United States: Material Adverse Change Clauses: Don´t Be Chicken Little

Many of you have spent hours negotiating and drafting "material adverse change" or "material adverse effect" (together, "MAC") clauses in merger and acquisition agreements. Most of that time is often spent drafting carefully tailored carveouts from the general MAC definition and precisely crafted exceptions to those carveouts. Unfortunately, a review of the jurisprudence on MAC clauses shows that your efforts may be meaningless if you fail to specifically define or quantify what is "material" to your client. If you represent a buyer, this could leave you in the unenviable position of Chicken Little, claiming the sky is falling without any sympathy from the court.

Evolution of MAC Clauses

A MAC clause is a provision in an acquisition agreement that generally gives the buyer the right to terminate the agreement (or the leverage to renegotiate its terms) if a business or economic change occurs that has or could reasonably be expected to have a material adverse effect on the acquisition target before the deal closes. As recently as 15 years ago, the MAC clause was a relatively uncontroversial boilerplate provision that received little attention in the negotiation of a purchase agreement. Traditionally, a MAC was defined simply as "any material adverse change in the business, results of operations, assets, liabilities, or financial condition of the target company." Since the early 1990s, however, the MAC definition has changed significantly, with parties negotiating complex carveouts and exceptions from the definition, such as carveouts for general changes in the economy or certain changes in law, but, typically, only to the extent that such changes do not have a disproportionately negative effect on the business being acquired.

This complexity has been increasing over time. In 1993, only 18 percent of MAC definitions contained a specific exception to the traditional elements, and the average MAC definition in 1995 included less than one exception. By 2000, approximately 83 percent of MAC definitions contained at least one exception, and the average MAC definition included nearly four exceptions. This trend has continued over the last decade with MAC definitions often containing up to a dozen separate carveouts and exceptions from the traditional concept. Indeed, to combat this ever-increasing complexity, the United Kingdom Panel on Takeovers and Mergers (the governmental unit that regulates public company transactions in the U.K.) enacted specific rules relating to MAC clauses in public company acquisition agreements, essentially standardizing MAC clauses in U.K. public deals.¹

Given the greater specificity with which modern MAC definitions are drafted, you might reasonably assume that courts would be more likely to affirm a party's use of the clause as grounds to terminate a transaction. In reality, courts have taken the opposite approach.² Although there is significant anecdotal evidence that MAC clauses often lead to private renegotiations and settlements among M&A parties, there are very few court decisions interpreting MAC clauses in any context, and fewer still where courts have enforced a MAC clause to allow a party to terminate its obligation to close. Although limited, the existing case law on MAC clauses suggests that they should be drafted not only with specificity, but with quantifiable and easily determined monetary thresholds or descriptions of triggering events.

MAC Decisions

It should not come as a surprise that most of the leading decisions interpreting MAC clauses have come out of the Delaware Chancery Court. Delaware jurisprudence on this topic has been widely discussed by commentators, and can be boiled down to the following:

• Whether a MAC has occurred is a highly factual inquiry to be made on a case-by-case basis with attention to the size of the transaction and parties involved.
• A MAC clause should be interpreted as a backstop protecting a buyer from the occurrence of unknown events that it could not otherwise predict.
• An event or occurrence must threaten the overall earnings potential of an acquisition target in a durationally significant manner to constitute a MAC.
• In the absence of express language to the contrary in an agreement, the burden of proof in an MAC dispute lies with the party claiming that a MAC has occurred.
• An event should constitute a MAC only when viewed from the long-term perspective of a reasonable buyer.³

While the Delaware decisions offer the most detailed instruction on how to approach a MAC dispute, as noted in the highly publicized decision in Hexion Specialty Chemicals, Inc. v. Huntsman Corp.,⁴ no Delaware court interpreting a merger agreement has ever found a MAC to have actually occurred.

