Recent dramatic changes in the availability and cost of debt financing and other market conditions have caused an increasing number of buyers to invoke clauses in acquisition agreements intended to permit a buyer to terminate a pending acquisition. Most often, buyers are relying on “Material Adverse Change” or “Material Adverse Effect” clauses (“MAC/MAE clauses”) in their acquisition agreements as a means to exit deals, although in the just-decided United Rentals, Inc. v. Ram Holdings, Inc., Dec. 21, 2007 Opinion, Civil Action No. 3360-CC (Del. Ch. 2007), the Delaware Chancery Court ruled that a Cerberus acquisition subsidiary “only” had to pay a $100 million termination fee pursuant to the terms of the acquisition agreement, instead of being compelled to close the pending acquisition.
MAC/MAE clauses generally define the circumstances that allow a buyer to terminate an otherwise binding obligation to close an acquisition as a consequence of some event impacting the target and occurring after the signing of the acquisition agreement. The differences between MAC or MAE clauses are not substantial. Often, the definition of either clause is drafted to include all changes, events and effects. Generally, a clause that is triggered by an “effect” sweeps broader than a clause triggered by a “change” because “change,” raises questions of the buyer’s prior awareness.
Recent Termination Cases
The most recent court decision in a significant deal termination case occurred Dec. 27, 2007. In Genesco, Inc. v. The Finish Line, Inc., Dec. 27, 2007 Memorandum and Order, Case No. 07-2137-II(III) (Tenn. Ch. 2007), the Tennessee Chancery Court, applying Tennessee law, ruled that because Finish Line was not excused from performance by the MAC/MAE clause in issue, Finish Line should be compelled to specifically perform its acquisition of Genesco.1 In the Genesco case, UBS, Finish Line’s lender, agreed to fund the $1.5 billion acquisition. However, when Genesco’s Q2 and Q3 earnings signaled that 2007 would be one of Genesco’s worst years in the past 10, UBS put pressure on Finish Line either to renegotiate the price of the deal or declare that a MAC/MAE had occurred.2
The Tennessee Chancery Court, citing the earlier Delaware decisions in In Re IBP, Inc. Shareholders Litigation, IBP, Inc. v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch. 2001) and Frontier Oil Corp. v. Holly Corp., 2005 Del. Ch. LEXIS 57, 128 (Del. Ch. 2005), applied a three-part “common sense” test, based on the particular “context and circumstances of the merger,” to determine whether significant changes in Genesco’s business had occurred that would permit Finish Line to terminate the acquisition.3
First, the court determined that any “measure of the change” must be evaluated to determine significance.4 The court found that Genesco’s predicted 2007 earnings would be among its lowest in the past 10 years, which demonstrated a measurable, significant change.5
Second, “whether the change relates to an essential purpose or purposes the parties sought to achieve by entering the merger” must be evaluated to determine significance.6 Although Finish Line entered into the merger for strategic growth, synergy and decreased cyclicality purposes, the court found that the secondary purpose, relying on Genesco’s cash flow to pay the costs of a 100 percent financing, was significantly affected by the decrease in Genesco’s earnings.7
Third, “the duration of the change” must be evaluated to determine significance.8 The court’s reasoning on this point is especially interesting. The court concluded that the fact that the MAC/MAE clause allowed the seller to cure any MAC/MAE before the Dec. 31, 2007 outside termination date constituted an “acknowledgment by the parties” that a three- to four-month change was durationally significant and not merely a “blip,” as mentioned in Tyson.9 Therefore, the changes in Genesco’s earnings from May 2007 until Dec. 31, 2007 were durationally significant.10 Based on these significant changes, the court held that Genesco’s drop in earnings constituted a MAC/MAE.11
Nonetheless, Finish Line did not prevail. The court held that even though an “MAE has occurred,” Genesco was protected by a carve-out in the operable MAE clause that exempts material adverse effects that result from or arise out of changes in “general economic conditions.”12 Based on expert testimony, the court concluded that “Genesco’s decline in performance in 2007 is due to general economic conditions such as higher gasoline, heating oil and food prices, housing and mortgage issues and increased consumer debt loads.”13 The court even went as far as to cite UBS’s own 2007 financial performance as evidence of the change in general economic conditions.14
