When a Good Deal Goes Bad: Recent Market Turmoil Puts Spotlight on ‘Material Adverse Change’ Clauses in M&A Transactions
November 30, 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 in the summer of 2007 have faced 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’ (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 in our more detailed discussion of this topic by Sven Milelli and Vanessa Grant on the McCarthy Tétrault website.
Putting the MAC Clause in Play
Historically, MAC clauses have rarely been invoked in a public manner. One notable example was Johnson & Johnson’s use of the clause to renegotiate a lower purchase price of its acquisition of Guidant in November 2005. More recently, MAC clauses have been cited, with varying results, in several high-profile acquisitions where rapidly changing market conditions have caused transactions to become economically unattractive to buyers, including those for targets Home Depot Supply, Harman International, Genesco, Acxiom and Sallie Mae.
MAC Clauses in the Courts
As they are rarely invoked, MAC clauses have seldom been litigated in the courts. That trend is changing. Two US 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 United States, 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. The court in those cases decided that 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 and increasingly seller-friendly MAC clauses.
In view of the high bar now 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 particularly want to consider triggers, the inclusion or exclusion of specific events and the use of monetary thresholds.
McCarthy Tétrault Notes:
MAC clauses are a powerful contractual tool that potentially grant a party either significant leverage to renegotiate a deal where the target suffers an adverse change prior to closing or 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.