Recent decisions of the Delaware Chancery Court, coupled with extreme market dislocation and a general retreat from the seller’s market of 2004-2007, have brought renewed focus on “material adverse change” (MAC) clauses in private M&A contracts. Specifically, buyers are once again requesting MAC provisions that permit them to avoid closing deals when there is a short-term disruption in the target’s business. This dynamic first emerged in 2001 following the Chancery Court’s IBP v. Tyson Foods case, which established an extremely high bar for a buyer to clear in order escape from a signed deal. Although sellers persevered and short-term MAC provisions never became prevalent, current market conditions and a lack of available credit have allowed the few buyers in a position to execute transactions to use their leverage to put it back on the table.
Prior to the Tyson Foods case, some buyers presumed they could terminate a deal if there was a material change to any of the fundamental assumptions underlying their negotiated purchase price, such as EBITDA run rate. Instead, the Chancery Court in that case concluded that only an adverse change “consequential to the [target’s] earnings power over a commercially reasonable period ... measured in years rather than months” could constitute a MAC. Following that decision, particularly in the robust market environment of 2004-2007, the Tyson Foods philosophy and the overall seller-favorable market conditions combined to reduce significantly, if not eliminate, the efficacy of MAC clauses as a basis for buyers to escape from signed deals1. Over this period, negotiations in the market produced MAC definitions that included an ever expanding list of events that could not constitute a MAC2.
Against this backdrop came the most recent Delaware Chancery Court decision on MACs, in September 2008, involving the dispute between Apollo-backed Hexion Specialty Chemicals and Huntsman3. Hexion attempted to escape from a merger agreement with Huntsman by arguing that a deterioration in Huntsman’s business between signing and closing amounted to a MAC under the merger agreement. Hexion focused its arguments on Huntsman’s repeated misses from its forecasts in the period after signing, as well as an increase in Huntsman’s net debt as compared to its forecasted decrease and the underperformance of two of Huntsman’s operating divisions during that time frame.
The Chancery Court concluded that because Huntsman had specifically disclaimed any representations regarding projections, the failure to hit its EBITDA targets after signing could not be the basis of a MAC. The Chancery Court also concluded that the proper way to determine the existence of a MAC is to compare current results against the prior historical period and found only a small decline (3-6%) over annual periods. In addition, the increase in net debt had been small (5%) and the Huntsman business units affected by the downturn contributed only 25% of overall EBITDA and, thus, no MAC had occurred. Based on these conclusions, the Chancery Court held Hexion to its agreement to acquire Huntsman, a transaction that had become unfinanceable (the subject of separate pending litigation). In so doing the Chancery Court stated, “A buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close.”
In response to the current market conditions and to the Delaware Chancery Court’s decisions in this area, some acquirers in private M&A transactions (including private equity firms) have begun once again to push back, harder. These buyers are requesting MAC provisions that would allow them to avoid closing or to renegotiate deals when there is evidence of a short-term disruption in the target’s business, specifically rejecting by contractual agreement with the seller the longer-term framework that otherwise applies under Delaware law. For example, recent agreements we have encountered have included modified MAC provisions, which specify that adverse changes can be, “either short-term or long-term,” or can be viewed “without regard to their duration,” and the negotiation over these provisions has been intense. Amid the extreme volatility in today’s markets and the lack of access to credit, buyers seeking these provisions may experience more success than in prior years.
As with all contractual provisions, there is no “correct” position with respect to MAC clauses, and the ultimate contractual terms will reflect the relative leverage of the parties. From the buyer’s perspective, the preference for a short and long-term oriented MAC condition is understandable. Buyers and sellers haggle endlessly, before signing a deal, over adjustments to the target’s EBITDA that will serve as the basis for the purchase price. Ultimately, those adjustments translate into multiple-based increases or decreases to the final price, suggesting, at least before a deal is signed, they are material to both the buyer and the seller. Most buyers would likely say that if they were aware of the types of financial disruptions that occurred in the Tyson Foods and Huntsman cases before signing a deal, they would attempt to renegotiate the deal or walk away if they were not compensated in some fashion. Conversely, sellers remain appropriately concerned about certainty of execution, particularly once a sale process has narrowed to a single buyer, a transaction is announced and leverage begins to point in the direction of the buyer. MAC clauses in acquisition agreements are also often dependent upon MAC clauses in related financing agreements, a separate topic that is currently evolving.
It is too early to tell whether a significant percentage of buyers will prevail in negotiating for short-term MAC provisions, and if so, whether the trend will last beyond the current economic crisis. It is also unclear whether the attempt to negate Delaware law standards for MAC clauses by contract will arise in the public company M&A context and how other state courts will rule on the issue4. Contractual terms become most relevant in times of extreme market disruption – these times certainly involve that, and thus continuing and increasing focus on MAC clauses in M&A negotiations is likely to occur.