Additionally, the court rejected two tort claims by Finish Line and UBS for fraudulent concealment and securities fraud.15 Despite Genseco’s “sharp dealings” in not voluntarily providing updated May 2007 financial information after it became available, the court held that Genesco had not committed fraud.16 After dismissing Finish Line’s and UBS’s allegations of affirmative misrepresentations as not credible, the court determined that no concealment of information occurred based on the merger and confidentiality agreements, the due diligence procedure established between the parties and Tennessee law.17
The court reached these conclusions because (1) the merger agreement as well as the confidentiality agreement expressly provided that Finish Line was not relying on any information except that information expressly set forth in the merger agreement18; (2) the due diligence procedure established between the parties required Finish Line and UBS to specifically request updated information, which Finish Line and UBS failed to do19; and (3) Tennessee law bars a party from claiming fraud based on concealed information when the party had the means to obtain the information.20
As is common in such agreements, the merger agreement at issue in Genesco provided for specific performance. Accordingly, the court held that Genesco was irreparably harmed because it had deferred business and strategic plans and expended resources on the merger.21 Therefore, unless the court in a pending New York lawsuit initiated by UBS determines that the merged entity would be insolvent, thereby relieving UBS of its duty to finance the buyout, the Tennessee Chancery Court determined that “specific performance is not a futile, harsh result.”22
On Dec. 21, 2007, the Delaware Chancery Court rendered a decision on the leveraged buyout of United Rentals, Inc. by a Cerberus Capital Management acquisition subsidiary.23 United Rentals, Inc. v. Ram Holdings, Inc. Although this case has been reported in the press as raising MAC/MAE issues, this case actually turned on contractual provisions that allegedly permitted the buyer to terminate, pay a pre-negotiated termination fee of $100 million, and have no further liability.24
After the buyer informed United Rentals that it would not complete the acquisition and would instead pay the termination fee, United Rentals initiated an action in Delaware Chancery Court to compel specific performance. However, the court ruled that United Rentals was not entitled to specific performance.25
To reach its decision, the court rigorously analyzed ambiguous and contradictory contractual provisions set forth in the acquisition agreement.26 The Delaware Chancery Court determined that during negotiations, Cerberus had intended to limit United Rentals’ remedy, in the event Cerberus terminated the acquisition without cause, to the payment of a $100 million termination fee.27
The court held that (1) because of failures in the drafting process, the agreement was ambiguous as to remedies; (2) there was no clear evidence of a common understanding among the parties on remedies; and (3) ultimately, under the “forthright negotiator” principle, United Rentals knew or should have known from specific positions taken at negotiating sessions that Cerberus subjectively believed its only obligation on termination of the agreement would be payment of the termination fee.28
J.C. Flowers/Sallie Mae
J. C. Flowers & Co. invoked the MAC/MAE clause in its deal to acquire Sallie Mae, asserting that (1) new legislation would hinder student loan business; and (2) the current economic environment made closing the deal as planned unacceptable.29
Sallie Mae subsequently sued J.C. Flowers in the Delaware Chancery Court.30 On Oct. 23, 2007, the parties agreed to waive any provisions in the merger agreement that would prevent Sallie Mae from conducting its business or seeking other merger partners.31 This agreement essentially foreclosed a specific performance remedy for Sallie Mae. Accordingly, a pre-negotiated $900 million reverse termination fee is the likely remedy if the Delaware Chancery Court finds that no MAC/MAE occurred.32
The Delaware Chancery Court is expected to decide this case in 2008.33
Kohlberg, Kravis, Roberts & Co. and Goldman Sachs invoked the MAC/MAE clause in their then-pending $8 billion buyout of Harman International.34 Rather than litigating the issue, the parties subsequently agreed to terminate the acquisition, with the former purchasers further agreeing to buy $400 million of Harman convertible debt, convertible into Harman equity at $104 per share (well below the $120 per share price specified in the acquisition agreement).35
As recently as Jan. 1, 2008, a deal termination clause became a newsworthy topic, when PHH Corporation announced that it has given a notice of termination to General Electric Capital Corporation pursuant to the $1.7 billion merger agreement between PHH and GECC. The merger agreement provided that a wholly-owned subsidiary of GECC would merge with and into PHH, and that immediately following the closing of the merger, GECC would sell PHH’s mortgage business to Pearl Mortgage Acquisition, an affiliate of The Blackstone Group.
