Canada: Material Adverse Effect Conditions: Treat Them as Boilerplate at Your Peril

Most merger or acquisition agreements use the concept of a "material adverse effect" (MAE) or "material adverse change". Typically, the agreement will have a purchaser’s condition that no MAE shall have occurred in the acquired business before closing. In addition, sellers often attempt to use an MAE clause to qualify their representations and warranties—that is, a breach of a representation or warranty or a failure to satisfy a closing condition will occur only if the circumstances have an MAE. The importance of an MAE condition was recently shown in Johnson & Johnson’s proposed acquisition of Guidant Corporation, discussed later in this bulletin.

No leading Canadian cases have considered the MAE concept. Canadian companies, however, can look to U.S. court decisions as some indication of how the concept might be interpreted in Canada. Two decisions of the Delaware Court of Chancery, In re IBP Shareholders Litigation and the more recent Frontier Oil v. Holly, provide guidance on the way MAE clauses might be interpreted by a Canadian court. The question whether a party can exercise an MAE condition in any given circumstance is highly uncertain and fact-dependent. And there is no certainty that Canadians courts would choose to follow U.S. decisions. If the approach in IBP and Frontier is followed, however, a traditional MAE condition is likely to be read as a backstop protecting the purchaser only from the occurrence of unknown events, that substantially threaten the overall earnings potential of the target for a significant duration.

IBP involved an auction process initiated by IBP that resulted in Tyson agreeing to acquire IBP. During the auction process, Tyson learned about a potential accounting fraud at an IBP subsidiary and that earnings were projected to be below earlier predictions. The closing was delayed while IBP worked to resolve financial statement issues raised by the U.S. Securities and Exchange Commission, including how to report the fraud. During the delay, Tyson decided not to complete the merger and terminated the agreement, asserting in part that an MAE had occurred. IBP sued to require Tyson to complete the merger. The Court determined that an MAE had not occurred and ordered Tyson to complete the merger. In doing so, the Court noted that Tyson was simply having "buyer’s regret." The merger agreement had specifically allocated certain risks to Tyson, including the risk of any losses or financial effects from the accounting improprieties, and therefore these risks could not serve as a basis for terminating the merger agreement.

Frontier involved a merger agreement between Frontier and Holly, which was signed after four months of negotiations. In the week leading up to the signing of the merger agreement, Holly became aware of and concerned about a threatened environmental contamination class action involving one of Frontier’s subsidiaries. As liability appeared to be limited to the Frontier subsidiary, Holly signed the merger agreement but only after Frontier agreed to give a stronger representation and warranty about outstanding and threatened litigation, which, nevertheless, remained qualified by MAE. Subsequent to signing, the threatened litigation was commenced and it became clear that Frontier had guaranteed its subsidiary’s obligations and therefore Frontier would also be liable. After a lengthy period of unsuccessful renegotiations, Frontier sued Holly for repudiating the merger agreement and claimed damages. Holly disputed the repudiation claim, sued Frontier for breach of its representations and warranties and wrongful repudiation, and claimed damages. The Court determined, among other things, that there had been no breach of representation by Frontier because no MAE had occurred.

MAE conditions are important because they can give purchasers leverage to renegotiate before taking the more draconian step of walking away from a deal. The recent negotiations over Johnson & Johnson’s proposed acquisition of Guidant are an example. On December 15, 2004, Johnson & Johnson announced that it had agreed to acquire Guidant. However, Guidant later announced product recalls and related regulatory investigations that led Johnson & Johnson to conclude that an MAE in respect of Guidant had occurred. Johnson & Johnson refused to close the transaction. On November 7, 2005, Guidant filed a civil suit alleging that Johnson & Johnson was required to complete the acquisition under the merger agreement. This resulted in a renegotiation of the terms of the merger: the net acquisition cost was lowered from $23 billion to $19 billion in cash and stock (or a drop in value from $76 to $63.08 on a per share basis). The existence of the MAE condition in favour of Johnson & Johnson provided it with the leverage to renegotiate the transaction terms.¹

What lessons can be learned from IBP and Frontier?

• Choose words carefully. In both IBP and Frontier, the wording of the MAE clause itself was pertinent. The phrases "has", "would reasonably be expected to have" and "could reasonably be expected to have" an MAE establish significantly different thresholds, the use of could being the easiest to meet. When crafting the precise wording of an MAE clause, take care to ensure that the appropriate threshold and risk allocation are selected. In Frontier, the Court noted, "‘would’ connotes a greater degree ... of likelihood than ‘could’ or ‘might,’ which would have suggested a stronger element of speculation (or a lesser probability of adverse consequences)."

• Be specific. Purchasers concerned about an issue should include in the merger or acquisition agreement a specific representation, warranty, condition or indemnity (as is appropriate) or deal with it in the MAE definition itself. The more specific a purchaser can be, the better positioned it will be to rely on an MAE clause. In Frontier, for example, Holly was clearly concerned about the implications of the threatened class action, but did not specify in the merger agreement what specific occurrences would entitle it to terminate the merger agreement. Instead, Holly relied on the general wording in a traditional definition of MAE, which subsequently proved to be insufficient.

• Consider including a monetary threshold. As the Court stated in Frontier: "It would be neither original nor perceptive to observe that defining a ‘Material Adverse Effect’ as a ‘material adverse effect’ is not especially helpful." To add precision to the meaning of MAE, the parties could agree on a monetary threshold beyond which an MAE will be deemed to have occurred.

• Consider whether to quantify probable future effects. In many instances, the effect of an adverse change in the business will be felt for many months or years. How then should future effects be quantified? To add greater certainty to the meaning of MAE, the parties could agree on a method for determining the present value of future effects, using an agreed discount rate.

• Establish the burden of proof. Will the purchaser have the burden of establishing that an MAE occurred or will the seller have the burden of establishing that an MAE did not occur? Given the uncertainty surrounding the meaning of MAE, where the burden of proof lies can often be a determining factor. In Frontier, the Court held that because the parties had not established in the merger agreement who bore the burden of proof, it rested on Holly, the party seeking to establish that an MAE had occurred. Although not typical, parties could consider whether to allocate the burden of proof in a merger or acquisition agreement.

• Keep public statements consistent. If a purchaser wants to preserve its right to claim an MAE, it should ensure that all its public statements support this claim. In IBP, a negative inference was drawn from the fact that Tyson’s publicly expressed reasons for terminating the merger agreement did not include an assertion that IBP had suffered an MAE. This suggested to the Court that even Tyson did not regard a short-term drop in IBP’s performance as sufficient to cause an MAE. In contrast, Johnson & Johnson publicly and clearly asserted in its press release that it was refusing to close the Guidant acquisition because of an MAE.

MAE clauses are important provisions for merger or acquisition agreements, but they should not be treated as boilerplate. To increase the usefulness of MAE clauses, parties should give more thought and detail to the definition and use of the MAE concept.

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.