An often troubling aspect of merger or acquisition agreements is that the buyer will usually not actually buy the enterprise in question until several weeks, if not months, after the purchase price has been negotiated and agreed upon. Events and circumstances may arise causing the value of the enterprise to diminish so significantly that the buyer risks acquiring something for which it did not bargain. As a result, most merger or acquisition agreements include provisions known as material adverse change or material adverse effect (together, MAC) clauses. These clauses are intended to allocate risk of loss in value of the enterprise to the seller. The idea is that the seller should bear the risk if an event or circumstance occurs, or becomes known, that materially changes the “bargained-for” agreement. As a general rule, MAC provisions are heavily negotiated, with the buyer seeking a broad MAC clause for maximum flexibility with regard to closing a transaction. Not surprisingly, the seller tends to prefer a narrow MAC clause to ensure that the transaction closes at the agreed-upon merger price, keeping in mind established expectations and market difficulties in subsequently trying to sell an enterprise following a “busted” transaction. In this regard, a seller will frequently seek to include generic exceptions to the MAC clause for known risks and uncertainties as well as general market events and circumstances, including specific exceptions for risks and uncertainties that are applicable either to the enterprise in question or the industry in which it operates.
When events and circumstances occur that affect valuation, determining whether a MAC has occurred is not always clear, even when the change in valuation is significant. The two leading court decisions interpreting the application of MAC clauses—IBP, Inc. v. Tyson Foods, 789 A.2d 14 (Del. Ch. 2001), decided under New York law; and Frontier Oil Corp. v. Holly Corp., C.A. No. 20502, 2005 Del. Ch. LEXIS 57 (Del. Ch. April 29, 2005)—provide some guidance. Under IBP, the inquiry is fact-intensive, and a party seeking to invoke a MAC clause and walk away from a deal faces the high burden of proving that the event or events claimed to be a MAC “substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term hiccup in earnings should not suffice; rather the [MAC] should be material when viewed from the longer-term perspective of a reasonable acquiror” (IBP at 68). Further, Frontier Oil, which adopted the standards set forth in IBP as Delaware law, demonstrated the importance of carefully crafting MAC clauses. The case notes that the phrase “would have” or “would reasonably be expected to have” a MAC, as used in the agreement at issue there, created an objective test with a significantly higher threshold than would have existed if the parties had instead used the wording “could” or “might” (Frontier Oil at 124, n.209). This standard requires a buyer to look into not only the current state but also the future, and to produce evidence of a long-term downturn.
Many commentators view the declaration of a MAC not as a basis for “busting” a transaction, but rather as a basis to renegotiate the underlying agreement. One purpose of renegotiation is to obtain a more favorable price in the face of MAC claims. Even when a case does make it to trial, a settlement is generally reached before a judgment is entered. In the 2006 Valassis Communications, Inc. v. ADVO, Inc., C.A. No. 2383-N (Del. Ch.), McDermott represented Valassis Communications, Inc. Valassis asserted the existence of a MAC in a transaction that gave rise to litigation. Despite the commencement of a trial in the Delaware Chancery Court, the parties ultimately renegotiated certain terms of the transaction prior to the trial’s conclusion. These examples demonstrate a general willingness by parties to renegotiate to avoid delay, possible litigation, the uncertainty of court judgments or the “busting” of a transaction altogether. As a result there has not been a tremendous amount of case law interpreting the enforceability of MAC clauses.
Two current cases may provide further guidance as to the application of MAC standards. On September 21, 2007, Genesco Inc. filed suit against The Finish Line Inc. and Headwind, Inc. (collectively, Finish Line) in the Chancery Court for the State of Tennessee (Case No. 07-2137-II). Genesco sought specific performance of a merger agreement pursuant to which Finish Line was to acquire Genesco. Genesco alleged that Finish Line and its lenders UBS Securities LLC and UBS Loan Finance LLC (collectively, UBS) stalled the deal because, among other things, Finish Line believed that it may have overpaid for Genesco and that the current credit market crunch had made financing for the transaction more expensive. Finish Line, on the other hand, claimed that Genesco was in breach of its merger agreement by unreasonably withholding additional financial information sought by Finish Line and UBS. UBS, which filed a motion to intervene after Finish Line filed a third-party complaint against the lender, alleged that Genesco had suffered a MAC. Notably, neither Finish Line nor UBS publicly cited any real evidence to support the contention that a MAC had occurred. This absence of evidence led many commentators to speculate that Finish Line and UBS were on a “fishing expedition.” Notably, subsequent to the filing of the lawsuit, Finish Line and UBS augmented their allegations by claiming that Genesco had fraudulently induced them to proceed with the merger agreement by concealing its actual financial results and revised financial projections.
