The Deal Professor by Steve M. Davidoff
March 10, 2008, 11:00 am
(Dealbook) We are now a good nine months into the market turmoil that began early last summer. The crisis has left a host of dead deals and tarnished companies in its wake — not to mention scores of scarred merger arbitrageurs who were repeatedly blindsided by cratered transactions.
Material adverse change clauses have played a critical role in these disputes. They have been the lever by which a number of buyers have sought to escape from takeover agreements. In Genesco, HD Supply, SLM and Accredited Home Lenders, among others, buyers have asserted MAC clauses to justify not completing their deals.
That’s a fair number of data points, and so it’s time to take stock of what we’ve learned.
A MAC Invocation is the First Step in a Negotiation
The historical notion of MAC disputes as a renegotiation tool has once again been borne out.
The reason is inherent in the way these clauses are structured. A MAC (also called a material adverse event/effect, or MAE) clause is a way for parties to allocate risk. When a company agrees to be acquired, there will almost always be a period of time between when the original acquisition agreement is executed and the transaction is completed. A MAC clause is a means for the parties to contractually allocate who will bear the risk of adverse events during this interim period. One formulation is “an effect, event, development or change that, individually or in the aggregate, is materially adverse to the business, results of operations or financial condition of the company and its subsidiaries, taken as a whole.” This is a qualitative test and not phrased in dollar terms.
The reason the parties don’t use dollar figures is bargaining leverage. A buyer can invoke a MAC to drive the price of an acquisition down by taking advantage of either changed market conditions or adverse events affecting the company to be purchased. Conversely, even though the buyer may utilize a MAC clause in this manner, a seller may also prefer a qualitative MAC clause to provide it with leeway to argue that an adverse event does not constitute a MAC. In both cases, the MAC clause works for the parties to settle typically at a lower price. The impetus towards settlement is compounded by the lack of substantial case-law on what constitutes a MAC. This is a self-fulfilling loop.
This is what we have seen in the recent wave. All of the MAC cases have been ultimately resolved through settlement rather than a determinative judicial judgment, though one difference has been that only a few deals, such as Accredited Home Lenders/Lone Star, have actually been renegotiated at a lower price; most have settled for a payment by the buyer to the seller, with deal itself being terminated.
And so, despite the relatively large number of MAC disputes, we thus far have only one judicial opinion further defining the scope of a MAC. This was the opinion of the Tennessee Chancery court in Genesco v. Finish Line. Unfortunately, the opinion of that court is not likely to be precedential or particularly useful because of its unique posture under Tennessee law and somewhat flawed reasoning.
Private Equity Buyers Can’t be Trusted with MAC Clauses
The negotiating balance between buyers and sellers that a MAC clause creates has been upset by the structure of private equity transactions.
Private equity deals typically have had a reverse termination fee structure that permits the buyer to exit the deal for any reason by paying a lump sum, typically about three percent of the transaction value. In these circumstances, sellers often rely partially on “soft” factors such as reputation to ensure a deal closing.
The problem with this structure is that it sets an upper bound for maximum damages, and mitigates the risk to a private equity firm in invoking a MAC compared to strategic deals, where the buyer can be forced to complete the deal if no MAC is found. Moreover, a private equity firm may be more incentivized to invoke a MAC to “cover” for the reputational issue.
This is what appeared to happen in a host of deals in the fall. One example is the failed Acxiom transaction. In those deals, a MAC was invoked, but a settlement was reached along the lines of the reverse termination fee, but for slightly less.
So where does that leave us? In private equity deals, parties may want to rethink the inclusion of a MAC clause. Given the continued use of the reverse termination fee structure in private equity deals, the inclusion of a MAC clause provides the private equity firm cover to invoke the MAC clause to “completely” walk from the transaction. Given the damage a MAC claim inflicts on a company, the company will be heavily incentivized in such circumstances to settle out at a lower figure, setting the reverse termination fee as an upper bound of payment.
While we are seeing anecdotal evidence that MAC clauses are getting more seller-friendly, it still does not fully address this issue. If private equity firms are going to obtain the optionality they want, preserving compensation for the seller in a busted deal is an equally worthy goal. This is particularly true since private equity firms are most likely to invoke the reverse termination fee structure in MAC-type situations. Strike a blow for seller rights: Kill the MAC in private equity deals.
