noted that there were at least five different causes of action Page 15 that could be brought and more than seven types of damages that could be soughtincluding punitive damages and emotional distress damages. Furthermore, the Holly Board learned that "[i]n California, there is no limit to the amount the plaintiffs can collect on personal injury claims.... [and p]unitive damages are only limited by the general factors that apply to such damages and any Constitutional limits."28 While there was no estimate of potential liability, as a point of reference, Dintzer's memorandum did note that the Anderson case against PG&E, which was the subject of the Erin Brockovich movie, resulted in a $400 million award, which was later reduced to $333 million by settlement. Dintzer also anticipated the "shark effect" leading to an increase in the costs of defending any potential litigation. The shark effect was defined as the risk, after the settlement of a toxic tort case, that additional lawsuits would be filed against the same defendants, at times by the same law firms who filed the original suit, on behalf of different plaintiffs. Several examples were supplied, including the Anderson litigation, as a way of demonstrating that "[s]ettling cases with certain plaintiffs is no guarantee that the controversy will go away."29 Page 16 Lastly, the memorandum predicted that the duration of any lawsuit might be prolonged, thus leading to an increase in costs. Furthermore, the Board was advised that "recent changes in California law to the procedures for summary judgment which strongly favor plaintiffs . . . make it very difficult to achieve summary judgment."30 The memorandum forecast that, even though it might be possible to achieve summary judgment, "extensive and expensive discovery would have to occur before" it would be ripe.31 The memorandum finally cautioned that it might be easier for plaintiffs in California to present questionable science to the jury as a way of proving liability "because California has not adopted the Daubert standard, which applied to the Federal Rules of Evidence."32 J. Holly's Board Approves the Merger Agreement After receiving Dintzer's memorandum, Holly's Board "continued to consider and discuss the benefits of the proposed transaction for the Company's stockholders versus the potential risks associated with the transaction in light of the potential California Claim."33 "[A]lthough the Board noted that its legal counsel probably would not be able to advise the Board with absolute certainty that Frontier was clearly insulated from any Page 17 potential liability,"34 the Board decided "that it was in the best interest of the Company's stockholders to proceed with the proposed transaction now and for the Company to continue to investigate and evaluate the potential California claim."35 Thus, the Board ended the meeting by approving the Merger Agreement. Before turning to the events following execution of the Merger Agreement, it may be helpful to review the various exit strategies afforded by that agreement. For purposes of this action, there were, in general, three avenues: (1) if a party's representations and warranties in the Merger Agreement were or, in some instances, became inaccurate, including, if threatened litigation would have or would reasonably be expected to have a Material Adverse Effect; (2) if a party exercised its "fiduciary out"; and (3) if the parties mutually agreed to termination.36 Recitation of pertinent provisions of the Merger Agreement is unavoidable. Section 7.1 allows "Termination by Mutual Consent": This Agreement may be terminated at any time prior to the Effective Time by the mutual written agreement of Holly and Page 18 Frontier approved by action of their respective Board of Directors in their respective discretion for any reason, including due to the number of Holly Dissenting Shares exceeding 5% of the Total Holly Common Stock Number or the number of Frontier Dissenting Shares exceeding 5% of the total number of shares of Frontier Common Stock outstanding immediately prior to the Effective Time.37 Section 7.2 establishes other ways the Merger Agreement could be terminated by either party, including a failure to close by the "drop dead date" of October 31, 2003, or a failure of one of the parties to obtain the requisite stockholder vote to send the transaction to closing. This provision provides in pertinent part: Section 7.2 TERMINATION BY FRONTIER OR HOLLY. At any time prior to the Effective Time, this Agreement may be terminated by Holly or Frontier, in either case by action of its Board of Directors, if: (a) the Mergers shall not have been consummated by October 31, 2003; provided, however, that the right to terminate this Agreement pursuant to this clause (a) shall not be available to any party whose failure or whose affiliates' failure to perform or observe in any material respect any of its obligations under this Agreement in any manner shall have been the principal cause or, or resulted in, the failure of the Mergers to occur on or before such date; or (b) the Holly Requisite Vote shall not have been obtained at a meeting (including adjournments and postponements) of Holly's stockholders that shall have been duly convened for the purpose of obtaining the Holly Requisite Vote; or (c) the Frontier Requisite Vote shall not have been obtained at a meeting (including adjournments and Page 19 postponements) of Frontier's stockholders that shall have been duly convened for the purpose of obtaining the Frontier Requisite Vote. . . . Sections 7.3 and 7.4 contained comparable provisions authorizing Frontier and Holly to terminate the Merger Agreement, for reasons, such as breach of representations,38 without cure within thirty days, and the transaction's "fiduciary out" for those instances when the directors' fiduciary duties would no longer allow them to support the Merger. The similar provisions stated in full: Section 7.3 TERMINATION BY