Training Session: Material Adverse Change Clauses
By Peter Ingerman and Charles Hord
Chadbourne runs internal training sessions for lawyers in the project finance group and interested clients. The following is an edited transcript of a session on material adverse change clauses in corporate transactions, principally mergers and acquisition transactions, that took place by videoconference in mid-March among the Chadbourne offices in New York, Washington and London. The speakers are Peter Ingerman and Charles Hord in the New York office. Copies of the handouts used for the presentation can be obtained by sending an e-mail to email@example.com or firstname.lastname@example.org.
A material adverse change — or “MAC”— clause is a representation and warranty or a closing condition to a transaction that protects a buyer against adverse changes in the condition of the target. The clause usually applies between some predetermined date, often prior to the date the agreement is executed, through closing of the transaction, which may occur some time after the agreement is executed. We will use the terms “material adverse change” and “material adverse effect” interchangeably in this presentation since the definitions of these terms typically cover both changes and effects.
Two recent developments have focused attention on MAC clauses.
The first is an important decision that the Delaware Chancery Court issued last June. The case involved a merger agreement in which Tyson Foods had proposed to acquire IBP. Tyson Foods canceled the contract, relying in part on a MAC clause.
The second development is the terrorist attacks on September 11, which gave everyone a new appreciation for what sorts of adverse events might overtake a transaction between signing and closing.
Before we get into more detail on the recent developments, let’s take a look at what a MAC clause looks like. If it is incorporated as a closing condition, it would read something like the following:
Since [a specific date], there shall not have occurred (or reasonably be expected to occur) any events, changes or developments which, individually or in the aggregate, have had or would reasonably be expected to have a Material Adverse Effect with respect to the Company.
MAC language will also typically be found in the representations and warranties section of an agreement. The seller will represent and warrant that since some date — often this date is tied to the most recently audited financial statement of the target — the target has not suffered a MAC. To extend the protection of such a representation through closing, one of the conditions to closing will be that all the representations and warranties are true and correct in all material respects as of the closing date.
A very basic definition of “Material Adverse Effect,” taken from a transaction involving the acquisition of a company, looks something like this:
(a) When used in connection with the Company or its subsidiaries, any change or effect (or any development that, insofar as can reasonably be foreseen, is likely to result in any change or effect) that, individually or in the aggregate with any such other changes or effects, is materially adverse to the condition (financial or otherwise), business, assets, liabilities, results of operations or prospects of the Company and its subsidiaries, taken as a whole; and (b) when used in connection with any Shareholder or Buyer, any change or effect (or any development that insofar as can reasonably be foreseen, is likely to result in any change or effect) that, individually or in the aggregate with any such other changes or effects, will prevent any Shareholder or Buyer, as the case may be, from materially consummating the Transaction or performing his or its obligations under this Agreement.
One interesting thing to note about the definition is that “materiality” is not defined. It almost never is and thus there is no general quantitative or qualitative standard as to what is “material.”
Another interesting point is that this definition purports to establish an objective standard. Occasionally a subjective standard will be used instead — that is, whether something is reasonable “in the judgment of” the buyer or seller. This is typical where both the buyer and seller have the right to invoke the clause to get out of their deal.
MAC clauses are not just at home in mergers and acquisitions. You often see them in underwriting agreements, giving the underwriter the ability to walk away from a deal prior to an IPO. In such an agreement, the clause will often relate to a general disruption in financial markets.
Financing “outs” also appear in commitment letters, loan documents and lease documents. There again, the clauses will have slight differences in flavor, but concepts will be similar to the clauses found in M&A agreements. In project finance documents like construction contracts, MAC clauses will often be used to protect a developer from having to build its project if an act of God makes the project uneconomic or unreasonable in some respect.
Court decisions teach us that MAC clauses are not substitutes for specific closing conditions that address known risks and contingencies. Courts are hesitant to find that a material adverse effect occurred. Reported decisions are often surprising because there is a very low level of predictability of outcomes.
One court decision — the Borders v. KRLB Inc. case — involved an acquisition agreement for a radio station. Between the signing of the agreement and the scheduled closing date, the radio station’s ratings fell by about half. The MAC clause in the acquisition agreement was fairly typical. It said, in effect, that 1) since a specified date the target must not have suffered a MAC, 2) the business of the target must have been conducted along its ordinary course, and 3), as is typical in these provisions, the target must not have done anything specified on a long list of items since the given date. The court looked at the provision and concluded that the language was only intended to protect the buyer against volitional acts taken by management of the target. In the court’s view, the clause did not provide protection from elements that were beyond the control of management.
I think that most readers, in looking at the MAC clause in the KRLB case, would have separated out the first point, which said that the company had not suffered a MAC, from the second and third points of the provision, which said that the business of the target had been conducted in its ordinary course and certain actions had not been taken. Only the last two provisions address volitional acts. The MAC clause appears to protect the buyer against material adverse change whether or not it resulted from intentional acts by management. That is not how the court read it. The draftsman might have done better to have two separate clauses.