It should also not be surprising that other states have looked to Delaware for guidance in resolving MAC disputes. For example, the court in Genesco, Inc. v. The Finish Line, Inc.⁵ primarily cited Delaware cases decided prior to Hexion to find that, under Tennessee law, a decline in Genesco's performance during the period between the signing and closing of a merger agreement was sufficient to constitute a MAC; however, the court decided that the occurrence of the MAC did not justify termination of the agreement due to the application of a carveout for a MAC occurring as a result of general economic conditions.

In addition to Genesco, there are a number of other decisions from courts outside of Delaware that provide helpful guidance on MAC clauses. Specifically, Nip v. Checkpoint Systems, Inc.⁶ and Allegheny Energy, Inc. v. DQE, Inc.,⁷ decided under Texas and Pennsylvania law, respectively, show that MAC clauses that do not force a court to interpret "materiality" in a vacuum may be more effective. In particular, the cases indicate that MAC clauses should be drafted with a quantifiable materiality threshold for a court to be truly able to determine what the parties intended to be "material."

In Nip, the court considered whether the seller losing its second-largest customer constituted a MAC. The acquisition agreement defined a MAC as:

The court analyzed the long-term effects of the lost customer relationship and, although the customer had cancelled purchase orders that amounted to only $15,000 in sales, the court believed the loss of potential future income from the customer's repeat business would exceed $50,000. Thus, the Nip court affirmed the trial court's ruling that a MAC had occurred.

In Allegheny, the district court granted judgment for DQE, finding that DQE did not breach a merger agreement by terminating the agreement due to a change in law that had a comparatively large impact on Allegheny. The merger agreement included the following specific concept in the definition of a MAC:

In determining whether the effect of the new legislation, which caused Allegheny to have a write-off that was more than three times the size of the write-off taken by DQE, constituted a MAC, the court considered the definitions of the terms "material," "adverse," and "effect," holding that "adverse" and "effect" have common and plain meanings and are not ambiguous. With regard to the term "material," the court stated, "[a]lthough there is a common understanding of what the term 'material' encompasses, the inherent relativity of this word makes it ambiguous in the absence of any qualifying language." The court noted that the agreement provided no further explanation as to how "material" should be interpreted and held that in addition to the common and plain meaning of the word, one must consider an event in light of the size and nature of a transaction and the nature of the parties' businesses to determine if the event is material. Using this interpretation, the court found that the change in law disproportionately affected Allegheny compared to DQE, and thus a MAC had occurred. While the MAC definition at issue did not contain a specific dollar threshold for determining materiality, the comparative impact language with respect to the proposed legislation was integral to the court's decision.

Unfortunately, in the states that were studied, Nip and Allegheny are the only examples of decisions where courts found that termination of a purchase agreement was appropriate based on the occurrence of a MAC. As such, the holdings in those cases are instructive, but clearly not determinative of the treatment of MAC clauses generally, particularly taking into consideration the choice of law in the agreements at issue. Given the lack of cases finding that a MAC justified termination of an agreement, a review of decisions where a MAC was not found to have occurred offers some additional guidance on the drafting of MAC clauses.

In particular, the decision in Borders v. KRLB, Inc^.8, another Texas decision, illustrates that parties should explicitly call out any metrics or projections they view as fundamental to a transaction. The dispute in Borders centered around an alleged breach of a purchase agreement by Borders, which had attempted to terminate the purchase of a radio station based on a dramatic decrease in the station's Arbitron ratings⁹ from 9.8 to 4.2 shortly after the purchase agreement was signed. The purchase agreement contained a relatively standard absence-of-MAC representation and warranty. In affirming the trial court's determination that the drop in Arbitron ratings was insufficient to constitute a MAC, the court noted that nothing in the purchase agreement mentioned Arbitron ratings, nor did it include any language guaranteeing or promising Borders that the station would maintain its audience share. The court's explicit recognition that the parties could have included a provision regarding Arbitron ratings highlights the importance of including all specific metrics or projections that the parties rely upon in making their decision to enter into a purchase agreement.

