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In an important development in the law relating to Material Adverse Effect ("MAE") clauses in merger agreements, Vice Chancellor Stephen P. Lamb of the Delaware Court of Chancery ruled on September 29 that Hexion Specialty Chemicals, Inc., an affiliate of Apollo Management LP, may not walk away from its deal to acquire Huntsman Corp. for $6.5 billion. The case, Hexion Specialty Chemicals, Inc. v. Huntsman Corp., is an important indicator of how courts may interpret MAE clauses, and comes at a time when the current economic crisis makes it more likely that MAE clauses will be tested in other transactions. Significantly, the Delaware decision then was followed by a Texas court ruling on September 30 that bars affiliates of the Credit Suisse Group and Deutsche Bank from withdrawing financing for the deal.

Hexion, a producer of adhesives used in plywood, agreed to purchase Huntsman, the world's largest producer of epoxy additives, in July 2007. Apollo filed suit in June 2008, claiming both that it had no obligation to close the deal as the post-merger entity would be insolvent, and because Huntsman had suffered a MAE. The MAE language in the merger agreement provided that Apollo's obligation to close was conditioned on the absence of "any event, change or development that has had or is reasonably expected to have, individually or in the aggregate" a MAE. "MAE" was in turn defined as "any occurrence...that is materially adverse to the financial condition...of the Company...," excluding changes in "general economic or financial market conditions" or occurrences "affect[ing] the chemical industry generally." The Court rejected Apollo's insolvency argument, largely on the basis that its insolvency opinion was flawed,1 and went on to address the MAE argument.

In finding that Huntsman had not suffered a MAE, the Court relied heavily on In re IBP, a leading Delaware case (applying New York law) on the interpretation of MAE clauses. Noting that, "absent clear language to the contrary" the party seeking to invoke an MAE clause bears the burden of proving that an MAE has occurred, the Court cited In re IBP for the proposition that "a buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close," and noted that "Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement." Elaborating on the oft-cited reasoning from In re IBP that "[a] short-term hiccup in earnings should not suffice" to succeed on a MAE claim, the Court explained that "a significant decline in earnings by the target corporation during the period after signing but closing" could constitute a MAE if those poor results can be "expected to persist significantly into the future."

The Court then turned to the question of "what benchmarks to use in examining changes in the results of business operations post-signing of the merger agreement – EBITDA or earnings per share." Finding earnings per share "problematic" in the context of a cash acquisition, the Court instead reasoned that "[w]hat matters is the results of the business," and that the target's "fortunes" should be "examined through the lens of changes in EBITDA." In concluding, based on past and projected EBITDA figures, that Huntsman had not suffered a MAE, the Court also cited the "macroeconomic challenges Huntsman has faced since the middle of 2007 as a result of rapidly increased crude oil and natural gas prices and unfavorable foreign exchange rate changes." The Court's determination that EBITDA, rather than earnings per share, was a more appropriate benchmark for evaluating MAE claims, appears to be the first judicial pronouncement on this subject.

Having found that no MAE had occurred as to Huntsman as a whole, the Court rejected Apollo's claim that (i) a 5% increase in Huntsman's post-closing debt was not material to Apollo's valuation of the transaction; and (ii) problems with two Huntsman divisions amounted to a MAE, given that "Huntsman as a whole is not materially impaired by their results."

Finally, the Court found that Apollo had engaged in a "knowing and intentional breach," and that the liquidated damages clause of the merger agreement (by which Apollo's damages were capped at $325 million) was therefore inapplicable. However, because the agreement also contained an express agreement that Apollo could not be made to specifically perform the closing, the Court ordered Apollo to "specifically perform its obligations under the merger agreement, other than the obligation to close." Thus, Apollo may decide whether or not it wishes to close, but if it chooses not to, and breaches the merger agreement in doing so, it will be liable in damages, and those damages will be uncapped.

Hexion is consistent with prior rulings in showing that purchasers face a heavy burden in attempting to use MAE clauses to avoid merger agreements. The case also highlights the importance of carve-outs often used in MAE clauses – as the parties here had excepted general economic or financial market changes, which language figured prominently in the Court's ruling. Hexion suggests that parties negotiating MAE clauses seriously consider terms that might (i) shift the burden of proof regarding use of the clause; and (ii) provide greater specificity in the types of changes that may constitute a MAE, including changes in general market or macroeconomic conditions.