In another case — Northern Heel v. Compo Industries — a buyer was seeking to exit an acquisition on the basis that the production of the target had declined dramatically since the parties signed their acquisition agreement. The agreement included a typical, broad MAC clause. It did not include a representation or warranty about the target’s production. The court decided that the MAC clause was not broad enough to encompass the decline in production. If the buyer was so concerned about production, chastised the court, it should have asked for a special representation to cover a potential decrease. Again, this seems contrary to how most of us interpret MAC clauses — that they are not tied to specific events like most representations and warranties are.
The lesson we must take from these cases is that the traditional interpretation of MAC clauses is unpredictable. It is also safe to say that courts are reluctant to “interfere” or permit a contract to be “broken” on the basis of a MAC or for any other reason. Therefore, one cannot just assume that a MAC provision is a substitute for carefully drafted, specifically tailored representations and warranties or closing conditions addressing specific risks and contingencies of the acquired business that have been identified by the buyer.
IBP v. Tyson Foods
This lesson brings us to the first development that has brought MAC clauses back into focus: the recent decision by the Delaware Chancery Court in IBP v. Tyson Foods.
The IBP/Tyson merger agreement resulted from a competitive auction to acquire IBP. The target’s principal business was to act as a middleman for fresh beef and pork. It bought live animals, slaughtered them, and sold the butchered meat to supermarkets and other companies that would do further processing.
During the auction process, Tyson was given a great deal of information that suggested IBP was entering a “trough” in the beef business. The beef business is cyclical and there are often troughs and peaks that last several years. In addition, during the due diligence process, Tyson was informed that an IBP subsidiary known as “DFG” had been victimized by accounting fraud of $30 million or more. Tyson Foods had significant information that IBP was projected to fall short of its fiscal year 2000 earning projection.
The evidence indicated that by the end of the auction process, Tyson had very little confidence in the ability of IBP’s management to forecast future results and, in particular, thought that DFG was a disaster that should have been written off. Nevertheless, Tyson increased its bid for IBP by about $4 per share. In addition, Tyson signed a merger agreement that essentially provided IBP an unlimited ability to recognize further losses in connection with the DFG accounting problem. This stemmed from a provision that said there were no liabilities of the target, except as disclosed on Schedule 5.11. Schedule 5.11 said in effect that there were no undisclosed liabilities — except for the accounting problem at DFG and any further losses associated with the accounting problems at DFG.
After the merger agreement was signed, both Tyson and IBP saw declines in their operating results, due in large part to adverse weather during the winter of 2000 to 2001. As time went on, Tyson became more and more disenchanted with IBP and finally, by the end of March 2001, sent a letter to IBP saying that it was breaking off the merger. IBP sued Tyson, seeking specific performance of the agreement.
Tyson Foods asserted a number of affirmative defenses to IBP’s claim, one of which was that IBP had suffered a material adverse effect because the target’s earnings for the first quarter of 2001 were 36% lower than its earnings for the first quarter of 2000. The merger agreement contained a very broad MAC clause; there were no carve-outs. The court held that no material adverse change occurred. The court said:
“[A] buyer ought to have to make a strong showing to invoke a material adverse effect exception to its obligation to close .... [E]ven where a material adverse effect condition is as broadly written as the one in the merger agreement, that provision is best read as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term hiccup in earnings should not suffice; rather the material adverse effect should be material when viewed from the longer-term perspective of a reasonable acquirer.”
A couple key points arise. One obvious: the court put the burden on the buyer to show that a material adverse effect occurred. In addition, the court said that the protection against the unknown goes to substantial events — events that threaten the overall earnings potential of the target. Since the target’s business was cyclical, the court pointed out that perhaps there was no reason to think a short-term drop in earnings was evidence of any long-term problem. Finally, the court suggested that it was not 100% certain of its decision on the MAC issue, which paves the way for an appeal by Tyson Foods.
As a side note, an interesting fact that played into the court’s decision on the MAC issue was that Tyson Foods’ publicly expressed reasons for terminating the merger did not include an assertion that IBP had suffered a material adverse change. The MAC argument was not asserted until later — after the litigation began. This fact helped lead the court to believe that it was really just a case of buyer’s regret.
The other recent event that brought MAC clauses into focus is the terrorist attack on September 11, 2001. Recently, someone performed an informal survey of pre- and post-September 11 acquisition agreements in public deals. The conclusion was that there really has not been much obvious change in public deals, at least not in terms of contract language. One exception is a power industry merger agreement between Reliant and Orion Power that was signed on September 26, 2001. Their agreement included a very complex MAC clause with a carve-out for “any change to financial or securities markets or the economy in general” unless caused by material worsening of current conditions caused by acts of terrorism or war. In this agreement, an economic downturn would not be a MAC unless it stemmed from another terrorist incident.
Looking forward a bit, it will be interesting to see how the courts deal with the case stemming from the failed Enron-Dynegy merger. Dynegy repudiated its $9 billion merger agreement with Enron right after Enron’s bond rating was slashed to junk status by the three major rating agencies. Unlike Tyson Foods, Dynegy claimed publicly that it was relying on the MAC to terminate their agreement. Enron promptly filed a breach of contract suit against Dynegy.