HOLLY. At any time prior to the Effective Time, this Agreement may be terminated by Holly, by action of its Board of Directors, if: Page 20 (a) (i) there has been a breach by Frontier of any representation, warranty, covenant or agreement set forth in this Agreement or if any representation or warranty of Frontier shall have become untrue, in either case such that the conditions set forth in Section 6.2(a) would not be satisfied and (ii) such breach is not curable, or, if curable, is not cured within 30 days after written notice of such breach is given to Frontier by Holly; provided, however, that the right to terminate this Agreement pursuant to this Section 7.3(a) shall not be available to Holly if it, at such time, is in material breach of any representation, warranty, covenant or agreement set forth in the Agreement such that the conditions set forth in Section 6.3(a) shall not be satisfied; (b) prior to obtaining the Frontier Requisite Vote, the Board of Directors of Frontier shall have withdrawn, modified, withheld or changed, in a manner adverse to Holly, such Board's approval or recommendation of the Agreement or the transactions contemplated hereby, or recommended a Frontier Superior Proposal, or resolved to do any of the foregoing; or (c) prior to obtaining the Holly Requisite Vote, Holly is the Withdrawing Party pursuant Section 5.4(b) (it being understood that Holly shall not have the right to terminate this Agreement pursuant to this Section 7.3(c) unless and until Holly shall have paid Frontier all amounts due under Section 7.5(a)). Section 7.4 TERMINATION BY FRONTIER. At any time prior to the Effective Time, this Agreement may be terminated by Frontier, by action of its Board of Directors, if: (a) (i) there has been a breach by Holly of any representation, warranty[,] covenant or agreement set forth in this Agreement or if any representation or warranty of Holly shall have become untrue, in either case such that the conditions set forth in Section 6.3(a) would not be satisfied and (ii) such breach is not curable, or, if curable, is not cured within 30 days after written notice of such breach is given by Frontier to Holly; provided, however, that the right to terminate this Agreement pursuant to Section 7.4(a) shall not be available to Frontier if it, at such time, is in material breach of any representation, warranty, covenant or agreement set forth in this Agreement Page 21 such that the conditions set forth in Section 6.2(a) shall not be satisfied; (b) prior to obtaining the Holly Requisite Vote, the Board of Directors of Holly shall have withdrawn, modified, withheld or changed, in a manner adverse to Frontier, such Board's approval or recommendation of this Agreement or the transactions contemplated hereby, or recommend a Holly Superior Proposal, or resolved to do any of the foregoing; or (c) prior to obtaining the Frontier Requisite Vote, Frontier is the Withdrawing Party pursuant to Section 5.4(b) (it being understood that Frontier shall not have the right to terminate this Agreement pursuant to this Section 7.4(c) unless and until Frontier shall have paid Holly all amounts due under Section 7.5(b)). The term "Withdrawing Party," employed in both Section 7.3 and Section 7.4, is defined in Section 5.4(b) which provides in part: The Board of Directors of Holly or Frontier, as applicable (the "Withdrawing Party," the other party being the "Non-Withdrawing Party"), may at any time prior to obtaining the Holly Requisite Vote or Frontier Requisite Vote, as applicable, (A) withdraw, withhold, modify, or change, in a manner adverse to the Non-Withdrawing Party, any approval or recommendation regarding this Agreement or the transactions contemplated hereby or (B) approve and be prepared to enter into or recommend and declare advisable any Holly Superior Proposal or Frontier Superior Proposal, as the case may be, if its Board of Directors determines in good faith after consultation with its outside legal counsel that the failure to take the action in question would be inconsistent with the fiduciary obligations of such Board of Directors under applicable law.39 Page 22 If either party used the fiduciary duty termination provisions to avoid the Merger, Section 7.5 provides that the terminating party would pay the other party $15 million as a break-up fee in addition to reimbursing the other party up to $1 million in expenses incurred in connection with the Merger Agreement. Section 7.5 provides in part: Section 7.5 EFFECT OF TERMINATION (a) If this Agreement is terminated (i) by Holly or Frontier, after the public announcement (made prior to the closing of the polls for the vote of Holly stockholders for the purpose of obtaining the Holly Requisite Vote) of a Holly Acquisition Proposal, pursuant to Section 7.2(b); (ii) by Frontier pursuant to Section 7.4(b); (iii) by Holly pursuant Section 7.3(c); then Holly shall pay Frontier the Holly Termination Amount (as defined below) and, in addition, reimburse Frontier for all expenses incurred by Frontier in connection with this Agreement up to the Reimbursement Maximum Amount (as defined below) prior to or upon termination of this Agreement. All payments under this Section 7.5(a) shall be made in cash by wire transfer to an account designated by Frontier at the time of such termination or, in the case of a termination pursuant to Section 7.3(c), prior to such termination). The term "Holly Termination Amount" shall mean $15,000,000. The term "Reimbursement Maximum Amount" shall mean $1,000,000. In addition, Holly shall reimburse Frontier for all expenses incurred by Frontier in connection with this Agreement up to the Reimbursement Maximum Amount if this Agreement has been terminated pursuant to Section 7.2(b) even if Frontier is Page 23 not entitled to any Holly Termination Amount under this Section 7.5(a). Holly acknowledges that the agreements contained in this Section 7.5(a) are an integral part of the transactions contemplated