By Anthony J. Rospert and Hope Y. Lu
Tony Rospert is a partner and Hope Lu is an associate in Thompson Hine's Business Litigation group in the firm's Cleveland office. Mr. Rospert focuses on complex business and corporate litigation involving public and private companies, including pre- and post-closing merger disputes. Ms. Lu also assists clients with merger litigation and uses her fluency in Chinese, both Mandarin and Shanghainese, in her representation of various business clients.
Since the downturn in the global economy began in the fall of 2008, a number of proposed mergers involving public companies have been called off by one party or the other, leading to increased litigation between buyers and sellers. When adverse events or circumstances come to light post-signing, one of the parties may attempt to “walk away” from the transaction prior to closing. In an attempt to terminate merger deals prior to closing, parties are invoking the contract clause commonly referred to as a material adverse change or material adverse event clause (MAC clause) as grounds for termination of the pending transaction.
When called to apply these provisions, courts narrowly interpret MAC clauses and often struggle to define materiality in the context of a particular set of facts claimed to warrant non-performance. Companies and their lawyers, if they are not already doing so, should take greater care in negotiating these provisions in their deal documents to balance the certainty of the merger against the right of the other party to walk away because of developments between signing and closing.
In this article we will examine pre-closing disputes in merger transactions and the role that MAC clauses play in these disputes. We will also review the current state of the law on MAC clauses and discuss how courts interpret materiality under these provisions. Finally, we will outline drafting considerations for parties to help mitigate the risk of expensive and uncertain MAC-related pre-closing litigation.
MAC clauses affect deal certainty. In public-company mergers, there is typically a delay between signing and closing while the parties obtain shareholder and governmental approvals and secure financing. During that period, for various reasons including unexpected changes in circumstances or buyer's or seller's remorse, one of the parties may start looking for an exit. A properly drafted MAC clause allocates the risks of a material change occurring between signing and closing.
The American Bar Association's model MAC clause defines “material adverse change” as follows:
Since the date of the Balance Sheet, there has not been any material adverse change in the business, operations, properties, prospects, assets or condition of any Acquired Company, and no event has occurred or circumstances exist that may result in such materialadverse effect.
Determining what is meant by the term “material” in a MAC clause is often the core issue in pre-closing merger litigation. Rarely is materiality defined in the merger agreement, which leads to uncertainty and ambiguity. Instead, parties use broad language, leaving it to the courts to define materiality within the context of the particular set of facts.
Litigation involving the interpretation of MAC clauses is a high-risk proposition due to the uncertainty involved in interpreting these clauses. Indeed, there are only a handful of fully litigated material adverse change cases, and they tend to involve fact-specific disputes that require a full trial for resolution. As described below, courts have set a very high standard for parties seeking to avoid closing on the grounds of a material adverse change. These results stem from public policy favoring enforcing signed deals and the courts' lack of sympathy for buyer's or seller's remorse.
In the seminal 2001 Delaware Court of Chancery case IBP v. Tyson Foods, the buyer, Tyson Foods, sought to terminate a $3.2 billion deal by invoking a MAC clause. Despite a 64 percent decline in the target's earnings, the court found there was no material adverse change. It concluded that MAC clauses “are best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of a target in a durationally-significant manner.” The court elaborated that “durationally-significant” means a “commercially reasonable period,” which is measured in years rather than months--not a “short-term blip.”
In IBP, problems with the target's earnings, assets and financial reporting failed to constitute a material adverse change because, though significant, they could nonetheless be corrected in “several years.” The court also commented that Tyson Foods got what it expected when it signed the merger agreement--an “erratically profitable company.” Thus, the court ordered Tyson Foods to close the deal.
In 2005, the same court in Frontier Oil v. Holly, which involved a $450 million merger, concluded that a threatened environmental class action concerning one of the buyer's subsidiaries did not entitle the seller to invoke a MAC clause. The seller argued that the buyer's potential liabilities could have a material impact on the value of the buyer's stock that the seller's shareholders were to receive in the merger. As a result, the seller was reluctant to proceed with the transaction unless the merger agreement was amended to account for the increased liability. The court held that the threatened litigation did not constitute a material adverse change because the seller failed to show how it would significantly affect the buyer's share price over a “longer term.”
Finally, in Hexion v. Huntsman, the Delaware Court of Chancery held that the seller's inability to hit target numbers projected when the deal was signed, without more, did not constitute a material adverse change. There, Hexion, the buyer, sought to terminate a $10.6 billion deal. Hexion even obtained a third-party opinion stating that the seller was insolvent in order to support its theory of a material adverse change. The court still found that the seller had not suffered a material adverse change, concluding that a few bad quarters were not enough to trigger the applicability of the MAC clause. The court also commented that “Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement.”
It is significant that Delaware courts have never found a material adverse change in the merger context, but in November 2013 the Delaware Court of Chancery may have softened its position. In Osram Sylvania, Inc. v. Townsend Ventures, LLC, the court, in denying a motion to dismiss, opined that acts of financial manipulation prior to executing a merger agreement and the failure to meet sales forecasts could constitute a material adverse change.
