When a Good Deal Goes Bad: Recent Market Turmoil Puts Spotlight on “Material Adverse Change” Clauses in M&A Transactions
October 31, 2007
Sven O. Milelli
The recent deterioration in credit markets has resulted in a sharp downturn in global M&A activity, particularly by private equity buyers who until recently enjoyed significant advantages over traditional "strategic" purchasers due to their ability to finance and syndicate increasingly large acquisitions on favourable terms. As a result, many buyers in debt-financed acquisitions announced prior to the credit crunch – with an estimated total transaction value in excess of $350 billion globally – are now facing increased pressure from their financial sponsors to renegotiate deal terms or walk away from their transactions. Faced with the prospect of having to pay sellers significant termination fees in connection with their failure to close a deal, many buyers are invoking the "material adverse change" or "MAC" (or "material adverse effect") clauses in their merger agreements in an attempt to abandon transactions without liability or as leverage against the seller to reduce the purchase price.
What is a MAC Clause?
A MAC clause, which is customary in merger or acquisition agreements, generally serves to release a party – principally the buyer in an all-cash transaction – from its obligation to complete the transaction without penalty in the event that the other party experiences an unexpected and significant impairment to its business, operations or financial condition prior to the closing of the transaction. In negotiating a MAC clause, the parties focus both on what constitutes a "material adverse change" as well as what doesn’t, with sellers seeking the narrowest possible definition with as many exceptions to the definition as possible and buyers seeking the reverse.
An example of a MAC clause is included at the end of this article.
Putting the MAC Clause in Play
Historically, MAC clauses have rarely been invoked in a public manner. One notable example was Johnson & Johnson’s renegotiation of its acquisition of Guidant in November 2005 following Guidant’s announcement of a product recall. By credibly invoking its MAC clause and threatening to walk away from the deal, J&J was able to gain the leverage necessary to extract a lower price. (Guidant was ultimately acquired by Boston Scientific, who topped J&J’s lowered bid). More recently, MAC clauses have been cited in several high-profile acquisitions where rapidly changing market conditions have caused transactions to become economically unattractive to buyers. These attempts have met with varying results:
- Faced with both the credit crunch and deteriorating housing market conditions, Home Depot agreed in late August 2007 to lower the purchase price for its Home Depot Supply unit from $10.3 billion to $8.5 billion in response to mounting pressure from its private equity buyers and their financial sponsors.
- Buyout firm Kohlberg Kravis Roberts and Goldman Sachs’s private-equity arm cited reduced earnings projections in invoking the MAC clause and abandoning their proposed $8 billion acquisition of audio equipment-maker Harman International. On October 22, Harman announced that it had entered into an agreement under which KKR and Goldman Sachs would purchase $400 million of convertible notes of Harman in return for the termination of the merger agreement without payment by the buyers of a $225 million termination fee.
- In its $1.5 billion purchase of retailer Genesco, The Finish Line Inc. cited Genesco’s failure to provide required financial information necessary to determine whether Genesco had suffered a material adverse effect as grounds for termination; on September 21, 2007, Genesco brought suit against Finish Line in Tennessee to force it to complete the transaction. The suit is expected to be heard in early November.
- After worsening financial results were cited by its private equity buyers as constituting a MAC, information management company Acxiom Corporation agreed on October 1, 2007 to terminate its $2.25 billion acquisition in return for a $65 million reverse termination fee. On October 10, 2007, Acxiom Corporation issued a press release stating that it had received full payment of the $65 million settlement amount.
- Private equity firm J.C. Flowers & Company cited both the recent credit crunch and enactment of unfavourable legislation as constituting a MAC in its efforts to renegotiate its $25 billion buyout of U.S. educational lending giant Sallie Mae, which responded by bringing suit in Delaware on October 8, 2007 for payment by J.C. Flowers of a $900 million reverse termination fee.
MAC Clauses in the Courts
Seldom invoked, MAC clauses rarely have been litigated in the courts. That trend is changing. Two U.S. court decisions in Delaware, In re IBP Shareholders Litigation and Frontier Oil v. Holly, provide some guidance as to how the current litigation of MAC clauses may be decided. Although no leading cases in the M&A context have been considered in Canada, Canadian companies could look to these decisions, as well as the outcome of the current wave of litigation in the U.S., for an indication as to how MAC clauses might be viewed in Canada. Together, the IBP and Frontier cases set a high standard for invoking a MAC clause successfully, and place the burden of proof squarely on the party claiming that a MAC has occurred. Although outcomes will depend on the particular facts and circumstances of each case, the Delaware court held that a general MAC clause can be relied on only to protect the buyer from the occurrence of "unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner." Accordingly, in the absence of a material event that has a long-term negative impact on the target, a general MAC clause may not be invoked; mere "buyer’s remorse" will not permit a buyer to back out of a deal without penalty.
