Material Adverse Change Clauses:

One Size Doesn't Fit All I

A. "Material adverse change" (or "material adverse event") clauses - commonly known as "MACs"- are a common means of allocating the risks presented by adverse business or economic developments occurring between the signing and the closing of a merger or acquisition agreement.

B. While sometimes viewed as "boilerplate" or "standard" provisions of merger and acquisition agreements, should not be viewed as a "one size fits all" commodity.

1. Judicial analysis of MACs is heavily dependent not only on the language of the overall agreement, but the particular facts presented.

2. Buyers cannot assume that broad MAC language will cover virtually any adverse economic development.

a) Especially in an economic environment in which business performance, stock prices and external market conditions, are subject to rapid and sometimes unpredictable change, MACs should be carefully drafted, and carefully analyzed when invoked, in light of the particular facts and circumstances surrounding the transaction, and the objectives and concerns of the parties to the transaction.

II. Any analysis of a MAC must begin - although it may not end - with the language negotiated by the parties.

A. A MAC may be defined as an event, change or occurrence which, individually or together with any other event, change of occurrence

1. has [or would have] [or may have] [or may reasonably be like to have] [or causes] [or may be reasonably likely to cause]

2. a material adverse effect[or a material adverse change]

3. on the financial position, business, properties, assets or results of operations [or prospects] [or value]

4. of the Company and it subsidiaries [taken as a whole].

B. Modifications and Exclusions

1. Some clauses explicitly include adverse effects on the Company's "prospects," or implicitly include such effects by referring to changes which "may" adversely affect the Company's performance.

2. Some clauses explicitly exclude changes or effects caused by conditions disclosed to the buyer prior to the signing of the agreement, or matters which are the subject of express representations and warranties.

3. Some clauses explicitly exclude certain external market conditions affecting the U.S. or global economy as a whole.

4. Some clauses explicitly exclude possible legislative or regulatory changes that may affect the parties' businesses going forward.

5. Some clauses contain explicit "materiality thresholds" excluding adverse effects which do not exceed a specified dollar figure.

6. Some clauses contain explicit exclusions for effects or change caused by announcement of the transaction itself.

III. Despite the obvious importance of drafting, MACs are rarely construed based on the language of the MAC alone; instead, courts often look to the circumstances surrounding the proposed transaction to divine the parties' intentions.

A. Because the question of materiality is fact-specific, it is often difficult for buyers to get complaints dismissed, or for either buyers or sellers to get summary judgment, based on the language of the MAC alone.

1. For example, in Pine State Creamery Co. v. Land-O-Sun Dairies, 201 F.3d 437 (4thCir. 1999), the Fourth Circuit ruled that the question of whether the sudden emergence of operating losses during a two month period between signing and closing was "material" could not be resolved as a matter of law, but was instead a question for the jury.

2. The ruling reversed the district court's grant of summary judgment in favor of the seller, which had gone into bankruptcy after the buyer terminated an asset purchase agreement. The seller had argued that the buyer's termination was not justified by the sudden emergence of operating losses following the signing of the agreement, since the transaction involved the purchase of assets rather than the acquisition of a going concern.

3. However, the Fourth Circuit found evidence that the parties had considered the seller's continued profitability to be material, as reflected in the incorporation of the seller's financial reports into the agreement. The question of whether the extent of the losses was "material" for purposes of the MAC - given the seasonal nature of the seller's business - was a question of fact which could not be resolved on a summary disposition.

B. In the absence of an explicit definition of materiality, the courts may look to what a "reasonable acquiror" in similar circumstances would believe is material, assuming the existence of a fully developed factual record.

1. In IBP Inc. v. Tyson Foods, Inc., 2001 Del. Ch. LEXIS 81 (June 15, 2001), the Delaware Chancery Court (applying NY law) ordered specific performance of a merger agreement after construing a MAC to exclude short-term deteriorations in performance that had not been shown to affect the long-term performance of the seller, despite the fact that there was no such explicit limitation in the broad language of the MAC.

a) IBP warranted that it had "not suffered a material adverse effect" since the "balance sheet date" except as set forth elsewhere in the agreement. A material adverse effect was defined as "any event, occurrence, or development of a set of circumstances or facts which has had or reasonably could be expected to have a Material Adverse Effect...on the condition (financial or otherwise), business, assets liabilities, or results of operations" of IBP or its subsidiaries "taken as a whole."

b) Tyson argued that a deterioration in IBP's sales performance over two quarters triggered the MAC clause, permitting it to terminate the agreement.

c) The Court found that the deterioration in IBP's sales performance over two quarters compared to the prior years results, if annualized, would be "consequential" to a reasonable acquiror. However, there was no evidence in the record that demonstrated that the deterioration was more than short term; to the contrary, there was evidence in the record that IBP's business was seasonal, and that Tyson knew this.

d) The Court thus turned to the "larger context" in which the parties were negotiating to inform the appropriate standard of materiality.

e) Noting that merger contracts between sophisticated parties are "heavily negotiated and cover a large range of specific risks explicitly," the court found that the lack of a specific clause dealing with short-term changes in performance meant that the MAC applied only to "fundamental events that would materially affect the value of a target to a reasonable acquiror."

f) The court found that, with respect to long term strategic buyers, such as Tyson, even a broadly worded MAC clause should operate as a "backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner."

