Recent political and economic events have made it abundantly clear that the continuing constriction of credit has had a profound impact on the orderly functioning of the US and world economies. The tightening of credit markets has had a particularly pernicious effect on the mergers and acquisitions market which has seen a marked increase in the number of “busted” or renegotiated deals since the crisis began. In the current environment, the terms upon which would-be lenders may have committed funding are often dramatically out of market by the time the transaction is to close and funds are to be provided. The result is an inability to syndicate and magnified risks for the lending party. Similarly, would-be acquirers have sought to exit transactions that, at one time, may have made business sense but now do not. The attempt by Hexion Specialty Chemicals to walk away from its US$6.5 billion acquisition of Huntsman Corporation, which was rejected on September 29th in an opinion from the Delaware Chancery Court,1 is merely the latest example in a litany of transactions which have fallen victim to changed circumstances.
In addressing the increased risks caused by the credit crunch, lenders and acquirers have tried to use a variety of contractual approaches to avoid consummation of problematic transactions, with varying degrees of success. The most commonly used, but perhaps least legally certain, is the invocation of a material adverse change/effect (“MAC”) clause. In fact, one of the principal arguments asserted by Hexion as justification for abandoning the deal with Huntsman was the allegation that Huntsman had experienced a material adverse change under the terms of the transaction.2 Generally, a MAC clause permits an acquirer (or its lender) to walk away from the transaction upon the occurrence of some unknown contingency which fundamentally impairs the value of the target. (Known contingencies often are, or should be, provided for in deal documentation through specific conditions precedent.) Most MAC clauses relate solely to the financial condition, business, assets, liabilities or results of operations of the target entity, though some clauses (typically referred to as “market MAC’s”) relate to conditions in the overall economic environment. The clause at issue in the Hexion/Huntsman transaction related solely to the business of the target with certain carve-outs for general economic conditions or circumstances affecting the chemical industry in general.3
MAC clauses are very difficult to enforce, with the party seeking to avoid the transaction bearing the burden of proving that a MAC has, in fact, occurred. In evaluating the scope of a MAC clause (both those relating to the target and those keyed to the market) courts generally employ a fact-specific analysis typically guided by the text of the clause itself, the available evidence concerning the parties’ negotiation and interpretation of the clause, the commercial context in which the transaction takes place and the purpose of the agreement containing the MAC. In applying the terms of a MAC to an alleged triggering circumstance or event, the court usually will examine the following factors:
any specific financial benchmarks or criteria included in the MAC;
- the buyer’s purpose in acquiring the target entity (i.e., short-term losses would have greater weight in short-term investments as opposed to long-term strategic mergers where the focus may be on the effect on an entity’s long term value or business prospects);
- the commercial context of the losses suffered (i.e., setbacks to core businesses are necessarily more crucial than those to secondary businesses); the absolute and proportionate amount of the losses sustained;
- whether the acquirer could have protected itself against the loss through an explicit, specific warranty from the target;
- alternative motivations a party may have for trying to exit the transaction;
- whether the MAC claim is reasonable and in good faith in light of the totality of the circumstances.
Due to the fact-dependent nature of the showing required, claims under a MAC clause are rarely decided on a motion to dismiss since a court cannot grant such a motion where there are material facts in dispute. MAC cases often settle, however, before reaching a determination of the merits given the significant stakes typically involved.
The leading case on the interpretation and application of MAC clauses is In re IBP, Inc. Shareholders Litigation.4 In In re IBP, the target brought suit seeking specific performance of a merger agreement. The acquirer claimed that a MAC had occurred, allowing it to avoid closing. The Delaware Chancery Court, applying New York law, found that a decline of sixty-four percent (64%) in quarterly earnings over the previous year, an impairment charge of US$60.4 million (16% of average EBITDA over the previous five years, amounting to between US$.50 and US$.60 per share), the significant underperformance (only 1.4% of projections) of a division touted as a “driver of profitability” and a thirty-nine percent (39%) reduction in earnings projections by analysts did not justify invocation of the MAC clause.5 The Court awarded specific performance to the target, noting the cyclical nature of the target’s business and a particularly severe winter leading to an increase in livestock prices (a key input for the target).6
The continued primacy of In re IBP was recently confirmed in the opinion and order of Vice Chancellor Stephen P. Lamb, of the Delaware Chancery Court, rejecting the invocation of a MAC clause by Hexion/Apollo to avoid its obligations pursuant to its merger agreement with Huntsman Corp.7 The Court in Hexion adopted the reasoning of In re IBP and held that Hexion/Apollo had not met its high burden of showing a material adverse effect had occurred since “[a] short-term hiccup in earnings should not suffice” to invoke a MAC without the expectation that “poor earnings results . . . [will] persist significantly into the future.”8 The Court also noted that “Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement.”9 Following Vice Chancellor Lamb’s ruling in its favor, Huntsman filed another lawsuit10 in Texas state court against two banks that had agreed to provide financing to effectuate the merger with Hexion. In that suit, the Texas court granted Huntsman’s request for an injunction enjoining the banks from filing suit, at any time prior to closing of the transaction or expiration of the banks’ commitment letter, seeking a declaratory judgment that the combined Hexion/Huntsman entity would be insolvent (thus, relieving the banks of their obligation to fund the merger).11 In announcing its decision, the Court expressed concern that the filing of such an action by the banks prior to closing or expiration of the commitment letter would impede the efforts of Hexion/Apollo and Huntsman to reach agreement as to revised terms of the transaction which might permit the merger to be consummated without further legal proceedings.12 The Texas trial court’s concerns appear to have been well-founded since, after losing their appeal of the injunction,13 the banks announced on October 28, 2008 in a joint statement that the solvency opinion and CFO certificate provided by the parties were not “reasonably satisfactory” as required by the commitment letter and, thus, the banks would not fund the transaction.14
As widely anticipated, on October 29, 2008, Hexion filed suit against the banks in New York State Supreme Court seeking specific performance of the banks’ obligation to provide funding for the transaction to allow Hexion to consummate its agreement to acquire Huntsman. Hexion will also undoubtedly seek an order from the court enjoining the expiration of the commitment letter (set to expire on November 1, 2008), at least until such time as the court can consider the merits of the parties’ dispute as to the solvency of the proposed combined Hexion-Huntsman entity.
UPDATE: As expected, today Hexion filed suit in NY State Supreme Court against the Banks seeking specific performance of their obligation to fund Hexion's acquisition of Huntsman.