Negotiating a MAC Clause
Given their role as a potential "escape hatch" for a buyer, MAC clauses are among the most heavily negotiated provisions in a merger or acquisition agreement. Buyers and sellers must face off in determining the scope of the MAC definition and the general and specific exceptions to it, with outcomes generally determined by their relative bargaining power. Prior to the recent credit crunch, strong M&A activity led by private equity buyers had resulted in an overheated, seller-friendly environment. This trend was reflected in increasingly seller-friendly MAC clauses, with an observed increase in MAC exceptions for several categories of events, including changes in securities markets, industry conditions, the trading price or volume of a target’s stock, laws and regulations affecting the target, as well as terrorism, acts of war and changes in political conditions.
In view of the high bar set by the courts for proving that a MAC has occurred, an effective MAC clause will be tailored to reflect as closely as possible the bargained-for allocation of risk between the buyer and seller. When negotiating the general MAC definition, buyers and sellers will want to consider the following:
- Triggers. Is the clause triggered by the actual occurrence of a MAC (seller friendly), or the mere occurrence of an event that would or could reasonably be expected to result in a MAC (increasingly buyer friendly)?
- Specific Events. Are the parties aware of specific events or developments that could impact the seller prior to closing? If so, they should clearly include or exclude these changes from the MAC definition to provide greater certainty later on. Where a specific event is known to be material, it may be preferable to draft a separate closing condition specifically covering the occurrence or non-occurrence of the event.
- Monetary Thresholds. If the parties want greater precision in the definition of a MAC, they should consider specifying a monetary threshold for loss beyond which a MAC will be deemed to have occurred.
MAC clauses are a powerful contractual tool which potentially grant a party either significant leverage to renegotiate a deal where the target suffers an adverse change prior to closing or the ability to walk away from the deal entirely. The recent downturn in private equity-led M&A activity will test the trend toward seller-friendly MAC clauses, and likely generate further refinements to the judicial interpretation of MAC clauses.
A MAC clause with exceptions might look like this:
"Material Adverse Change", when used in connection with the Target, means any adverse change that constitutes or would reasonably be expected to constitute a material adverse change on the business, operations or financial condition of the Target and its subsidiaries, taken as a whole; provided, however, that any adverse effect that is temporary in nature or that results directly or indirectly from or relates directly or indirectly to any of the following shall not be deemed to constitute, and shall not be taken into account in determining whether there has been or would be, a Material Adverse Change to the Target:
- changes or developments in international, Canadian, United States or EU political, economic, financial or market conditions, or in the economy, political or market conditions or currency exchange rates in Canada, the United States or the EU;
- changes or developments resulting from any natural disaster, any act of sabotage or terrorism or any outbreak of hostilities or war, or any escalation of any such natural disaster or acts of sabotage or terrorism or hostilities or war;
- conditions generally affecting the [Target’s industry] sector or companies in that sector (except to the extent such conditions have a disproportionately large adverse change on the Target and its subsidiaries by comparison to the adverse change such conditions have generally on the other companies in that sector, it being understood that, in determining whether there has been or would be a Material Adverse Change on the Target, such disproportionately large adverse change may be taken into account only to the limited extent that it exceeds the adverse change such conditions have generally on the other companies in that sector);
- conditions generally affecting companies in the U.S., Canada or the EU involved in the development or marketing of products manufactured by the Target (except to the extent such conditions have a disproportionately large adverse change on the Target and its Subsidiaries by comparison to the adverse change such conditions have generally on the other companies involved in the development or marketing of such products, it being understood that, in determining whether there has been or would be a Material Adverse Change on the Target, such disproportionately large adverse effect may be taken into account only to the limited extent that it exceeds the adverse change such conditions have generally on the other companies involved in the development or marketing of such products);
- the payment of any amounts due to, or the provision of any other benefits to, any officers or employees under employment contracts, non-competition agreements, employee benefit plans, severance arrangements or other arrangements in existence as of the date of this Agreement and disclosed in the Disclosure Letter;
- any breach by Buyer of this Agreement or the Confidentiality Agreement;
- the announcement of the execution of this Agreement, the pendency of the transactions contemplated hereby, the performance of any obligation hereunder or the completion of any of the transactions contemplated hereby, including any pre-acquisition reorganization (including any litigation or impact on the relationship of the Target or any of its subsidiaries with employees, customers, suppliers, partners, service providers or creditors);
- any event, occurrence, development or circumstance disclosed in the Disclosure Letter;
- the taking of any action, or any failure to act, contemplated or permitted by this Agreement or consented to by the Buyer;
- changes in GAAP or applicable Laws or interpretations thereof;
- failure to meet any published or other revenue o earnings estimates or projections of the Target, or a decline in the market price or volume of trading of the Target’s securities on the TSX (in and of itself), provided, however, that notwithstanding the foregoing, any adverse effect on the business, operations or financial condition of the Target and its subsidiaries that has resulted in such failure or such decline may be taken into account in determining whether there has been a Material Adverse Change on the Target; or
- any request or requirement by any Governmental Entity that any of the Buyer, the Target or any of its subsidiaries enter into any agreement or arrangement, or take any action, as a condition or prerequisite to the granting of any of the Appropriate Regulatory Approvals.