2. The Chancery Court's construction of the MAC to apply only to "durationally-significant" changes in IBP's performance was especially noteworthy given that the MAC in question ­ unlike many others ­ contained forward-looking language that expressly included events or occurrences "that reasonably could be expectedto have a material adverse effect...." Even with a forward-looking MAC, Tyson was unable to prove materiality simply by annualizing the impact of a short-term decline.

3. The Chancery Court also rejected Tyson's assertion that the IBP's write-off of the value of a subsidiary constituted a MAC, either by itself or together with the deterioration in IBP's sales performance.

a) Tyson had been alerted to the impairment of assets at the subsidiary prior to the signing of the agreement.

b) The write-off was a one time charge against a subsidiary which contributed only 1% of IBP's overall earnings.

c) The inclusion of possible additional liabilities relating to the subsidiary in a schedule of liabilities excluded from IPB's financial representations and warranties undercut Tyson's argument that the write-off was material.

C. Explicit definitions of materiality may not preclude fact questions where ambiguity arguably exists as to other terms of the MAC.

1. For example, in Great Lakes Chemical Corp. v. Pharmacia, 2001 Del. Ch. LEXIS 85 (June 29, 2001) the Delaware Chancery Court declined to dismiss Great Lakes' claims for breach of a MAC in its agreement to purchase NSC, a Pharmacia subsidiary.

a) Pharmacia had warranted that there had been "no change in the business of [NSC, a subsidiary] that would have a Material Adverse Effect." A Material Adverse Effect was defined in the agreement as "a negative effect or a negative change on the operations, results of operation or condition(financial or otherwise) in an amount equal to $6,500,000 or more."

b) Great Lakes alleged that various external market factors, including price cutting in the aspartame market, and the precarious financial condition of one of NSC's customers, had significantly affected Pharmacia's business adversely.

c) However, Pharmacia argued that the MAC clause by its terms did not apply to changes caused by external market conditions.

(1) On the one hand, neither the MAC itself nor the definition of "material adverse effect" distinguished between internal and external causes.
(2) On the other hand, all of the express representations and warranties made by Pharmacia in the agreement concerning the condition of its business related to internal, as opposed to external, factors. Pharmacia argued that this reflected the parties' intention to limit the MAC only to internal factors.

d) The court found that while Pharmacia's interpretation was reasonable, the broad term "business of the Company" could also reasonably be read to include diminished sales resulting from external market factors.

e) Noting that Great Lakes and Pharmacia were sophisticated parties capable of writing exclusions into the MAC had they so intended,the court found that the question of whether changes caused by external factors were excluded could not be resolved as a matter of law.

2. See also Polycast Technology Corp. v. Uniroyal, Inc., 792 F.Supp. 244 (S.D.N.Y. 1992) (question of whether the cancellation by seller's customer of a major contract constituted a material adverse change in the seller's business was a question of fact precluding summary judgment).

D. However, courts have generally been reluctant to find a MAC ambiguous based on the lack of a specific exclusion for "prospects." To the contrary, courts have generally declined to read forward-looking concepts into a MAC where none are expressly included.

1. Pacheco v. Cambridge Technology Partners, 85 F.Supp 2d 69 (D. Mass 2000) (granting summary judgment against buyer alleging that declines in target's revenue growth rates over a two month period constituted an actual change in performance, as opposed to a deterioration in projected performance).

2. Goodman Mfg. Co. v. Raytheon, 1999 WL 681382 (S.D.N.Y. Aug. 31, 1999) (dismissing allegation that change in target's production status constituted a change in financial condition, where agreement disclaimed representations or warranties as to future performance).

3. S.C. Johnson & Son, Inc. v. DowBrands, Inc.,167 F. Supp 2d 657 (D.Del. 2001) (dismissing claim that filing of patent infringement suit by third party against seller constituted an material adverse change; because the infringement claim had not yet been adjudicated, the only effect the claim could cause was prospective, rather than actual).

