Canada: Recent Developments In Market Practice And The Law Governing Material Adverse Change Clauses

Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Mergers & Acquisitions, April 2008

Material adverse change (MAC) (also referred to as material adverse effect) clauses are present in some fashion in virtually every merger or acquisition agreement. In an M&A transaction, a MAC clause allocates the risk of an unforeseen adverse event occurring during the time between signing and closing. Buyers typically want to ensure that they can get out of the deal if an event occurs prior to closing that is materially detrimental to the target. The recent downturn in credit markets has highlighted the significance of MAC clauses, particularly for debt-financed buyers. Not surprisingly, the law concerning MAC clauses is not static. This article considers recent U.S. case law developments regarding MAC clauses in M&A transactions that are likely to have implications in Canada and should be considered when negotiating and drafting a merger or acquisition agreement. For a discussion of MAC clauses in the context of other commercial agreements, please see "Litigation of Material Adverse Change Clauses in Derivatives Contracts" in Blakes Bulletin on Litigation, April 2008.

Case Law Relating To MAC Clauses

Notwithstanding the prevalence of MAC closing conditions in M&A agreements, there has been surprisingly little case law in Canada regarding MAC clauses. However, there are a number of important U.S. decisions that provide guidance on how MAC clauses may be interpreted by courts in Canada.

IBP v. Tyson Foods

The 2001 decision of the Delaware Court of Chancery in IBP, Inc. v. Tyson Foods Inc. is the leading U.S. decision addressing MAC clauses in the context of an M&A agreement. Tyson and IBP entered into a merger agreement whereby Tyson agreed to acquire IBP. While conducting its due diligence, Tyson learned of several potential issues relating to the IBP business, including a potential downward trend in IBP's beef processing business, as well as possible significant accounting issues with one of IBP's subsidiaries. Despite these findings, Tyson signed the merger agreement, which included a representation that IBP had not suffered a MAC since a specified date. A MAC was defined in the agreement as "any event, occurrence or development of a state of circumstances or facts which has had or reasonably could be expected to have a Material Adverse Effect...on the condition (financial or otherwise), business, assets, liabilities or results of operations of [IBP] and [its] subsidiaries taken as whole." Tyson later sought to terminate the merger agreement on the basis of a further downturn in the beef processing business and further accounting problems at the IBP subsidiary.

The Delaware court took a narrow view of the MAC clause and came to two important conclusions:

I. the party seeking to terminate the agreement has the burden of proving that the MAC has occurred; and

II. a MAC closing condition protects an acquiror from the occurrence of (a) unknown events that (b) substantially threaten the overall earning potential of the target (c) in a durationally significant manner.

The court indicated that "durationally significant" should be measured in years rather than months, and held that the short-term drop in earnings did not substantially threaten IBP's overall earnings potential in a durationally significant manner. The court concluded that since Tyson was aware of the accounting problems and the cyclical nature of the livestock industry, these were not unknown risks. The court ruled that Tyson had improperly terminated the merger agreement and Tyson was forced to acquire IBP on the original terms of the merger agreement.

Frontier Oil Corporation v. Holly Corporation

In 2005, the Delaware Court of Chancery revisited the issue of MAC clauses in the case of Frontier Oil Corporation v. Holly Corporation. Frontier and Holly were both mid-sized petroleum refiners and had entered into a merger pursuant to which Frontier would acquire Holly for US$450-million in cash. Prior to signing the merger agreement, Frontier delivered various due diligence materials to Holly's counsel, including a newspaper article describing plans by Erin Brockovich (of movie fame), and the law firm she was associated with, to bring a mass toxic tort suit against several defendants, including a subsidiary of Frontier.

The lawsuit alleged that drilling and processing activities at an oil rig located on the Beverly Hills High School campus had released air contaminants that caused a disproportionately high incidence of cancers suffered by students of the school. The subsidiary of Frontier previously held an interest in the site. Holly retained a prominent firm in Los Angeles to provide advice and guidance with respect to toxic tort litigation. Frontier argued that the potential litigation was merely a nuisance claim and, in any event, Frontier was insulated from liability because the claim was against a subsidiary and not against Frontier itself. Holly was sufficiently comfortable with the issue that it signed the merger agreement.

Shortly after the merger agreement was signed, the threatened litigation was in fact commenced and the parties learned that Frontier had guaranteed its subsidiary's obligations under the lease for the oil production site and would have direct liability under the toxic tort claim. The merger agreement included a representation from Frontier that there was no litigation other than litigation that would not have or reasonably be expected to have, individually or in the aggregate, a material adverse effect. There was also a closing condition that this representation remain true on closing. MAC was defined in the agreement as "a material adverse effect with respect to the business, assets and liabilities (taken together), results of operations, conditions (financial or otherwise) or prospects of a party and its subsidiaries on a consolidated basis." Frontier attempted to terminate the deal on the basis of the litigation. The court concluded that the decision in IBP v. Tyson, which had applied New York law, accurately described the law of Delaware as well.

The court concluded that Holly had not shown that the toxic tort claims and the cost associated with them would have a material adverse effect on Frontier over a durationally significant period. The court noted that the outcome of the environmental litigation could be catastrophic for Frontier but that Holly had not demonstrated the likelihood of that outcome. Even though the estimated defence costs were in the range of US$15 to US$20-million, the court concluded that Holly had not demonstrated that Frontier would be unable to absorb the projected defence costs without experiencing a material adverse effect. The court also noted that, following the decision in IBP v. Tyson, a MAC clause helps to protect a purchaser from the existence of unknown (or undisclosed) factors, rather than factors known to the parties prior to signing the agreement.

