The current dispute between SLM Corporation (“Sallie Mae”) and a consortium of buyers led by J.C. Flowers II, L.P. (“JCF”) concerns the invocation by the buyers of a “material adverse effect” (“MAE”) clause in the parties’ merger agreement. The dispute not only provides a useful opportunity to revisit IBP, Inc. v. Tyson Foods, Inc.,1 the leading Delaware case on MAE clauses, but also serves as a reminder of the importance of clear and unambiguous language in critical deal provisions.
On April 15, 2007, Sallie Mae, the nation’s largest college student loan company,2 entered into a merger agreement with the JCF consortium. The agreement provided for the acquisition of Sallie Mae for $60 per share in cash (or a total value of $26 billion) and the payment by the JCF consortium of a $900 million termination fee if it failed to comply with its obligations to consummate the transaction. At the time of negotiations, both parties knew that Congress was considering legislation that could have a material impact on the student loan industry. Consequently, Sallie Mae and JCF negotiated specific language, through a carveout in the definition of “Material Adverse Effect,” which sought to allocate this risk. The relevant part of the MAE definition is as follows:
“Material Adverse Effect” means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from:… (b) changes in Applicable Law (provided that, for purposes of this definition, “changes in Applicable Law” shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading “Recent Developments” in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority; (c) changes in global, national or regional political conditions (including the outbreak of war or acts of terrorism) or in general economic, business, regulatory, political or market conditions or in national or global financial markets; provided that such changes do not disproportionately affect the Company relative to similarly sized financial services companies and provided that this exception shall not include changes excluded from clause (b) of this definition pursuant to the proviso contained therein….
On Sept. 27, 2007, Congress enacted the College Cost Reduction and Access Act of 2007 (the “Act”). The Act reduced the direct subsidies Federal Family Education Loan Program (“FFELP”) loans, reduced the federal guarantee of FFELP loans, and increased FFELP lender origination fees. On Oct. 2, 2007, the consortium informed Sallie Mae that, as a result of the enactment of the Act and the impact of recent turmoil in the credit markets, Sallie Mae had suffered an MAE, and the conditions of the buyers to consummate the merger were not satisfied.
In response, Sallie Mae filed suit in the Delaware Chancery Court seeking a ruling that the consortium had rescinded the merger agreement and that no MAE has occurred under the merger agreement. Sallie Mae claims that it is entitled to the $900 million termination fee.
Summary of the Parties’ Main Arguments: Differential Impact vs. Materiality Threshold 3
According to Sallie Mae, an MAE can only be declared on the basis of the Act if the difference between the adverse impact caused by the Act and that of proposed legislation disclosed in Sallie Mae’s annual report constitutes a “material adverse effect” on its business. According to Sallie Mae, the proposed legislation is likely to result in an incremental decrease in its projected net income of only between 1.8 and 2.1% over the next five years.
According to the consortium, if a “change in Applicable Law” is, in the aggregate, more adverse to Sallie Mae than the proposals described in Sallie Mae’s annual report, then the entire impact of the legislation must be assessed for purposes of the MAE clause. The buyers claim that the full impact of the Act constitutes an MAE under the merger agreement. In addition, they argue that even if Sallie Mae’s interpretation of the MAE clause is accepted and a differential test applied, the result would be the same because, among other things, the Act calls for $22.3 billion in subsidy cuts, whereas the proposed legislation contemplated between $10 billion to $15.5 billion in subsidy cuts.
IBP v. Tyson
The leading case interpreting an MAE clause under Delaware law is IBP v. Tyson. Tyson executed a merger agreement with IBP on Jan. 1, 2001. During the next financial quarter, IBP suffered poor financial performance and disclosed that accounting fraud had occurred at one of its subsidiaries, resulting in the write-off of the value of that subsidiary, a modest contributor to the revenues and earnings of IBP (approximately 1%). At the end of March 2001, Tyson terminated the merger agreement and brought a claim, arguing that the deterioration of IBP’s sales performance over two quarters triggered the MAE clause and gave Tyson the right to terminate the agreement.
Vice Chancellor Leo E. Strine, Jr. held that no MAE had occurred and ordered specific performance of the Tyson merger agreement. In his decision, Vice Chancellor Strine construed the MAE clause to exclude short-term deteriorations in performance that had not been shown to affect the long-term performance of the seller, despite the absence of any explicit language on duration of the adverse impact in the MAE definition.
In light of the IBP decision, practitioners have stressed the importance for buyers and sellers to use clear and unambiguous language in critical deal provisions to avoid costly and potentially adverse legal battles. Buyers are encouraged to seek express “outs” to a purchase agreement (e.g., an express closing condition or termination right), rather than take their chances that a court will interpret exclusions to an MAE clause in a favorable manner. Sellers are encouraged to draft exclusions to an MAE clause with precision.
Vice Chancellor Strine’s Initial Reaction to the Sallie Mae MAE Clause
The Sallie Mae case is a good example of how even sophisticated parties represented by expert M&A counsel can find themselves in a legal quagmire as a result of ambiguous drafting. Vice Chancellor Strine, who is presiding over the case, made the following comment on the parties’ MAE provision in a scheduling conference:
I have to say, the [buyers], the weakness from their position is this idea that, basically, one penny on top of what is outlined in the agreement more makes you count the whole thing as an MAE. That is not intuitively the most obvious reading of this. On the other hand, [Sallie Mae’s] position could have been much more clearly drafted if they wished to say that, essentially, all the legislation was a baseline, and you measure the incremental effect. I’m not sure that this is the greatest example of clear scrivening from either side.4
This dispute serves a useful reminder for both buyers and sellers that language in a transaction agreement concerning critical risk allocation must be clear on its face to reduce the risk of costly and potentially adverse legal battles.