by this Agreement, and that, without these agreements, Frontier would not enter into this Agreement; accordingly, if Holly fails promptly to pay any amount due pursuant to this Section 7.5(a), and, in order to obtain such payment, Frontier commences a suit which results in a judgment against Holly for the payment set forth in this Section 7.5(a), Holly shall pay Frontier its costs and expenses (including attorneys' fees) in connection with such suit, together with interest on the Holly Termination Amount and other amounts to be reimbursed to Frontier under this Section 7.5(a) from the date payment was required to be made until the date of such payment at the prime rate of Union Bank of California, N.A. in effect on the date such payment was required to made plus one percent (1%). If this Agreement is terminated pursuant to a provision that calls for a payment to be made under this Section 7.5(a), it shall not be a defense to Holly's obligation to pay hereunder that this Agreement could have been terminated at an earlier or later time. Section 7.5(b) is the mirror image of Section 7.5(a), with Holly and Frontier substituted for each other. Frontier's representations and warranties are set forth in Article IV of the Merger Agreement which provides in part: Except as set forth in the disclosure letter delivered to Holly concurrently with the execution hereof (the "Frontier Disclosure Letter"), . . . Frontier represents and warrants to Holly that: Section 4.8 LITIGATION AND LIABILITIES. Except as set forth on Schedule 4.8 of the Frontier Disclosure Letter, there are no actions, suits or proceedings pending against Frontier or any of its Subsidiaries or, to Frontier's knowledge, threatened against Frontier or any of its Page 24 Subsidiaries, at law or in equity, or before or by any federal, state or foreign commission, court, board, bureau, agency or instrumentality, other than those that would not have or reasonably be expected to have, individually or in the aggregate, a Frontier Material Adverse Effect. There are no outstanding judgments, decrees, injunctions, awards or orders against Frontier or any of its Subsidiaries, other than those that would not have, individually or in the aggregate, a Frontier Material Adverse Effect. There are no obligations or liabilities of any nature, whether accrued, absolute, contingent or otherwise, of Frontier or any of its Subsidiaries, other than those liabilities and obligations (a) that are disclosed in the Frontier Reports, (b) that have been incurred in the ordinary course of business since December 31, 2002, (c) related to expenses associated with the transactions contemplated by this Agreement or (d) that would not have or reasonably be expected to have, individually or in the aggregate, a Frontier Material Adverse Effect. Section 4.9 ABSENCE OF CERTAIN CHANGES. Since December 31, 2002, Frontier has conducted its business only in the ordinary and usual course of business and during such period there has not been any (i) event, condition, action or occurrence that has had or would reasonably be expected to have, individually or in the aggregate, a Frontier Material Adverse Effect; ... Holly, by Article III, made similar representations, except that Section 3.8 did not carry the same modifications as did Section 4.8, to accommodate the Beverly Hills concerns. Finally, Section 8.9(d) provides in its entirety: (d) "Material Adverse Effect" with respect to Holly or Frontier shall mean a material adverse effect with respect to (A) the business, assets and liabilities (taken together), results of operations, condition (financial or otherwise) or prospects of a party and its Subsidiaries on a consolidated basis or (B) the Page 25 ability of the party to consummate the transactions contemplated by this Agreement or fulfill the conditions to closing set forth in Article 6, except to the extent (in the case of either clause (A) or clause (B) above) that such adverse effect results from (i) general economic, regulatory or political conditions or changes therein in the United States or the other countries in which such party operates; (ii) financial or securities market fluctuations or conditions; (iii) changes in, or events or conditions affecting, the petroleum refining industry generally; (iv) the announcement or pendency of the Mergers or compliance with the terms and conditions of Section 5.1 hereof; or (v) stockholder class action or other litigation arising from allegations of a breach of fiduciary duty relating to this Agreement. "Holly Material Adverse Effect" and "Frontier Material Adverse Effect" mean a Material Adverse Effect with respect to Holly and Frontier, respectively. L. Holly Passes on Acquiring the Denver Refinery During the negotiations with Frontier, Holly was also pursuing the acquisition of a refinery in Denver, Colorado (the "Denver Refinery") which ConocoPhillips had been required by the FTC to divest. Because of Frontier's substantial presence in the Denver area, Holly's acquisition of the Denver Refinery would have posed significant antitrust concerns if it combined with Frontier. Thus, in anticipation of entering into the Merger Agreement, Holly abandoned its efforts to purchase the Denver Refinery. Page 26 M. Frontier Completes Financing for the Merger Frontier needed to finance the cash portion of the merger consideration to be paid to Holly shareholders.40 With Holly's concurrence,41 Frontier proceeded in April to borrow $220 million. The funds were borrowed well before the anticipated closing because of favorable interest rates. When it became apparent that the Merger would not close, Frontier would repay the debt. Its unreimbursed costs associated with the borrowing were approximately in excess of $20 million, including interest. During the fourteen weeks following execution of the Merger Agreement, two matters, both previously mentioned, would evolve. The Merger, because of one, both, or some combination of the factors, would