IV. What to Consider at the Negotiation/Drafting Stage

A. Obviously, buyers and sellers have different objectives in negotiating and drafting MAC clauses.

1. Sellers want an acquisition agreement with as few "outs" as possible.

a) In volatile markets, or where the economic trends are uncertain, the seller will try to exclude changes in external market and economic conditions, as well as changes in the company's "prospects."

b) A seller with seasonal or cyclical earnings, like IBP, may wish to include a defined monetary or temporal threshold of materiality.

c) Sellers will also want to pay close attention to the interaction of their representations and warranties, and the MAC clause.

(1) As noted above, while Tyson tried to argue that the write-off by an IBP subsidiary constituted a MAC even if it did not constitute a breach of a representation and warranty concerning IBP's financial statements, the Chancery Court found that the exclusion of potential write-offs from IBP's reps and warranties concerning its liabilities under cut this argument.
(2) The Chancery Court found relevant to the interpretation of the Pharmacia MAC clause ­ although not dispositive on a motion to dismiss ­ that all of Pharmacia's specific reps and warranties concerned internal developments, rather than external market factors.

2. Buyers will want maximum flexibility to consider their options in changed economic circumstances.

a) Note that in IBP v. Tyson, the Chancery Courtlimited a broadly worded MAC clause with no exclusions in part because a "contrary rule will encourage the negotiation of extremely detailed `MAC' clauses with numerous carve-outs or qualifiers. An approach that reads broad clauses as addressing fundamental events that would materially affect the value of a target to a reasonable acquiror eliminates the need for drafting of that sort."

(1) Ironically, however, the result in IBP v. Tyson could lead a "reasonable acquiror" to conclude that explicit drafting ­ for example, the setting of a monetary materiality threshold ­ is extremely important.
(2) This is particularly true given that the MAC in IBP v. Tyson was read narrowly despite orward-looking language which included changes would could be "expected" to cause a material adverse effect.
(3) In light of the ruling, buyers may not wish to rely solely on the inclusion of forward-looking language in the MAC, but may also seek to include explicit ­ and relatively low ­ thresholds of materiality.

b) A reasonable "acquiror" might also want to make clear that even if changes in external economic or market conditions, by themselves do not constitute a MAC, the agreement is drafted so as to clearly include ­ unlike the clause in Great Lakes ­ actual material adverse changes in performance or results regardless of whether they are caused by external market factors.

3. Where an agreement is an equity transaction or a "merger of equals," reciprocity will be an important issue, and it may not be clear which party is more likely to invoke the MAC clause.

a) In such cases, it is important to recognize that a court considering extrinsic evidence to construe a MAC is likely to look at the respective positions the parties took the negotiation of the agreement.

b) See e.g. Allegheny Energy, Inc. v. DQE, Inc., 74 F. Supp 2d 482 (W.D. PA. 1999) (in rejecting plaintiff's narrow construction of a MAC, the court took note of the fact that plaintiff had sought a MAC that would cover a broader range of events).

V. What to Consider at the Termination/Litigation Phase

A. Remember the previous positions you've taken, even if ­ or especially if ­ you no longer agree with them.

1. For an acquiror considering invoking a MAC clause to terminate the agreement, make clear your reliance on the MAC clause even before litigation starts.

a) In IBP v. Tyson, the Chancery Court found significant the fact that Tyson's contemporaneous public statements about its reasons for terminating the agreement did not include the assertion that IBP had suffered a MAC.

2. Be aware of the negotiating history of the provision ­ and any related representations and warranties ­ and be prepared to explain any perceived inconsistencies between your negotiating position and your litigation position. See Allegheny v. Uniroyal, suprA.

B.. Don't assume that forward-looking language in the MAC will cover any and all adverse effects on future performance. Even where actual results have been adversely effected, be prepared to demonstrate why such changes should ­ or shouldn't ­ be considered more than a "short-term hiccup."

1. In IBP v. Tyson, the Chancery Court acknowledged that IBP's first quarter was "subpar," and its downturn, if annualized, would be considered "consequential" to a reasonable acquiror.
2. But the court found Tyson's failure to present expert evidence that quantified the diminution of IBP's value or earnings potential in light of its first quarter performance to be "significant."

a) IBP's failure meet its projections were not sufficient evidence of materiality, since it had never warranted that it would meet those projections.

b) This gap in proof was all the more significant given that Tyson's investment banker had concluded a purchase of IBP at the deal price was a "great deal" for Tyson even if pessimistic projections were used. 3. By contrast, IBP presented evidence tending to show that its "subpar" first quarter performance was due to the inherently cyclical nature of its business, and non-recurring circumstances.

C. Where the MAC does not contain forward-looking language, buyers should be prepared to confront judicial skepticism concerning arguments that downward revisions in projections, or declines in growth rates, standing by themselves, constitute changes in the business or financial condition of the seller.