The MAC Exclusions Matter
There is also a renewed focus on the carve-outs in every MAC clause. These carve-outs define events that, while materially adverse, are excluded from the definition of a MAC clause. As such, they are the principal place in a MAC clause where buyers and sellers allocate closing risk. The parties can agree any carve-out they wish, but generally parties negotiate carve-outs that allocate market and systemic risk to the buyer and allocate closing risk to the seller for adverse events that particularly and disproportionately affect it.
The SLM and Genesco disputes in particular brought renewed focus on the wording in these carve-outs. There, the parties were seemingly surprised at the exclusions they had negotiated. In SLM’s case it was the scope of the meaning of “disproportional” in a MAC exclusion for changes in laws related to the student lending industry. The Genesco dispute highlighted the potentially wide out an economic industry exclusion could provide a seller in a MAC. The lesson is that these exclusions may be wider than you think and that they are the heart of a MAC clause. Pay attention.
A new MAC strategy has also emerged. In the Genesco case, Finish Line did not initially invoke a MAC. Rather it claimed that the merger agreement among the parties required Genesco to provide Finish Line further information to make such a determination. Despite Genesco’s cries that this was a fishing expedition, the court ordered that Genesco provide such information. Sure enough, Finish Line subsequently claimed a MAC.
Wachovia is following a similar strategy in its litigation to escape financing the Clear Channel/Providence transaction. Wachovia is claiming that it needs further information to make a determination of whether a MAC to the Clear Channel television station business has occurred. This is a claim that, at a minimum, will delay a transaction.
But this strategy is already getting a cold reception in Delaware. Last week, at a hearing on the Clear Channel/Providence/Wachovia litigation, Vice Chancellor Leo Strine Jr. stated to Wachovia’s counsel:
I’m saying is I don’t know what claims you’ve made yet. If what you’re
claiming is that there was some sort of breach of covenant by your client
whereby they were supposed to have been providing certain types of information,
then I understand that there may well be a relationship between that failure to
provide information and your ability to claim an MAE if the information that you
did not get would justify such a call.
But, on the other hand, if you basically already have it, or you really
haven’t been able to call it, then, again, we’re not in that business, and I
don’t think that’s the law of contracts, that you go get to hit and hope.
Translated: Delaware is likely to be less friendly to fishing expeditions or other claims that this is information not in your possession.
And an Example
Let’s conclude by giving an example of an actual MAC clause, the one in the Countrywide’s merger agreement with Bank of America. That agreement defines a material adverse change as:
a material adverse effect on (i) the financial condition, results of operations or business of such party and its Subsidiaries taken as a whole (provided, however, that, with respect to this clause (i), a “Material Adverse Effect” shall not be deemed to include effects to the extent resulting from (A) changes, after the date hereof, in GAAP or regulatory accounting requirements applicable generally to companies in the industries in which such party and its Subsidiaries operate, (B) changes, after the date hereof, in laws, rules or regulations of general applicability to companies in the industries in which such party and its Subsidiaries operate, (C) actions or omissions taken with the prior written consent of the other party, (D) changes, after the date hereof, in global or national political conditions or general economic or market conditions generally affecting other companies in the industries in which such party and its Subsidiaries operate or (E) the public disclosure of this Agreement or the transactions contemplated hereby, except, with respect to clauses (A) and (B), to the extent that the effects of such change are disproportionately adverse to the financial condition, results of operations or business of such party and its Subsidiaries, taken as a whole, as compared to other companies in the industry in which such party and its Subsidiaries operate) or (ii) the ability of such party to timely consummate the transactions contemplated by this Agreement.
This is a middle-of-the-road MAC clause. (For a more seller-friendly one, see the Penn Gaming/Fortress merger agreement.)
Consider recent reports that the FBI is conducting a criminal inquiry into Countrywide: Would that be a MAC, thereby triggering a walk right by Bank of America? Hard to say — a walk right is only triggered if there is a breach of a representation and warranty that rises to the level of a MAC. This investigation certainly might cause such a breach of Countrywide’s representations as to no legal action or compliance with laws.
But to be a MAC, the investigation would have to be something that was not disclosed on the disclosure schedules to the merger agreement that qualify this representation. It would also have to have had or would reasonably be expected to have a MAC on Countrywide.
The disclosure schedules are not public, so we don’t know the answer to the first question. As for the second, a mere investigation is hard to be a MAC; one view is that unless the actual investigation itself causes the MAC, then there is none.
So right now, we just simply don’t know — though it seems not to be one.
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