Johnson & Johnson v. Guidant Corporation

In December 2004, Johnson & Johnson announced that it had agreed to acquire Guidant Corporation, the second-largest U.S. maker of implantable defibrillators and pacemakers, for approximately US$23-billion in cash and stock. After signing the agreement, but prior to closing, Guidant was forced to recall its heart defibrillators and was subject to a lawsuit commenced by New York Attorney General Elliot Spitzer, which alleged that there had been undisclosed design flaws in defibrillators manufactured by Guidant that could have fatal consequences.

As a result of the product recalls, regulatory investigations and the lawsuit, Johnson & Johnson announced that it was considering backing out of the agreement in reliance on the MAC clause in the agreement. Guidant notified Johnson & Johnson that it would sue if Johnson & Johnson backed away from the deal. Johnson & Johnson was able to negotiate a US$4-billion (or 15%) reduction in the purchase price as a result of invoking the MAC clause. Prior to the completion of the acquisition, however, Boston Scientific stepped in with a higher, and ultimately successful, offer to purchase Guidant.

Genesco v. Finish Line

A more recent dispute in the U.S. involved a MAC clause found in the merger agreement between Finish Line, Inc. and Genesco, Inc. In 2007, Finish Line agreed to acquire a footwear retailer, for US$1.5-billion in a highly leveraged transaction without any financing condition. Shortly after signing the merger agreement, Genesco announced quarterly earnings well short of projections. As a result, Finish Line and UBS (which provided the financing for the merger) refused to proceed, prompting Genesco to bring a lawsuit in Tennessee to compel the completion of the acquisition. Finish Line argued that the earnings shortfall constituted a MAC, while Genesco countered that the weak performance of the company was a short-term decline (a "blip") due to general economic conditions such as high gas prices, housing and mortgage issues, and other conditions that fell within the carve-outs of the MAC clause in the merger agreement.

The Tennessee trial court accepted Genesco's testimony that the decline was due to general economic conditions and also found that the decline was not disproportionate to declines suffered by its peers in the industry. The court held that the agreement contained a carve-out for general economic conditions and the MAC claim was therefore rejected. The court nonetheless proceeded to complete its MAC analysis (for "completeness") and held that, while noting the ruling in Tyson that a "blip" in earnings does not constitute a MAC, the language used in the merger agreement was an acknowledgement by the parties that, in the context of this merger, a MAC could occur in only three or four months. This part of the decision opens the door for an interpretation that the high threshold required for a MAC to be considered "durationally significant" as established in the Tyson and Frontier decisions can be lowered by careful drafting.

The parties subsequently reached an out-of-court settlement totalling nearly US$200-million to terminate the merger agreement and settle all other related lawsuits prior to the commencement of a separate action in New York by UBS to avoid proceeding with the financing. It is uncertain if the decision, the first U.S. court decision to consider MAC clauses since the commencement of the credit crunch, will have any precedential value going forward. However, the case does highlight the importance for sellers of having carefully-drafted and comprehensive MAC carve-outs.

The Genesco settlement is only one of a number of recent MAC disputes that have settled before courts have had the opportunity to provide further guidance on MAC clauses. Leveraged buyout transactions in the U.S. have increasingly been sidetracked by buyers or their financers seeking to use a MAC clause to back out of their commitment as a result of the reduced availability and the increased cost of buyout funding. Most of these cases, such as Sallie Mae, Harman International and Genesco have resulted in settlement payments from the buyer to the seller and an outright termination of the deal. Other cases, such as Accredited Home Lenders and Home Depot, have followed the Guidant example of a renegotiated purchase price and the consummation of the proposed acquisition. We may see more of these settlements and price renegotiations as the downturn in credit markets continues.

Drafting Considerations

U.S. case law and recent market experience demonstrates the need for close attention to drafting when parties are negotiating merger agreements. We highlight three considerations in particular:

  1. General vs. Specific

    Where a specific risk has been identified in due diligence prior to signing an agreement, the buyer should rely upon a specific, objective closing condition rather than relying on a general MAC closing condition. Where specific concerns relating to issues known to the parties are addressed by way of a representation or closing condition, a MAC closing condition nevertheless remains an important way of providing the buyer with some protection for unknown risks (those not identified prior to signing the agreement).
  2. Prospects

    Buyers and sellers often negotiate as to whether changes in "prospects" can constitute a MAC. Prospects refer to the opportunities for future success of the target company that are reasonably foreseeable at the time of signing the agreement. The buyer wants prospects included on the basis that the future of the business is a legitimate concern, while the seller wants it excluded on the basis that future operations are the seller's risk. If the buyer has specific concerns that might fall within the scope of prospects, they should be addressed specifically in representations or conditions as appropriate.
  3. Carve-Outs

    Recent deal dynamics have been such that sellers have been able to erode the limited comfort provided by MAC clauses by inserting numerous exclusions or carve-outs. Some of the more frequent carve-outs that we see include:
    • changes in general economic or financial market conditions
    • changes in industry conditions
    • changes resulting from the announcement of the transaction, including loss or threatened loss of customers or suppliers or financing sources
    • changes resulting from the parties' compliance with the terms of the agreement
    • changes in generally accepted accounting principles or requirements
    • changes in law or interpretation thereof
    • acts of terrorism or war
    • changes in the share price or the failure of the target to meet financial projections, although generally buyers will want to ensure that factors causing such changes or failures can be considered a material adverse change

Buyers will want to ensure that, where appropriate, changes having a disproportional effect on the target, in the context of the industry and geographical region in which it carries on business, are excluded from the carve-outs. Sellers will want to ensure that the loss of a carve-out is only to the extent of the disproportionate effect and not absolute upon the occurrence of any disproportionate effect.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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