Runaway MAC Carve-outs

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday January 14, 2013 at 8:59 am
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Editor’s Note: The following post comes to us from Neil Whoriskey, partner focusing on mergers and acquisitions at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Whoriskey.

The definition of “material adverse change” plays a critical role in public company merger agreements, effectively defining the situations in which a buyer may walk away from the transaction. There is significant case law defining what is (or, much more commonly, what is not) a material adverse change, but the case law only serves to interpret the agreed definitions. The agreed definitions, in turn, are typically very vague in defining what is a material adverse change (leaving lots of scope for judges), but explicit in listing the types of changes that may not be considered in evaluating whether a material adverse change has occurred. The use of these carve-outs to limit what may be considered a material adverse change has expanded significantly in recent years — arguably to a point where it may make sense for the pendulum to start to swing back.

It has been traditional for adverse effects attributable to changes in general economic conditions to be excluded in considering whether a material adverse effect has occurred, such that e.g., a loss of sales attributable to the great recession, no matter how severe, would not give buyer the right to terminate a merger agreement. This carve-out from the material adverse change definition can be grouped with others, such as carve-outs for downturns in the target industry, changes in law or accounting policies, acts of war, etc. — all of which shift to buyer the risks associated with the environment in which the target operates. What is notable is that over the last several years, not only has the percentage of deals that shift these “environmental” risks to buyer increased significantly, but MAC carve-outs that shift to buyer the risk of the deal, and (anecdotally at least) even the risk of running the business, have also increased markedly.

First, the empirical evidence, courtesy of the annual ABA Deal Points studies. [1] Listed below are various “environmental” MAC carve-outs, with the Deal Points calculation of how frequently these carve-outs appeared in 2004 deals (the year examined in the first Deal Points study) and in 2010 (the year examined in the last Deal Points study).

Carve-out 2004 2010
General Economy 92% 100%
Industry 75% 98%
Change in Law 43% 89%
Change in Accounting Principles 42% 94%
War/Terrorism 24% 90%

As can be seen, “environmental” risks in every category were more likely to be shifted to buyer in 2010 than in 2004. Risks associated with a downturn in the target industry were 30% more likely to be shifted to buyer in 2010. Adverse changes attributable to changes in law or accounting principles were more than twice as likely to be shifted to buyer in 2010. War and terrorism risks were almost four times as likely to be shifted to buyer. It is hard to conceive of a general rationale for buyers as a group to be more tolerant of these risks in 2010 than they were in 2004.

Risks associated with the deal itself also appear to have been, in the aggregate, assumed by buyer much more frequently than in the past. One indication of this is the increased prevalence of a carve-out for any adverse effects arising as a result of the announcement or pendency of the merger. This carve-out serves to protect the target from claims that a material adverse change has occurred due to, e.g., target’s employees quitting en masse (because they don’t want to work for buyer or see little chance that they will be retained after the merger), or customers defecting or shifting orders to a competitor as a result of the announcement. Leaving aside the question as to whether seller is in a better position than buyer to evaluate and mitigate these risks (a question that will have a different answer in each deal), it is clear that this carve-out has become more prevalent in recent years. In 2004, 69% of merger agreements for public company targets included this carve-out; by 2010, the percentage had increased to 90%, a 30% percent increase.

Moreover, while it is perhaps more anecdotal, other carve-outs that have the effect of shifting deal risk to buyer have also become popular — at least in targets’ drafts. These include a carve-out from the material adverse effect definition for any adverse effects arising (or reasonably likely to arise) from the consummation of the transaction. While this sometimes defended as a temporal extension of the carve-out for adverse effects arising from the announcement or pendency of the merger (i.e., employees/customers/suppliers are likely to leave, but only if the deal is consummated), there are additional risks associated with the consummation of the merger. For example, consummation of the merger may trigger termination of a critical IP license, while the mere announcement of the merger would not. If buyer has accepted this carve-out, the effect of the termination of this critical license would not constitute (or even contribute to) a material adverse effect. [2] Even more directly, in one recent deal the target managed to insert not only a carve-out for changes arising from the consummation of the merger, but also a carve-out for adverse changes arising as a result of a failure to obtain any consents (regardless of whether those consents were identified by target as being necessary in connection with the transaction).