not happen. The parties are deeply divided as to their relative significance. The first involves Beverly Hills. Not only was litigation commenced, but also, and more importantly, it was learned that Frontier would not be able to rely upon its "corporate separateness" defense because it had guaranteed Wainoco's obligations under the lease for the oil production site at Beverly Hills High School. The second was a new MLP presentation by Lehman Page 27 Brothers for a public offering of Holly's pipeline assets. Lehman Brothers' analysis suggested that Holly had significantly undervalued those assets and, thus, that Frontier had struck a good, perhaps too good of a, deal. 1. (a) The Beverly Hills Litigation In early April, Norsworthy and Glancy flew to California to meet with Holly's attorneys at Gibson Dunn and to visit the site of oil wells on the campus of Beverly Hills High School. On April 28, 2003, the Masry law firm filed twenty-three initial notices of claims with the City of Beverly Hills and the Beverly Hills Unified School District on behalf of former students of Beverly Hills High School, employees of the school, and residents living near the school. Those notices contained allegations that emissions from the oil field or production facilities had caused cancers and related health problems. In light of these notices, Gibson Dunn informed Holly of its view that a lawsuit would be filed within the next two months. On June 9, the Beverly Hills Litigation became a reality with the commencement of an action entitled Moss et al. v. Venoco, Inc., et al. (the "Moss Complaint") in the Superior Court of the State of California for the County of Los Angeles, Central District.42 The seventy-page complaint was Page 28 brought on behalf of twenty-one plaintiffs, two of whom were deceased. It alleged that toxic emissions from the oil production facilities had caused an unusually high rate of cancer and Hodgkin's disease among former students of Beverly Hills High School.43 Significantly, and perhaps most importantly from the point of view of Holly, the action was directed not only against Wainoco, but Frontier as well; it alleged that Frontier had contractually guaranteed Wainoco's obligations under the lease of the Beverly Hills oil wells. At this point, Holly decided that it needed a second opinion as to the risks associated with the Beverly Hills Litigation. Thus, on June 11, 2003, Holly retained the firm of Carrington, Coleman, Sloman & Blumenthal, LLP ("Carrington Coleman") to evaluate the Beverly Hills claims and to determine if Frontier, in contrast to a mere subsidiary of Frontier, faced potential liability. On June 12, the Holly Board met and received a presentation from Gibson Dunn about the Beverly Hills Litigation.44 Gibson Dunn reported that it expected as many as 200 additional plaintiffs to file claims; that it could take two to three years, or more, to prepare the initial case for trial; Page 29 that it would be hard to exclude adverse expert witnesses; that there would be no cap on punitive damages; and that legal fees could be $200,000 per month or more. Gibson Dunn also advised that while it could not predict the ultimate outcome of the litigation, Frontier's exposure could run into the hundreds of millions of dollars.45 Gibson Dunn nevertheless remained optimistic about Frontier's ability to extricate itself at an early stage from the litigation by use of the corporate separateness defense. (b) Frontier as Guarantor and Indemnitor Both Frontier and Holly were shocked by the allegation in the Moss Complaintwhich was factually correctthat Frontier had guaranteed Wainoco's performance and indemnified various Beverly Hills entities. To fully understand their impact, a short history of the Beverly Hills oil wells is necessary. In 1959, the Beverly Hills Unified School District leased the portion of its lands which now contain the oil wells to one Allen Guiberson. This lease contained a provision which called for the lessee to indemnify Beverly Hills Unified School District for any costs it might incur as a result Page 30 of the lessee's use.46 In 1985, this lease was assumed by Wainoco Oil & Gas Company, and guaranteed by its parent Wainoco Oil Corporation,47 which is now Frontier. Thus, Frontier has guaranteed Wainoco's performance through the indemnification provision in the 1959 lease.48 Waverly Oil Company, Inc. assigned the lease to Wainoco. Chevron USA, Inc. (or its predecessor, Standard Oil Company of California) at one time had held the lease rights. As part of the lease assumption, Wainoco (including the corporate entity now known as Frontier) executed a Consent Agreement which, in substance, made Frontier directly liable to Chevron for Page 31 performance of the lessee's obligations.49 Thus, Frontier may have a direct obligation to indemnify Chevron. Before the Merger Agreement was signed, Holly had engaged in the typical due diligence effort of a company considering a merger. As part of this inquiry, Holly specifically requested from Frontier any materials relating to indemnities or guarantees, and, in fact, made the following request in its initial due diligence request list: Indemnities, Guarantees and Other Obligations. Copies of all documents and agreements pursuant to which the Company or any other [Frontier] Entity has any continuing indemnification, guarantee or other obligations to any third party with respect to the disposition of assets.50 Frontier has suggested that the Wainoco indemnification documents were available to Holly, in the sense that Holly's V&E lawyers were in the same room where they were stored and had access to the board minutes reflecting their approval. Nevertheless, these documents were neither discovered during due diligence nor directly provided by Frontier.51 On the other hand, it is also clear that Frontier's management did not know about the indemnitiesor had forgotten about themwhen the Page 32 Merger Agreement was signed. For