PHH terminated the merger agreement pursuant to an express provision allowing it to do so if the deal was not completed by Dec. 31, 2007.
It was a condition to closing of the merger that Pearl Mortgage Acquisition be ready, willing and able to consummate the mortgage business sale transaction. PHH reported that Pearl Mortgage Acquisition had expressed concern about its ability to obtain debt financing to consummate the mortgage business sale.
In its announcement that the deal had been terminated, PHH stated that PHH “has been informed that Pearl Acquisition was not able to obtain the requisite debt financing. Pursuant to the terms of the merger agreement, the company has requested payment of $50 million from an affiliate of The Blackstone Group as a termination fee.”36
Prior Case Law
The most widely cited case discussing MAC/MAE clauses has been IBP, Inc. v. Tyson.37 In the Tyson case, the Delaware Court of Chancery ordered Tyson, the buyer, to specifically perform the merger agreement, and rejected Tyson’s assertion that a material adverse effect had occurred.38 Tyson had argued that it could terminate the pending acquisition of IBP in part because of issues with IBP’s earnings, assets and financial reporting.39
The merger agreement in the Tyson case had a New York choice of law clause; accordingly, the Delaware Chancery Court applied New York law in holding that Tyson was unjustified in terminating the deal on material adverse effect grounds. The court determined that “a buyer ought to have to make a strong showing to invoke a material adverse effect exception to its obligation to close.”40 The court stated that even if material adverse effect clauses are “broadly written,” they are “best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of a target in a durationally-significant manner.”41
The court further stated that “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 acquiror.”42 In footnotes, the court in Tyson noted that the standard it set forth was intended to make the manner in which MAC/MAE clauses are drafted less important than whether the change complained of is durationally significant.43 After a detailed factual analysis, the court found the case “close,” but ultimately ruled that the earnings issues and subsidiary impairments, while significant, would be corrected in several years.44
Subsequently, in the 2005 decision in Frontier Oil v. Holly, the Delaware Court of Chancery adopted the Tyson standard, which applied New York law,45 as the standard under Delaware law as well.46 In Frontier, Holly, the seller, became aware of a threatened environmental contamination class action involving one of the buyer’s subsidiaries. Holly argued that this potential threat to the buyer’s share price would have a material adverse effect because the potential litigation losses and costs would devalue the Frontier shares that Holly shareholders were to receive in the transaction.47 The court held that Holly did not meet its burden of proving that either the losses or costs, or both, would significantly affect Frontiers’ share price over a “longer term.”48
The Current State of Termination Clauses
In light of the recent changes in the credit markets, and the impact of those changes on negotiating leverage, it is especially important that parties understand and carefully draft deal-termination provisions.