For further evidence of how far the pendulum has swung in favor of target, consider the increased prevalence of carveouts that go beyond shifting deal risk, and actually shift the risk of running target business (pre-close) to buyer. In this regard, note that a carve-out for the failure of target to meet its projections was included in 15% of public merger agreements in 2004, increasing to 85% of deals in 2010 — an increase of almost sixfold. This may not be particularly probative, given that a large number of these clauses must have excluded from the carve-out any underlying causes that resulted in the failure to meet the projections — such that the carve-out merely excludes one forward looking measurement of the underlying adverse effect. However, that presumably might have been as true in 2004 as 2010, and the greater willingness of buyers to accept this carve-out is reflective of the broader trend of allowing more risk to be shifted to buyer via the MAC carveouts.

Again somewhat anecdotally, we have noticed a number of target drafts where target attempts to carve out any adverse effects arising from actions taken with the consent of buyer. It is unclear why, under any circumstances, target should not take responsibility for its own actions, regardless of whether buyer has consented. Moreover, in certain circumstances buyer may be required to consent (e.g., if consent cannot be unreasonably withheld). Imagine a situation where target wants to sell of one of its less important operating subs in a jurisdiction in which buyer does not operate and does not wish to enter. Buyer happily consents. It turns out that the sub has a license to use and sublicense the target’s critical and very marketable IP. Buyer has no walk right. Should the risk of diligencing the sale of the subsidiary be so fully on buyer?

Even more surprising are the attempts (accepted in at least one recent transaction) to carve-out any adverse effects arising from the performance of the merger agreement itself. As it is typically an obligation of the target to operate in the ordinary course of business, this carve-out would seem to exclude any adverse changes resulting from operating the business in the ordinary course!

So why have carve-outs run wild to such an extent? It is of course difficult to attribute these changes in the aggregate market to any single phenomenon. Maybe it has just been a long sellers’ market. Maybe as the 2001 IBP v. Tyson case [3] has filtered into the market, buyers have become more and more convinced that they will never see a material adverse change that is unforeseen, sustained and severe enough to meet the standard set in that case – making the whole MAC concept close to useless.

Regardless of the cause, the material adverse change definition remains fundamental to the construct of public company merger agreements. If the target business deteriorates severely between signing and closing, or is in significantly worse condition than represented, the buyer has no remedy other than termination, and that remedy is triggered only by the occurrence of a material adverse change. When a buyer has been run through a tough auction process and paid top dollar for a company in the hope that it will continue to operate at the top of its game, every assumed risk should be carefully examined, whether it is an “environmental” risk (now almost universally shifted to buyer), deal risk, or risk of running the company. Buyers should ask whether they will be willing to part with as much cash as they have agreed to pay if, e.g., there is a severe downturn in the industry, or a change in law that will affect operating results. This is particularly true in deals where regulatory approvals or other factors will delay closing, allowing greater time for material adverse changes to develop. Hopefully we will see the pendulum swing back before a buyer’s CEO is forced to tell his board that yes, there has been an unforeseen, sustained, and severe downturn in target’s business, but we are still buying it.

Endnotes

[1] See ABA 2007 Strategic Buyer/Public Target Deal Points Study (Nov. 5, 2007) and ABA 2011 Strategic Buyer/Public Target M&A Deal Points Study (Dec. 29, 2011).
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[2] Note that this carve-out also indirectly has the effect of waiving certain breaches of representations by target. If target has breached its “material contracts” or “no consents” representations by failing to schedule the IP license as a material contract that required consent, the breach will not have a material adverse effect due to the carve-out. Termination rights for breaches of representations in a public company merger agreement generally arise only if the breach would give rise to a material adverse effect. (This was true in 100% of public deals in 2010; 87% in 2004.)
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[3] In re IBP, Inc. S’holders Litig., 789 A.2d 14 (Del. Ch. 2001).
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