These Delaware opinions suggest that a court might find one or more of the following to constitute a material adverse change, permitting termination of a merger agreement:
• Events that were unknown at the time of the agreement that one of the parties later discovers will have an impact in a “durationally-significant manner” (IBP, 2001)
• Events that are “substantial” in degree and duration (Holly, 2005)
• Events that will “persist significantly into the future” (Hexion, 2008)
Ultimately, it appears that courts will require materiality to be proved on the basis of a long-term perspective--short-term hiccups or blips will not suffice.
If, as suggested by this analysis, courts rarely find the existence of a material adverse change that would support a party's decision to walk away from a merger agreement, then one must ask: Why even start the process of invoking a MAC clause?
The first, most obvious reason is that parties are invoking MAC clauses to gain negotiating leverage. Parties are hoping to restructure the deal even if they may be unlikely to win in court. In making the argument, a party may obtain significant price or other deal concessions by invoking a MAC clause because the other party may not want to incur the costs and time to litigate. Rather, the other party may find it preferable to make concessions or, alternatively, to pay a break-up fee and dedicate its time and efforts to finding a more willing merger partner.
This begs a further question: Why not invoke a MAC clause in every deal in order to obtain negotiating leverage? Because it can impact a party's reputation in the market. In July 2008, The Deal Newsweekly published an article titled “Blackballed,” which referred to sellers “blackballing” private equity firms from their auctions and quietly soliciting only strategic buyers because of the number of private-equity buyers invoking MAC clauses. Thus, the market can act as a check against the unwarranted use of MAC clauses.
In crafting forward-looking provisions governing developments during the time between signing and closing, the parties should consider addressing three types of risks:
• Systemic risks, e.g., general economic conditions
• Financial risks, e.g., deterioration in a buyer's or target's financial condition
• Agreement risks, e.g., shareholder lawsuits resulting from the merger announcement
In drafting to adequately balance these risks, the key is to carefully consider specific types of material changes that will warrant cancellation of the transaction. Parties can alleviate some of the deal and litigation risks associated with broadly written MAC clauses by identifying specific carve-outs that will not be deemed to constitute material adverse changes, narrowing the time frames for identifying events alleged to be material adverse changes and specifying objective criteria to assess the materiality of a change. Alternatively, parties may decide to forgo the use of a MAC clause altogether and instead rely on representations and warranties and other conditions precedent to closing.
Typical MAC clause carve-outs include exceptions to the clause if the change or effect “results from or is attributable to” certain events such as acts of war or terrorism, adverse weather, changes in accounting principles, the seller's failure to meet analysts' or internal earnings estimates, interest rate or currency exchange rate changes, or changes in market price or trading volume of the seller's securities, etc. These provisions acknowledge that certain events would constitute a material adverse change but for the carve-out.
In Genesco, Inc. v. Finish Line, Inc., a seller filed suit in Tennessee federal court seeking to compel the buyer to close the $1.6 billion merger transaction. Initially the court agreed with the buyer's argument that the seller's drop in earnings constituted a material adverse change. The parties, however, had negotiated a carve-out in the MAC clause for effects resulting from changes in “general economic conditions.” The court found that the carve-out applied, and, thus, there was no material adverse change. Accordingly, the use of carve-outs can be beneficial in drafting MAC clauses to help remove some of the ambiguities and uncertainties in their interpretation and application.
Parties should also evaluate whether to incorporate specific time frames into the MAC clause. For example, in Genesco, the parties' contract acknowledged that a material adverse change could occur in the three- to four-month time period between signing and closing. In drafting MAC clauses, parties should consider contracting away the “durationally-significant” gloss that has been applied by the Delaware courts in defining materiality by acknowledging that the impact of a material adverse change can occur within shorter periods of time or without regard to duration.
Parties may also want to consider outlining specific objective criteria in the MAC clause, which could include any risk or metric important to the parties to provide greater certainty. Examples of objective criteria often negotiated in MAC clauses in merger agreements include:
• Seller must maintain certain sales levels or financial benchmarks
• Seller must maintain certain key contracts or customers
• Parties must not be the subject of any non-nuisance lawsuits
• Parties must maintain a minimum stock price or EBITDA, e.g. stock collar
If these objective criteria are not met, a party can terminate the transaction.
As an alternative to a MAC clause, parties may agree to specific representations and warranties or conditions precedent to closing. The intent of these provisions is to establish bright line tests, which constitute statements of fact that must be true as of the closing date. If any of the conditions are false at closing, the other party can walk away without incurring liability. For example, the objective criteria discussed above can be converted into representations and warranties, which can be used as an alternative to a broad MAC clause, thereby removing ambiguities in defining materiality. In doing so, however, the parties should take care that these warranties and closing conditions are not themselves qualified by materiality.
MAC clauses go to the heart of the most important question in a merger transaction: Do we still have a deal or not? The existence of a material adverse change is difficult to establish, but the clauses can be useful. To minimize the risks and maximize the advantages of a MAC clause, careful consideration when drafting the clause is crucial. Open-ended language about “material changes” likely will not provide adequate protection, so drafting specific language for MAC clauses, removing accidental ambiguity, and being deliberate about each criterion or provision ensures that the legal risks are addressed and the parties' interests are protected. If something is very important, a party should consider making it a condition precedent to closing rather than relying on a MAC clause.
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