MAC is Back! MAC is Back! MAC is Back!
Corporate & Finance Alert
November 11, 2008
No, not a stunning come from behind victory by John McCain on this occasion. Instead, the re-emergence of a perennial M&A favorite – the material adverse change (“MAC”) clause. Today’s uncertain economic environment requires both potential buyers and sellers to think hard about the inclusion of a MAC provision.
A MAC or material adverse effect (“MAE”) provision in a M&A agreement generally serves two very different purposes. First, a MAC definition provides a materiality qualification with respect to representations made by the Seller in the M&A agreement and therefore, protection to the Seller for any claimed breach of such representations. For example, it is common to see a representation relating to compliance with laws to be triggered only if non-compliance also amounts to a MAC or has a MAE.
The more important use of a MAC definition is to establish a condition precedent to the Buyer’s obligation to close based upon a deteriorated state of affairs that will permit a buyer to walk away from a deal prior to closing, often without penalty. This latter use is commonly known as a “MAC out” and appears among other conditions precedent in the M&A agreement that must be satisfied before a buyer is contractually obligated to close the deal.
MAC out provisions in large public transactions have become increasingly complex with sellers seeking to narrow the MAC definition by including an extensive list of exceptions. In turn, buyers have included exceptions to the exceptions. For example, a standard exception to the MAC definition is to exclude changes “resulting from general economic, financial, regulatory, or market conditions.” An exception to this exception would be to add a requirement that such change “not affect the target in a materially disproportionate manner as compared to other companies operating in the target’s line of business.”
MAC concerns are not only for parties engaged in mega-deals. A buyer of any sized business in today’s volatile and recessionary economy should be concerned about abrupt and dramatic changes to a target company. Sellers on the other hand are increasingly concerned that the credit crisis will force previously willing buyers (or their financiers) to change heart on a deal and look for any way to back out. A MAC is often the only potential escape route for a Buyer to terminate a M&A agreement without liability to the Seller. The current uncertainty in the economy and the financial markets means that MAC provisions are likely to receive increased attention by parties’ lawyers who are keen to protect their client’s interests. A difficult balance is likely to ensue between specificity in what amounts to a MAC and breadth to capture items that are not readily apparent at signing of the agreement.
The recent Delaware Chancery Court decision in Hexion Specialty Chemicals v. Huntsman Corporation highlights the difficulties that buyers face when seeking to rely on a MAC event to avoid their obligations to close a deal.
In July 2007, Hexion, which is 92 percent owned by Apollo Global Management and its related entities, entered into an all-cash merger agreement to acquire Huntsman in a transaction valued at approximately $10.6 billion. Following the signing of the merger agreement, Huntsman suffered several consecutive quarters of poor performance. Hexion subsequently filed a complaint seeking, among other things, a declaration that Huntsman had suffered a MAC, thus excusing Hexion from its obligation to close.
The court’s opinion provided a clear message for buyers – you can not rely on a general MAC condition to allow you to walk from a deal.
The court made it clear that a MAC is difficult to prove and the onus is on the buyer. Indeed, Judge Lamb noted that no Delaware court had ever found for a buyer on a MAC claim. He relied heavily on Vice Chancellor Leo E. Strine Jr.’s opinion in the 2001 case of IBP v. Tyson to describe a MAC as being a “significantly durational” adverse event “expected to persist in the future”, i.e. a MAC event needed to have a long-term impact, possibly years rather than months.
Hexion claimed that Huntsman suffered a MAC under three different theories: (i) disappointing results in earnings from July 2007 to the present, relative to projected performance; (ii) an increase in net debt since signing, contrary to the parties’ expectations; and (iii) underperformance by two of Huntsman’s divisions. The court dismissed all of Hexion’s arguments.
Although Huntsman’s disappointing financial performance was well below management’s projections, the court instead compared Huntsman’s current financial performance against its historical financial performance over comparable periods, and found that Huntsman’s disappointing financial performance did not rise to the level of a MAC. It ignored the projections.
Hexion claimed that Huntsman’s net debt increased by 5 percent post-signing, despite management’s projections that net debt would decrease by 30 percent. The court found that Apollo and Hexion had assumed, in their own financial models, that Huntsman’s net debt would remain constant. As a result, the court concluded that because the reduction of net debt was merely an “added attraction” of the deal, Hexion could not claim that a 5 percent increase in net debt was a MAC.
The court noted that a MAC was measured against Huntsman and its subsidiaries as a whole, accordingly, even if there was a MAC at a particular division, to excuse Hexion’s obligations to close, the MAC must be considered in the context of Huntsman’s consolidated business.
The Huntsman court made clear that a party terminating an agreement based on the occurrence of a MAC faces a very heavy burden. Because buyers are assumed to be purchasing the target as part of a long-term strategy, courts will look well beyond the current financial cycle (and even beyond a full year) to determine if a MAC has occurred. The court’s “contextual” analysis may include not only the terms of the agreement, but also financial models and industry-related information known to the buyer before signing.
When negotiating M&A agreements, parties should carefully consider specific pre-closing adverse financial scenarios that may cause the buyer concern. Because of the heavy burden placed upon buyers attempting to terminate based on a MAC claim, the buyer needs to be specific regarding quantifiable adverse events. If, as in Huntsman, a buyer expects a target’s performance to essentially track projections during a pre-closing period, although not customary, it would be advisable to include specific EBITDA or other quantitative benchmarks (eg., sales, net working capital, etc.) in the agreement. Similarly, if a buyer is concerned about the target’s principal customers or suppliers, then the MAC should provide a specific standard (eg., a percentage loss based on existing sales or purchase volumes) which, if met, would trigger a MAC event. In this unsettled credit market and economy, a well advised Buyer or Seller should only enter into an M&A agreement with specific and quantitative MAC triggers to avoid unanticipated disputes and contractual liability if the target’s circumstances from signing the agreement to closing have adversely changed.