Merger and acquisition contracts typically feature a material adverse change or material adverse affect (together, MAC) clause, which gives the buyer the right to pull out of the deal or renegotiate the terms in the event of an unforeseen material adverse business or economic change affecting the target company or its assets between the execution of the definitive acquisition agreement and the closing of the transaction. A MAC clause also provides the seller with a way of qualifying certain representations and warranties so that relatively insignificant breaches are considered irrelevant (at least for purposes of closing). MAC clauses are highly negotiated in today’s deal environment. As a result, understanding recent trends in the drafting of MAC clauses, and how courts and of practitioners view these clauses, is essential to obtain the most advantageous deal.
Few cases about MAC clauses have been litigated and decided in the Delaware courts. However, Delaware case law has shown that the drafting of MAC clauses matters a great deal. In In Re: IBP, Inc. Shareholders Litigation, 789 A.2d. 14 (Del. Ch. 2001) (IBP v. Tyson), the merger agreement at issue contained a broad MAC clause with no carve-outs, rarely seen in today’s deal environment. Tyson Foods asserted that IBP, the target, had suffered a material adverse effect because IBP’s earnings for the first quarter of 2001 were 64 percent behind its earnings for the first quarter of 2000, but the Delaware Court of Chancery did not see this downturn as affecting IBP in the future on a long-term basis. The court determined that IBP had not suffered a MAC, and as a result of the ruling, Tyson Foods had to complete its purchase of IBP.
The MAC clause at issue in Frontier Oil Corp. v. Holly Corp,. C.A. No. 20502 (Del. Ch. Apr. 29, 2005) was different than the MAC clause at issue in IBP v. Tyson in that it contained carve-outs. In Frontier Oil v. Holly, the parties drafted the MAC clause to exclude certain events, such as general economic, regulatory or political conditions or changes; financial market fluctuations; and general changes in the petroleum industry. These carve-outs are still seen frequently today. However, the MAC clauses at issue in these two cases were similar in a significant way. In both cases, the MAC clause contained a qualifier that a given effect “would reasonably be expected to” have a MAC, requiring the seller to think ahead about the impact of possible future events. The “reasonably expected” qualifier continues to make a frequent appearance in the drafting of MAC clauses today.
Before the signing of the merger agreement at issue, Holly, the buyer, had learned of the possibility of a toxic tort suit involving prior operations of a subsidiary of Frontier Oil, the seller. As a result of this information, the parties renegotiated the merger agreement, strengthening Frontier’s representations and warranties. They also slightly strengthened the definition of a MAC by replacing language referring to a MAC with respect to the “material condition” of a party with language referring to “the results of operations, condition (financial or otherwise) or prospects of a party.”
The court focused on Frontier’s representation regarding litigation. Frontier represented that there was no litigation pending or threatened against Frontier or its subsidiaries, “other than those that would not have or reasonably be expected to have, individually or in the aggregate, a Frontier Material Adverse Effect.” The court stated that “in substance, Frontier represented to Holly that [the toxic tort litigation] would not have [a material adverse effect] and would not reasonably be expected to have [a material adverse effect],” which the court viewed as creating an objective, forward-looking standard for a MAC. After examining the evidence that Holly presented regarding Frontier’s likelihood of success in the toxic tort litigation and the potential costs of the litigation, the court found that Frontier had not suffered a MAC. The court considered the forward-looking basis of the MAC clause in the merger agreement and concluded that the litigation must be viewed as material from the longer-term perspective of a reasonable acquirer to constitute a MAC. According to the court, the evidence presented by Holly did not meet this test.
Following the Tyson and Frontier Oil decisions, in which buyers were unsucessful in invoking a MAC to exit a deal, merger and acquisition practitioners began drafting agreements where a “material change” was defined more precisely with clearer contract language. For example, a “material change” would occur if a target’s revenues dropped 10 percent. With the trend toward precision in drafting, a host of additional MAC exceptions now appear, limiting a buyer’s ability to back out of a deal. Today’s generally seller-friendly environment has seen a greater frequency of exceptions to MAC clauses. For example, it is now common to see an exception to the MAC clause such that a buyer cannot claim a MAC for changes resulting from general economic, financial, regulatory or market conditions, so long as the changes have not affected the target in a “materially disproportionate” manner as compared to other companies operating in the target’s line of business. However, given the expected downturn in mergers and acquisitions activity and the tightening of the credit market, the trend in deal terms generally and MAC clauses specifically may be more favorable to the buyer.
If a seller has identified areas of concern regarding a target, these concerns should be addressed specifically, either in the MAC clause or as a separate closing condition. It is still best to draft as specifically as possible, with buyers negotiating MAC clauses tailored for the deal, or specific closing conditions that identify, for example, missed financial targets that give an objective standard on which to terminate an acquisition agreement. Given the state of the credit market, buyers and lenders are attempting to gain more flexibility in terminating a transaction if circumstances change between signing and closing. A MAC out in many instances produces the buyer and lender with the best opportunity to terminate a deal.