instance, during the due diligence period, Bechtol had represented that there were "none other than ordinary course."52 Gibbs admitted that he "had personally forgotten about [the] very existence" of the indemnities and was "shocked" by their discovery.53 However, these indemnities were included in an appendix to a memorandum to Frontier from Andrews Kurth on April 23, 2003, but they seemed to have escaped the notice of Frontier's management until approximately two months later.54 (c) Due Diligence II: The Indemnities are Discovered The fact that Frontier had indemnity obligations to the Beverly Hills Unified School District and Chevron, both named defendants in the Beverly Hills Litigation, came to the attention of Gibbs, Bechtol, and Robert V. Jewell, one of the Andrews Kurth lawyers representing Frontier, by at least June 30, 2003.55 Interestingly, when three of Holly's lawyers from Carrington Coleman, including Ken Carroll, came to Frontier's offices the next day, July 1, 2003, Frontier was not immediately forthcoming with this information. Instead, Holly's lawyers were taken to a meeting room where Gibbs surprised them with an hour-long presentation regarding the corporate Page 33 separateness defense.56 This prepared presentation was also attended by Edwards, Bechtol, and Jewell, who chimed in with other information at various points, including the Canadian tax ruling which, Frontier claimed, showed the viability of the corporate veil between it and Wainoco. While Carroll's chances to ask questions during the conversation were limited during the presentation, Carroll did ask several questions about various indemnities after Gibbs had finished. For instance, Bechtol confirmed that Wainoco had executed guarantees of the Beverly Hills High School leases when the leasehold interest had been acquired, something which Bechtol had originally indicated in an e-mail to Carroll on June 26.57 After being informed of this, Carroll asked the following question, "Well, in light of that guarantee, does the parent, Wainoco Oil Corporation [Frontier], have a direct obligation to indemnify the school district or the city?"58 The question was answered by a simultaneous "no" from Gibbs, Bechtol, and either Jewell or Edwards.59 After the meeting, Frontier did not immediately produce the indemnity and guaranty documents, but instead Holly's lawyers Page 34 were told that the ten to twelve boxes in the room contained all of the documents relating to Beverly Hills.60 In these boxes, the Carrington Coleman lawyers would find the following indemnities: the 1978 amendment to the 1959 lease of the oil wells which contained "kind of an oddball indemnification provision which required that the lessee indemnify both the city and the school district with respect to certain . . . challenges,"61 an obligation subsequently undertaken by Wainoco and guaranteed by Frontier; the Wainoco's sale agreement with Venoco in 1995 which contained "cross indemnities or reciprocal indemnities between the buyer and the seller;"62 and a consent agreement, signed with Chevron, whereby "Wainoco Oil & Gas had assumed the obligation to the lessee and Frontier ... had guaranteed those obligation to the school district."63 One thing absent from the boxes was the 1959 lease of the property, although a number of the documents made reference to it. Carroll asked Bechtol for a copy, but he could not immediately produce it. It was sent to Carroll at his office the following day. The contents of the lease contained the very indemnity Gibbs and Bechtol had disclaimed the previous day with Page 35 their unison "no." As Carroll wrote in an e-mail to two other Carrington Coleman lawyers: And finally, I now have the `59 lease. Remember yesterday when I asked if WOC had a direct obligation to indemnify the City or School district and 3 of them answered "NO" in unison? Well, look at paragraph 24 of the `59 lease: "Lessee shall and hereby agrees to indemnify, defend, and hold Lessor harmless from all damages, costs, . . . arising out of or in any way connected with . . . the conduct of any operations hereunder. . . ."64 Discovery of the indemnities was critical for Holly. Dintzer advised the Board that the existence of the indemnities "[c]hanged the whole picture in terms of what Frontier could be facing as this litigation unfolded."65 Existence of the indemnities essentially meant that the corporate shield defense was meaningless as Frontier now likely had a direct obligation to pay at least some of the damages and costs that might be incurred. 2. The Lehman Brothers MLP Presentation Before entering into the Merger Agreement, Frontier had performed its own analysis of Holly's proposed MLP and had projected a value in the range of $140 million to $150 million.66 On April 3, 2003, Gibbs and Edwards attended a meeting with Norsworthy and Clifton at Holly's offices in Dallas during which a presentation was given on the potential benefits of Page 36 the proposed MLP67 by Holly's adviser, Townes Pressler. This slide-show predicted a current value of the MLP assets as $248.3 million. After this presentation, Gibbs told Edwards, "We got a good deal."68 Norsworthy was aware, around the time of the Merger Agreement and in the weeks following, that the market was "hot" for MLP assets such as those Holly could offer.69 He also recognized that, as interest rates decrease, as they did during the period from March to summer 2003, the MLP would become more valuable.70 On June 23, 2003, Clifton received by e-mail a report, entitled "MLP Presentation" (the "Lehman Brothers MLP Presentation"), from Lehman Brothers.71 This report contained both the Frontier and Holly logos in the margins; it does not appear that Lehman Brothers ever sent the report directly to Frontier. The Lehman Brothers MLP Presentation included the following chart, which showed a substantial increase in value from the $248.3 million set forth by Townes Pressler at the beginning of April: Page 37 Sources and Uses of Funds72 ($ in millions)Base Case Case A Sources Uses Pre-tax Value to Frontier In sum, this report predicted a value for the MLP assets of between $346 million and $495 millionmore than double what Frontier had thought the value of the MLP effort was when the Merger was negotiated and, under Case A, double what Holly had thought the value was only two months earlier. Furthermore, under Case A, the value of the MLP exceeded the implicit valuation of the Merger by 8.5%. In other words, were this Page 38 report believed, by completing the Merger and then proceeding with the MLP, Frontier would essentially be acquiring Holly's refineries for free. The implications of the Lehman Brother's MLP Presentation were not lost on Clifton, who forwarded it to Jim Townsend, Holly's Vice President of Pipelines and Terminals, the following day, noting: "Although, [Lehman Brothers'] #'s maybe somewhat higher than they should be, look how high a value [they have for] the MLP worth post expansion/SLC related terminals/& exp. Rio Grande & interest."73 However, Clifton would also note that the Lehman Brothers MLP Presentation contained several errors and assumptions that resulted in overstating the value of the pipeline assets. For instance, he observed that the differences in value between the Base Case and Case A were the result of including in the MLP assets that Holly had acquired in 2003, the projected effects of expanding Holly's New Mexico refinery to increase flow through the pipeline, and an increase in debt.74 Lehman Brothers had assumed that the interest expense, or cost of debt, was 7% and the yield to the unit holders, when the units were sold, was 9%; therefore, an increase in debt had the corollary effect of increasing value.75 Even the Base Case Page 39 assumed $100 million in debt which was $50 million more than assumed in the presentation from Townes Pressler.76 Furthermore, Lehman Brothers had forgotten to include more than $4.5 million in expenses, related to such matters as corporate overhead, insurance and property tax, all of which would drive the value down by approximately $50 million.77 Clifton would eventually make handwritten notations on the Lehman Brothers MLP Presentation to correct for the errors he perceived, as well as to note where Lehman Brother's assumptions differed from those of Townes Pressler or included projected expansions.78 Thus, simply taking into account the expenses Lehman Brother forgot to include, while leaving all other assumptions the same, Clifton would recalculate the projections from the Lehman Brothers MLP Presentation as follows:79 Page 40 Sources and Uses of Funds($ in millions)
Base Case Case A Uses Pre-tax Value to Frontier On July 3, 2003, Clifton e-mailed the original version of the Lehman Brothers MLP Presentation to Edwards along with the following message: Julie [Edwards]: I don't know whether you & Jim [Gibbs] got a copy of this latest analysis from Lehman. For some reason, they have EBITDA in both cases overstated by $4.4MM (didn't include some o/h & insur, etc.) which would lower enterprise values by roughly $40MM + more or less. Dollars are bigger than Townes presentation due to higher debt @ 7% and IPO Page 41 assumed yield of 9%. Also case A includes the additional Rio Grande %, SLC terminals & expansion volume effects.80 While the Lehman Brothers MLP Presentation is a critical part of Frontier's repudiation case, I find as a matter of fact that no one on behalf of either Holly or Frontier accepted the projections at face value. For instance, Edwards, even after receipt of the Lehman Brothers MLP Presentation, believed the enterprise value for the MLP to be less than $280 million, and probably in the "mid 200s."81 This is not inconsistent with the testimony of Clifton who put the value in the range of $275 million to $300 million82 and Norsworthy who noted the increase in value from "the mid twos to the upper twos."83 O. The Holly Board Meets on July 9 The Holly Board met again on July 9 and received a status report on the Beverly Hills Litigation. Gibson Dunn informed the Board that defense costs alone would be substantial: early drafts of the Board's minutes indicate Page 42 they could be between $25 million and $40 million84 and the final version indicates that a range of $40-$50 million was discussed.85 The Board also received a presentation from Fletcher Yarbrough of Carrington Coleman. He was introduced as having been hired to "undertake an independent review of the Beverly Hills situations. . . . in addition to the analysis being done by Gibson Dunn."86 Yarbrough informed the Board that, based on what he had learned, Frontier was likely to be involved in the Beverly Hills Litigation through trial, and that it had direct contractual obligations to guaranty and indemnify other parties named as defendants in the Beverly Hills Litigation.87 As Yarbrough put it, the existence of the indemnities and guarantees meant that there was no "silver bullet" to protect Frontier from substantial litigation costs and liability.88 The Board, as might be expected, did not relish this news. For instance, Norsworthy expressed concern about Frontier stock "with this big, black cloud hanging over it."89 Similarly, Clifton "felt pretty uncomfortable personally about [the March 30] deal" and was unwilling to move forward Page 43 "without something that Frontier could bring to the table to mitigate the concern over Beverly Hills."90 Board member Jack P. Reid ("Reid") recalled that he had "greatly increased" concern over the indemnities, but believed that Holly would "probably be able to reach some type of agreement with Frontier" to address these concerns.91 During the course of the meeting, the Board considered issuing a Material Adverse Effect ("MAE") notice, but it ultimately rejected that course of action in favor of instructing Holly management to report its concerns to Frontier and to engage in a dialogue about those