Feeling some buyer’s remorse after your latest big purchase? Well, this happens to companies involved in multi-billion dollar mergers and acquisitions, too, in the time between signing an agreement and closing the deal. This is one reason that a material adverse change (“MAC”) clause is a standard feature in M&A agreements—to allow the buyer to exit the merger if certain adverse changes befall the target company, but to prevent the seller from backing out because it simply changed its mind. MAC clauses are a highly negotiated part of such agreements because they are the mechanism by which the buyer and the seller can allocate pre-closing risks between themselves. A MAC clause, in theory, gives the buyer a potential “out” if the target company experiences what the agreement defines as a “material adverse change” or “material adverse effect.”
A typical MAC clause might define a MAC as “any event, circumstance, fact, change, development, condition, or effect that, either individually or in the aggregate, has had or could reasonably be expected to have a material adverse effect on the business, financial condition, results of operations, or other aspects of the business of the target and its subsidiaries, taken as a whole.” Next come several carve-outs from this broad definition of a MAC. These carve-outs are usually the focus of MAC negotiations, since they serve to narrow the universe of what the buyer can argue constitutes a MAC.
Given the heavy negotiation that surrounds this clause, one might expect that it spawns a large amount of litigation. But the opposite is true. Commentators agree that there is a relative dearth of litigation on the subject, with only two cases in the Delaware courts addressing a buyer’s attempt to exercise a “MAC out” (in other words, to stop a deal in real time and resist the target company’s demand for specific performance) in the past 15 years. These two cases suggest a standard that, while stringent, is difficult to define.
This was a suit by the target company, IBP, Inc., for specific performance of the merger agreement, signed January 1, 2001, between itself and Tyson Foods, Inc., the acquirer. Tyson had terminated the merger with IBP, relying in part on the argument that the decline in IBP’s performance in the final quarter of 2000 and the first quarter of 2001 constituted a material adverse effect. Vice Chancellor Strine referred to the evaluation of a material adverse change argument as “an exercise that is quite imprecise.” The court noted that the MAC clause in this case was “fraught with temporal ambiguity,” meaning that it did not clearly specify the time frame in which a MAC could be found to have occurred. Ultimately, the court found that a MAC had not occurred in the short time period cited by Tyson: “[T]he important thing is whether the company has suffered a Material Adverse Effect in its business or results of operations that is consequential to the company’s earnings power over a commercially reasonable period, which one would think would be measured in years rather than months.” Finding no New York case law—which governed the substantive issues of the case—on the subject, VC Strine held that a New York court would place the burden of proof on the buyer attempting to invoke a MAC clause in order to terminate its obligations under the merger agreement.
In this case, two large chemical companies, Hexion and Huntsman, had entered into an agreement in July 2007 for the leveraged cash acquisition of Huntsman by Hexion. Like in In Re IBP, Inc., the target company sought an order for specific performance by the acquirer. The Chancery Court again found that a MAC had not occurred and that the acquirer was not excused from its obligations under the agreement. VC Lamb reaffirmed the IBP holding by stating that, “In the absence of evidence to the contrary, a corporate acquirer may be assumed to be purchasing the target as part of a long-term strategy.” This default assumption is quite seller-friendly as it protects the seller from a MAC termination based on short-term fluctuations in its performance. The court stated that it was “not a coincidence” that Delaware courts have never found a MAC to have occurred in the context of a merger agreement and reaffirmed that MAC clauses should be interpreted as “providing a backstop” to insulate the acquirer from a change in the target’s long-term earnings potential. VC Lamb concluded that “poor earnings results must be expected to persist significantly into the future” for an event to constitute a MAC.
A heavy burden on the buyer hoping for a MAC out
The only two Delaware cases on the subject seem to have closed the door firmly on buyers hoping to back out of a merger—and avoid the seller’s demand for specific performance—based on a material adverse effect argument. It is possible that the minimal amount of litigation on this issue in recent years is a result of the Delaware Chancery Court’s tough stance in the above two cases. Perhaps the court has sent a message to would-be litigants that their lawsuits would be a waste of their own time and resources with a minimal chance of success.
Placing the burden on the acquirer to prove that the target company has experienced a MAC presents multiple challenges. First, the acquirer may not have all of the information it needs to accomplish this task by virtue of being a separate entity. Second, requiring evidence of a long-term adverse effect on the target company essentially requires the acquirer to accurately predict the future of the target and back it up with reliable financial data.
In addition, the lack of litigation could be a result of the somewhat amorphous nature of the definition of “material adverse change.” The courts have not provided potential litigants with the specific or quantifiable criteria that may be used to determine whether a MAC has occurred. The carve-outs to the MAC clause negotiated by the parties in the agreement provide some guidance, but without judicial interpretation, these remain uncharted waters for potential litigants.
So what’s the big deal?
An article from lawyers at Debevoise & Plimpton suggests that buyers may still want to devote significant negotiation resources to MAC clauses in merger agreements because of the leverage that such clauses can provide if the buyer wants to try to force a renegotiation of the deal. The content of the MAC clause and the threat of MAC clause litigation can be helpful to a buyer when it seeks to force the seller to renegotiate for a lower price. As is so often the case, perhaps only the specter of MAC litigation is necessary for the clause to remain an effective component of merger agreements.
The preceding post was originally published on February 13, 2016 by the Columbia Business Law Review, and is available here.