Genesco, Inc. v. The Finish Line, Inc., et al. went to trial on December 10, 2007. On December 27, 2007, the Honorable Ellen Hobbs Lyle issued an opinion granting specific performance and ordering Finish Line to complete the merger. Even though Judge Lyle found that a MAC had occurred with regard to Genesco’s financial conditions (Slip. Op. at 33-37), the court held that the Genesco’s financial decline fit within a carve-out to the MAC clause contained in the parties’ merger agreement: “There is, though, the Court finds, one fact that is established by the greater weight and preponderence of the evidence from all of the competing analyses, and that fact is dispositive of the MA[C] issue: 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” (Slip. Op. at 31). Thus, because Genesco’s decline in performance was held to have been caused by “general economic conditions,” and was not disproportionate to the financial decline of others in its industry, it did not provide Finish Line or UBS with grounds to rescind the agreement (Slip. Op. at 33).
The court further held that Genesco did not commit a fraud, finding that several Finish Line and UBS witnesses lacked credibility. The Court stated that even though Genesco did not provide the data in question before the merger agreement was signed, the “fault [was] with Finish Line’s advisor, UBS and its agents, whom Finish Line was relying on to investigate Genesco” (Slip. Op. at 16). Neither Finish Line nor UBS asked Genesco or its advisors for this information after it was prepared, and “where Finish Line/UBS had the means at its disposal for obtaining the information it now claims was concealed, neither the law nor the parties’ agreements required Genesco or [its advisors] to voluntarily provide the information” (Slip. Op. at 16).
Although the Genesco opinion expands the universe of MAC decisions that practicioners may look to for guidance in crafting MAC provisions, because the case was decided under Tennessee law, it is unclear how far-reaching the impact of this decision will be.
SLM Corporation v. J.C. Flowers II L.P., et al,.C.A. No. 3279, commonly referred to as the Sallie Mae case, will also be closely watched. Filed on October 8, 2007, in the Delaware Court of Chancery, the Sallie Mae case involves the merger agreement for the sale of Sallie Mae to a consortium of investors led by J.C. Flowers II L.P. Valued at approximately $26 billion, the merger transaction has been on shaky ground since July 2007, when Flowers reportedly told Sallie Mae that the buyers were having second thoughts about the deal because of a plan in U.S. Congress to cut subsidies for student loans. Although Flowers does not deny that the buyers knew that subsidy changes were possible when the merger agreement was signed and announced in April 2007, the fund and the other buyers have argued that the new rules, as actually adopted by Congress, would be more costly to Sallie Mae than expected.
The disagreement turns on how much the smaller subsidies, which Congress approved in early September 2007, will adversely affect Sallie Mae’s long-term profits. Sallie Mae contends that the reductions will cut “core earnings” by 1.8 percent to 2.1 percent annually over five years. Flowers disagrees, and has stated that the impact of the subsidy cuts, combined with rising borrowing costs in the credit markets, will reduce “core earnings” by more than 14 percent in 2009, and by 20 percent in 2012.
According to Flowers, the legislation as passed and its effect on Sallie Mae’s earnings amount to a MAC, and defendants should be allowed to walk away from the deal, if that is their decision, without paying the contractually agreed-upon $900 million break-up fee. Sallie Mae disagrees and has sued for a declaration that no MAC has occurred, a declaration that defendants have repudiated the merger agreement and an award of money damages in an amount that is no less than the $900 million dollar break-up fee. Sallie Mae argues that, because the MAC provisions of the merger agreement specifically exclude contemplated legislation similar to that which Congress ultimately approved, Flowers must show that the legislation is materially worse than the proposed legislation fully disclosed in Sallie Mae’s public filings, in order to prove that a MAC has occurred within the agreement’s terms. Sallie Mae also argues that the problems in the credit markets are also excluded from the definition of a MAC, by the provision in the merger agreement excluding adverse changes in “general economic business, regulatory, political or market conditions.”
Flowers and the other buyers argue that defendants must only show that the legislation as passed is incrementally worse than the previously disclosed proposed legislation. Indeed, the relevant provision of the merger agreement states that the MAC exclusions do not include “changes in the 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” that were previously disclosed. Notably, this provision does not contain a materiality qualifier. As a result, the plain language of the agreement’s MAC clause seems to support Flowers’ argument. In light of the emphasis on word choice seen in Frontier Oil, a written decision in this case could provide practitioners with much-needed guidance and clarification in this important area of the law.
Although no firm trial date has been set in the Sallie Mae case, Vice Chancellor Leo E. Strine, Jr., who is presiding over the case, has set a tentative trial date of July 2008.