concerns.92 While the record is clear that the Holly Board did not change its recommendation or determine that an MAE notice should be sent on July 9,93 the record is also clear that, after the July 9 Board Meeting, Holly likely would not proceed to closing on the Merger Agreement in accordance with its express terms. This is not to suggest that Holly had repudiated the Merger Agreement; instead, it still had multiple options available to it, if Frontier did not adequately address its concerns, including declaring an MAE, exercising its fiduciary out, or seeking a mutual termination. Page 44 P. Holly and Frontier Meet on July 9 Immediately following the July 9 Board meeting, Norsworthy, Glancy, and Clifton flew (in a thunderstorm) from Dallas to Houston to convey the Board's concerns to Frontier. There, they met with Gibbs, Edwards, Bechtol, and Jewell. What happened at this meeting is the subject of some debate. Holly asserts that Frontier management was informed of the Holly Board's concerns and was presented with three options (1) restructuring the deal; (2) declaration of an MAE regarding the Beverly Hills Litigation; or (3) mutual termination. Frontier claims that, while Holly indicated its concerns, it was less than clear as to what options were available to accomplish the closing. The record is clear that at one point either Norsworthy or Glancy mentioned the possibility that the Beverly Hills Litigation could be an MAE to which Jewell responded that he "respectfully disagreed."94 Thus, while that exchange was short, lasting less than thirty seconds, the possibility of Holly's declaring an MAE and ending the transaction was expressed to Frontier at the meeting.95 Q. Frontier Decides to Renegotiate the Merger Terms Regardless of precisely what was said and what options were presented to Frontier at the July 9 meeting, the effect of it is clear Frontier Page 45 was placed on notice that, unless Holly's concerns were in some way assuaged, Holly would not proceed to closing under the Merger Agreement. For instance, Gibbs testified that "Mr. Norsworthy told [Frontier management] that his board would notwas very concerned about Frontier's stock and takingtaking the Frontier stock that we had in the original deal."96 In his deposition, he more clearly stated his understanding following the July 9 meeting that "Holly was not going to go forward with the merger based upon the March 30th agreement."97 Similarly, Edwards testified that she "understood on July 9 that it was very unlikely, if [Frontier] didn't do something, that Holly was going to proceed to a closing."98 Likewise, Bechtol recalled that he left the July 9 meeting thinking "that the business folks were going to need to get together and start trying to work towards some sort of renegotiation."99 Jewell perhaps put it most clearly of all by testifying that following the July 9 meeting "the ball was in our court to come up with some ideas . . . . [and] if we wanted to keep the deal together, we thought we would have to restructure."100 Page 46 The reasons for Frontier's willingness to renegotiate, instead of holding Holly to its deal, were best expressed by Gibbs: Q. Why didn't you just say to Mr. Norsworthy on July 9, "Hold on, Lamar. You signed a deal, and a deal is a deal and you're going to live by that or else?" A. You know, we had transactions put together here that we you only live once or twice for. You only get to these where it makes so much sense for your shareholders, their Holly shareholders, for Wall Street, for the bondholders, for employees. When you put the two companies together, creative form or fashion, helps the balance sheet, creates a real competitive power in the Rocky Mountains in an industry that's dominated by majors. We wanted to do this transactionthis transaction badly. We knew we had a good deal. We knew we had significant value for our shareholders going forward if this thing got closed. And we knew that we had quite a bit of leeway as far as being able to accommodate and sweeten and still maintain a good trade for our shareholders. And if [the Lehman Brothers MLP Presentation] was correct, had to assume it was, then the difference between the valuation that we had and this number, $250 million. So yes, we didn't want to lose the deal. We thought it was good for everybody going forward. Wall Street loved it. We had quite a bit of leeway in order to move up both the cash portion and the stock portion that we had. In the back of my mind was if if the new valuation, even on an apple-to-apple Page 47 basis of between $114 to $140 million of additional volume has been discovered here, Holly could at that point in time simply slip us $16 million and walk out into the sunset. Rather than have that happen, we were willing to go forward with a restructured deal.101 Thus, Frontier's decision to renegotiate was based on both its perception of an increase in MLP value in which it wanted to share and its knowledge that if Holly was not satisfied with the deal, it had an available exit strategy (and a relatively cheap one if the Lehman Brothers MLP Presentation were believed) under the Merger Agreement. This is the back-drop against which the subsequent negotiations took place. From July 9 to August 5, the parties engaged in protracted negotiations regarding how to restructure the transaction. These negotiations would eventually yield at least four models for a restructuring, all of which would be rejected, by one party or the other, for various reasons. On July 17, the parties met in Dallas and held a lengthy "brainstorming session" during which several proposals were discussed, including an all-cash deal with upside participation for Holly shareholders,102 a "synthetic" put with a financial institution, and a Page 48 combination of cash, notes, and warrants.103 They agreed on a restructuring under which, for a period after closing, Holly shareholders would be able to "put" their shares back to Frontier at a