The global credit crunch has not only dried up financing for many deals, it has prompted numerous private equity firms and companies to try to abandon deals they agreed upon before the economy faltered—with mixed success.
The weapon of choice is the material adverse change clause (also known as the material adverse effect clause), a cornerstone of merger agreements. Such clauses allow potential acquirers to walk away from deals if they can prove a major change in circumstance has happened at the company to be acquired.
And a lot has changed economically in the last six months.
Last year, for example, private equity firm Lone Star tried to abandon its deal to buy Accredited Home Lenders, citing a material adverse change at the mortgage banker. After Accredited filed a lawsuit, the two parties finally settled for a lower price. Mortgage insurers MGIC and Radian, on the other hand, called off their deal altogether, noting in a joint statement: “Current market conditions have made combining the companies significantly more challenging.”
Other deals turned more acrimonious. Earlier this year, student-loan lender Sallie Mae dropped its lawsuit against J.C. Flowers & Co., a private equity firm that had agreed in 2007 to buy Sallie Mae for $25 billion. Then Congress reduced subsidies last fall to education lenders like Sallie Mae; J.C. Flower promptly tried to negotiate the purchase price downward, saying the new legislation was a material adverse change. Sallie Mae had sued for a $900 million breakup fee, but ultimately dropped its claim when it lined up alternative financing to continue operations independently.
“We have had a lot of transactions that were negotiated in an earlier environment of easy money and economic expansion,” says Stuart Freedman, partner at the law firm Schulte Roth & Zabel. “Those deals have confronted a difficult reality of financing and the economy.”
MAC clauses are a critical—and intensely negotiated—provision of every merger agreement because no deals close at the same moment companies agree to them. Buyers sometimes need to obtain financing, and most deals usually need regulatory and shareholder approval. The MAC clause is intended to address changes that could take place during the intervening period.
The problem: Parties usually have very different ideas about how to define a “material” adverse change. The buyer wants to include specific metrics that would trigger a MAC. Conversely, the seller wants to put in as many exceptions to the definition as possible and to keep the language vague, making it harder for the buyer to back out.
“MAC provisions are anything but clear,” Freedman says. “Many say it is like pornography: You know it when you see it. But that is not always the case.”
Steve Siesser of the law firm Lowenstein Sandler says the conventional wisdom is that if EBITDA falls by 10 percent or more after a merger has been struck, the buyer can say a material adverse change has occurred and exit the deal. But Siesser stresses that the 10 percent rule is only a benchmark; no regulatory or legal authority has given a formal blessing to it. “Private equity clients throw it out there,” he says.
Scarce Court Guidance
Virtually every dispute over a MAC clause is settled, legal experts say. With so few actual court decisions, most lawyers point to IBP v. Tyson Foods, decided earlier this decade in Delaware, as the landmark decision worth studying. In that case, Tyson tried to break off its merger with IBP, another meat processor, after IBP reported financial problems at one of its subsidiaries. IBP subsequently disclosed accounting fraud at that subsidiary. Still, the vice chancellor of the Delaware Chancery Court, Leo Strine, ruled that no material adverse change had occurred.
The law firm Schulte Roth, in a legal bulletin reviewing the current state of MAC clauses, noted that Strine construed the MAC clause to apply to long-term performance of the seller—not a short-term stumble like an accounting investigation, since Tyson’s MAC clause never specified such short-term problems.
In light of that reasoning, Schulte’s bulletin says, “practitioners have stressed the importance for buyers and sellers to use clear and unambiguous language in critical deal provisions to avoid costly and potentially adverse legal battles.”
That is easier recommended than done; negotiating MACs is perhaps the most contentious and time consuming part of merger talks. “A certainty in life is that people won’t agree on MAC,” says Jeffrey Rothschild of the law firm McDermott Will & Emery.
One course of action for buyers is to identify specific financial tests that the target company must meet (EBITDA, revenues, and net worth, for example) to determine whether a material change has happened. But Howard Spilko of the law firm Kramer Levin Naftalis & Frankel says such exactitude can also backfire. “If you put in an EBITDA test and it is met, it’s hard to argue a decline in revenues is a MAC if it was not included as a test,” he says.
Siesser recommends that buyers establish separate MAC agreements with any lenders helping them finance a deal, so the lenders can’t change their minds either. Equally important: Any MAC agreement with a lender should never differ from the MAC agreement with the seller. Otherwise, Siesser warns, a company could end up obligated to close a deal even if its financing collapses.
“MAC provisions are anything but clear. Many say it is like pornography: You know it when you see it. But that is not always the case.”
— Stuart Freedman,
Schulte Roth & Zabel
And buying a company in distress—not an uncommon event these days—carries more considerations. Claiming a material adverse change can be more difficult, since the target company is already in pretty adverse shape to start. So a buyer may want to push hard for specific financial metrics before closing.
More Fine Print
Another common element of MAC clauses is the reverse break-up fee, which allows the buyer to scrap a deal in return for paying a fee to the seller. Usually, the seller can also pay a fee to the buyer if it finds a higher bidder. Rothschild says the standard fee is about 3 percent of the deal price.
One of the biggest negotiating points will be the carve-outs—which spell out exceptions to what constitutes a MAC, such as a change in the economy, industry conditions, or other factors beyond a company’s control. Buyers want to keep such exceptions few and far between. Sellers want the language to be as broad as possible.
In general, Spilko says, the specific wording and how the language appears in the MAC clause is crucial. “Whether you use ‘could’ or ‘would’ can have an effect,” he says.
Since the M&A market peaked last spring and the flow of deals has dwindled to a trickle, MAC clauses are now much more tightly crafted, lawyers say. In addition, more deals now include an EBITDA test as a closing condition, Freedman says. “I would fully expect these provisions in deals going forward, especially in private deals,” he adds.
Regardless, if a buyer no longer finds a proposed deal as attractive as it seemed when an agreement was first struck, expect the buyer to try to wriggle out of it no matter what the MAC clause says. Says Siesser: “In a difficult market, if you have to get out, you are looking for any life preserver. The MAC is a good one because it is subjective.”