Even after Tyson, drafting of MAC/MAE clauses has not changed very much. While the court in Tyson intended to enunciate a standard that would avoid drafting “prolixity,” its guidance has proved insufficient for attorneys to rely on in advising their clients.49
Many acquisition agreements still contain broadly worded MAC/MAE clauses (around 20 percent of recent deals, according to the M&A Market Trends Subcommittee of the ABA Committee on Negotiated Acquisitions).50
Buyers like broad clauses because there is more room to argue that their decision to walk away fits within the broad language. As stated in Tyson, where a broad clause applied, “the simplicity of [the clause] is deceptive, because application of those words is dauntingly complex…[and put the seller] at risk for a variety of uncontrollable factors that might materially effect its overall business or results of operations as a whole.”51
Over the years, MAC/MAE clauses have become quite lengthy, with many carve-outs, exceptions and other intricacies meant to add certainty to the applicability of the clause (about 80 percent, according to the M&A Market Trends Subcommittee of the ABA Committee on Negotiated Acquisitions).52 For example, such clauses may exempt declines in the overall economy; declines in the relevant industry sector (as contrasted with declines that disproportionately impact the target company); adverse weather, political, economic or general business conditions; interest rate or currency exchange rate changes; any change in applicable laws, rules, regulations, or GAAP; and adverse consequences arising from the execution, announcement and performance of the acquisition. Genesco is recent proof that courts are receptive to enforcing such carve-outs even if they otherwise find a MAC/MAE has occurred.
Parties can add clarity to their MAC/MAE clauses by quantifying a dollar value of the adverse occurrence, by referring to or specifically including the impact on an enumerated peer group, and by defining the duration of an event or occurrence before it is deemed to constitute a MAC/MAE. By using such MAC/MAE clauses, the parties, and a later reviewing court, will be more certain as to when the deal may be terminated.
However, because so few parties can or will negotiate and agree in advance on the quantitative thresholds of a MAC/MAE, only 8 percent of MAC/MAE clauses set forth quantified standards, according to the M&A Market Trends Subcommittee of the ABA Committee on Negotiated Acquisitions.53
Parties also can limit their exposure to MAC/MAE clauses (and indeed, can make such clauses far less significant to the acquisition agreement) by including a reverse termination fee that specifies and caps the seller’s financial remedy in the event the buyer fails to close.
Tyson and Genesco offer several practice tips in drafting and, after the fact, in invoking MAC/MAE clauses.
- Consider whether to expressly delineate what duration of time will result in a MAC/MAE. Tyson offers a lesson on this point. The court in Tyson specifically noted that short-term swings in earnings are more likely to be material for a “short-term speculator”54 in the stock of the target company, as contrasted with a long-term strategic buyer of the enterprise. Delineating in the merger agreement that short-term fundamental changes are or can trigger a MAC leaves less room for question later.
- Similarly, Genesco suggests that the existence of a MAC/MAE cure right, which expires on a date certain, is informative in determining how long an adverse change must last for the event to be durationally significant.55
- In invoking a MAC/MAE clause, what you know, say or do may hurt you in court later. For example, in Tyson, the court noted that Tyson’s statements and actions showed they were previously aware of several issues that were bases for its later assertion of a MAC/MAE.56 As noted in Tyson, such statements or actions reveal what the buyer considered material in entering into the agreement.57 Under Tyson, events have a material adverse effect only if they were “unknown” at the time of contracting.58 Also, the court in Tyson took issue with the fact that Tyson made no reference to material adverse effect in its rescission letter, asserting the issue “post-hoc” instead.59 Perhaps most damaging to Tyson: its own investment banker maintained its opinion that Tyson was paying a fair price even after the changes that Tyson cited as material and adverse had occurred.60
- Be diligent in enforcing your rights post-signing and pre-closing. In Genesco, the failure of the buyer or its investment banker to request, and follow-up on requests for, updated financial information made it difficult for the buyer to argue that Finish Line had committed fraud in not providing such information.61
- Limit the seller’s remedies. In Genesco and in Tyson, the court ordered buyers to specifically perform their agreements because monetary damages were inadequate. For example, the court awarded specific performance for the Tyson acquisition of IBP, which was structured as a stock-for-stock merger, because otherwise shareholders of IBP would lose the opportunity of owning shares in the “unique, synergistic combination” that the new Tyson would be.62 In each of these cases, negotiating for a limitation on specific performance remedies (as was the intent of Cerberus in the United Rentals case) may have prevented a forced closing.