Drafting Considerations

Obviously, courts are more likely to find that a MAC has occurred in situations where a MAC definition or clause contains explicit materiality thresholds or calls out specific triggering scenarios. The specific provisions that are desirable in a MAC definition will depend on the goals of a particular buyer, but, in general, the decisions indicate that buyers should negotiate a more detailed and easily interpreted MAC definition. Thus, you should consider the following when drafting such provisions:

Quantifiable Materiality Threshold. Whenever possible, include specific quantifiable materiality thresholds based on the issues most important to your client. This may be most important in the private equity context, where buyers may be subject to inflexible financing arrangements or engrossed in financial models based on a target company's projected financial performance.

Explicit MAC Items. If particular occurrences are important to your client, specifically account for them as a MAC. In the absence of such specific provisions, courts have ignored items that buyers later claimed were important in their decision to make an acquisition and, even worse, have used the lack of an explicit provision on an issue as evidence that the buyer was not actually concerned about the issue. One way in which this can be done is to add an additional sentence (or an "including, without limitation" phrase) at the end of a traditional MAC definition that sets forth certain items that will constitute a MAC, similar to the following:

Choice of Law. It looks like Delaware courts are less likely to find that a MAC has occurred than courts of other states, having specifically stated in Hexion that a party faces a "heavy burden" when invoking a MAC clause due to the backstop nature of MAC provisions. While the decisions of Delaware will likely be instructive to courts in other states, you should consider whether specifying a governing law other than Delaware will give a buyer a better chance to assert the occurrence of a MAC.

Interpreting Party and Burden of Proof. Consider contractually shifting the point of view from which a MAC clause should be interpreted and the burden of proving the occurrence of a MAC. As courts have noted, generally a MAC clause will be interpreted from the standpoint of a reasonable investor; however, the parties can contractually shift this often subjective decision to one of the parties or possibly a specific independent third party. Similarly, the parties can contract around the default rule that the party asserting the occurrence of a MAC has the burden of proving its occurrence, by contractually requiring the party disputing the occurrence of a MAC to prove that the negative event was in fact immaterial.

Forward-Looking Language. While well-drafted MAC definitions contain language that addresses the future prospects of a seller, such as "could reasonably be expected to," a number of the MAC clauses that have been litigated have not. To further protect a buyer, consider expanding the forward-looking perspectives of a MAC by including the concept of a seller's "prospects." While difficult from a negotiating standpoint, this may be sufficient to cause a negative event that would not otherwise be deemed a MAC to qualify.

Conclusion

Although MAC clauses in purchase agreements have become much more detailed over the past two decades, the additional complexity has not enhanced the ability of buyers to prove in court that a MAC has occurred. Courts have been extremely hesitant to rely on general backstop MAC clauses to allow buyers out of their purchase obligations, but they have been much more receptive to MAC clauses that convey the parties' true intent through the use of specific monetary thresholds or triggering events. Thus, buyers are much better off going into court and pointing to a specific bump on the seller's head than claiming generally that the sky is falling. Courts tend to ignore Chicken Little.

Footnotes

^{1. Elken, Andrew, Rethinking the Material Adverse Change Clause in Merger and Acquisition Agreements: Should the United States Consider the British Model, (82 S. Cal. L. Rev. 291, January 2009).}

^{2.This Commentary examines the case law in 10 states, those in which Jones Day maintains an office plus Delaware.}

^{3.In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001); Frontier Oil v. Holly Corp., 2005 WL 1039027 (Del. Ch. 2005); Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008).}

^{4.965 A.2d 715 (Del. Ch. 2008).}

^{5.Case No. 07-2137-II(III) (Tenn. Ch., Dec. 27, 2007).}

^{6.154 S.W.3d 767 (Tex. App. 2004).}

^{7.74 F. Supp. 2d 482 (W.D. Pa. 1999).}

^{8.727 S.W.2d 357 (Ct. App. Tex. 1987).}

^{9.Arbitron is the primary market research company for radio stations. The ratings indicate the share of the listening market held by a station and are critical to the sale of advertising.}

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.