fixed price (the "Put Proposal"). The Put Proposal would have given Holly shareholders protection against Beverly Hills Litigation in that, should the litigation drive the price of Frontier stock down, they could "put" the shares received in the Merger back to the surviving company at a guaranteed minimum price for a limited time following the Merger.104 If the Beverly Hills Litigation resolved itself or Frontier stock rose above that price, Holly shareholders could also participate in the appreciation in value.105 At the conclusion of the meeting, Frontier directed Andrews Kurth to work out the mechanics of the Put Proposal and to draw up a term sheet. Frontier, however, backed away from the Put Proposal several days later after Gibbs and Edwards discovered that the puts would have to be recorded as Frontier debt. Gibbs did not want to "leverage [Frontier's] balance sheet."106 He explained his concerns: This is a very capital-intensive business that also has a very large amount of working capital. A lot of that working capital is financed through trade terms. And even though it's very Page 49 large, it's very small as far as participants. Once you become overleveraged and illiquid, all that trade credit dries up; and many companies have found themselves in pretty sad situations by overleveraging, getting illiquid and have a commercial trade credit dry up.107 Frontier's rejection of the Put Proposal was communicated to Holly, along with another restructuring proposal under which Holly would implement the MLP before the Merger and the proceeds from the MLP placement would be used to finance an all-cash transaction for the Frontier-Holly Merger (the "Canoe Proposal").108 In effect, under the Canoe Proposal, Holly was expected to pay the purchase price for the benefit of Frontier with its own money. This proposal infuriated Norsworthy, who had been expecting a final term sheet on the Put Proposal. In a phone call to Edwards on July 21, Norsworthy rejected the Canoe Proposal, saying, "[W]hy would I need Frontier if I can do that? I can sell my own pipes. I can paddle my own canoe."109 The following day, after Norsworthy had calmed down, he called Edwards again and proposed a transaction which Glancy and he had formulated. This transaction would involve "moving the boxes" or finding a Page 50 way to organize the various entities in such a way that Frontier's potential liability would stay with Frontier stockholders and Holly's shareholders would be insulated from any potential exposure.110 While Edwards initially thought this was "a good idea" with "some feasibility," it was ultimately not pursued, most likely because of difficulties encountered in assuring the desired result.111 Another concept was a cash/stock election optiona merger structure under which the stockholders of Holly would have a choice between the original deal and one with more cash and less stock. Clifton faxed this proposal to Edwards on July 29 (the "July 29 Proposal")112 after he had reviewed it first with Norsworthy, Paul Stoffel, a Holly director, and Robert Wheeler) of Credit Suisse First Boston.113 This approach essentially converted the transaction from a merger to an acquisition. It eliminated the concept of a shared board and management structure and increased the cash consideration. The pertinent terms were as follows: 2. Holly Corporation shareholders can pick one of the two following options subject to a maximum cash outlay from [Frontier ("FTO")] of $275MM (Over-subscription of Page 51 "Option 2" will be prorated back to "Option 1" on equal basis to keep below maximum cash outlay of $275MM). Option 1Cash $11.11 FTO Stock 1 Share CVR 1 CVR
Option 2 Note: As long as FTO stock value is above $14 per share when election is made, there would be an economical incentive to pick "Option 1." 3. CVR Original CVR is modified by adding the following right to the jet fuel claim right: CVR holders will receive a payment equal to 50% of the "value" receive by FTO from the sale of "Holly Corporation's Pipeline and Terminal" assets to a third party or to a new MLP formed by FTO in excess of $250 MM, but less than $350 MM, plus 40% of the "value" receive by FTO in excess of $350 MM. In the event that FTO does not sell "Holly Corporation's Pipeline and Terminal" assets to a third party or a newly formed MLP within 18 months from the date of the merger, the CVR holder will receive a payment equal to $4 per share.114 Edwards liked this plan.115 From July 29 through August 5, the parties worked hard to adapt the July 29 Proposal into a form that would be Page 52 acceptable to all involved. Indeed, Edwards recalls "the last half of July as a blur of conversations and different things [they] were trying . . . to . . . solve the problem."116 Similarly, Clifton's desperation to close the deal is reflected in an e-mail sent to Edwards on August 1: I can't stress how important it is to get a proposal ASAP. If we blow another week I don't know if it will stay together. Again, I'll go anywhere, any time to try to resolve outstanding issues. . . . Let's keep it going to see if we can get there. Even I am losing patience.117 The parties came to an agreement on August 5, 2003 in Denver (the "Denver Agreement"). The meeting was among Holly and Frontier's senior management and financial advisors, but without lawyers. The Denver Agreement differed from the July 29 Proposal: Holly stockholders could elect to receive all stock or all cash; the cash portion of the deal was raised from $172.5 million to $210 million;118 Holly shareholders would receive a contingent value right equal, in the aggregate, to 35% of the consideration which Frontier would receive from the MLP to the extent that it exceeded $280 million. Under this deal Holly stockholders could elect to receive $28.25 in Frontier stock, or $27 in cash, subject to a $210 million cash Page 53 limit.119 Assuming full proration, this w |
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