Gregory R. Bishop
gbishop@williamsmullen.com

Business Law Today, March/April 2002. Copyright 2002 ABA.
Reprinted with permission from Business Law Today.  All rights reserved.  This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

They had high hopes for the merger. But then things didn't seem as promising as they once were. The buyer wanted out. Why? Could they get away with it?

Courts' interpretations of material adverse change (MAC) clauses in purchase and merger agreements are typically fact specific — making clear legal guidance in this area hard to find. Whenever a party to such an agreement decides to end a deal on the basis of a MAC, a battle between the parties as to the meaning of MAC normally follows. Unfortunately, sufficient legal precedence and principles are not available to guide the parties in such disputes. Therefore, long and drawn-out litigation often results.

In IBP Inc. v. Tyson Foods Inc., 2001 WL 675330 (Del. Ch. June 18, 2001), the court saw the need for guidance. Unlike previous cases, the Tyson decision provides helpful, contemporaneous insight on how a Delaware court — popular for its rich body of corporate case law — might interpret a MAC clause. The court seemed particularly determined to prevent parties with "buyer's remorse" from using the MAC clause to renege on a deal. This decision is timely in light of the recent economic downturn and the terrorist attacks on Sept. 11. These events could increase the frequency of buyers (primarily) using MAC clauses as a reason to terminate transactions.

For example, British advertising giant WPP Group PLC attempted to abandon its bid for Tempus Group PLC citing that the advertising slump following the Sept. 11 attacks had caused a material adverse change in Tempus' business, thus triggering the MAC clause (Britain's Takeover Panel rejected WPP's argument).

Also, Dynegy Inc. terminated its merger plans with Enron Corp. on the discovery of financial problems and suspected accounting irregularities at Enron (claiming Enron had violated the MAC clause). Enron filed suit against Dynegy alleging "breach of contract in connection with Dynegy's wrongful termination of its proposed merger with Enron." Enron also filed for Chapter 11 federal bankruptcy protection.

This article reviews the court's decision in the Tyson case and offers practical advice for business lawyers to consider when drafting MAC clauses.

In the latter part of 2000, Tyson Foods Inc. and Smithfield Foods Inc. competed to acquire IBP Inc. IBP accepted Tyson's bid and entered into a merger agreement with Tyson on Jan. 1, 2001. Prior to this agreement, IBP made Tyson aware of a downturn in its business cycle (that would cause IBP to fall well short of its 2000 earnings projections) and serious financial problems with one of its subsidiaries. However, Tyson continued to pursue IBP by increasing its bid for IBP over Smithfield.

Through this merger, Tyson hoped to create the world's largest meat products company. Also, by merging with IBP, Tyson could ensure that Smithfield would not become the world's largest meat products company. Therefore, the merger would accomplish two of Tyson's primary goals.

The severe winter of 2001 hit livestock supplies and vitality. That caused both Tyson and IBP to experience weaker than expected financial performance for the first half of 2001. Based on this and other factors, Tyson started to slow down its merger with IBP. Although Tyson cited accounting and SEC problems with one of IBP's subsidiaries as the reason for this slowdown, the actual reason appeared to be buyer's remorse — Tyson wished it had either agreed to pay less for IBP or had not entered into the transaction in the first place. On March 20, 2001, Tyson decided to terminate the merger.

Once Tyson made that decision, it began to organize the legal effort to support the decision. Among other legal reasons chosen (beyond the scope of this analysis), Tyson asserted that IBP had suffered a MAC within the meaning of the merger agreement that excused Tyson's failure to close the merger.

Although "confessedly torn about the correct outcome," the court held that IBP had not suffered a MAC within the meaning of the merger agreement and did not excuse Tyson's failure to close the merger. For this and other reasons, the court granted IBP's claim for specific performance of the merger agreement (granting specific performance of a merger agreement is somewhat unusual).

The following analysis focuses on the court's reasoning in holding that IBP had not breached the MAC clause of the merger agreement (after this decision, Tyson decided not to pursue an appeal, but to go ahead with the merger).

Tyson claimed that the decline in IBP's financial performance toward the close of 2000 and in the first quarter of 2001 as well as a significant "asset impairment charge" at one of IBP's subsidiaries together constituted a MAC. Section 5.10 of the merger agreement is a representation and warranty that IBP had not suffered a MAC since the "balance sheet date" of Dec. 25, 1999, except as set forth in the "warranted financials or Schedule 5.10" of the merger agreement.

The merger agreement defined a MAC as "any event, occurrence or development of a state 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] and [its] subsidiaries taken as a whole."

Although the court found the definition of a MAC to be simple, it found the application of the definition to be complex. First, the court had to decide the "time frame" the parties intended in determining whether a MAC had occurred. For instance, a short-term financial investor would be more concerned with whether a company met analysts' quarterly projections, whereas a strategic buyer would likely be more sensitive to a company's long-term prospects. Given Tyson's desire to be the world's largest meat products company and other factual considerations, Tyson did not fit into the short-term investor category — that is, when bidding against Smithfield, Tyson did not appear concerned about the current financial condition of IBP.

By this reasoning, the court did not intend to imply that Tyson was unconcerned with the financial condition of IBP. Rather the court was merely pointing out that in order to determine if a sudden downturn in business was to be considered material for purposes of interpreting the MAC clause, it would first have to determine Tyson's objectives for merging. Tyson's goals in negotiating and drafting the merger agreement were clearly long term in nature, thereby making Tyson a strategic investor.

Once the court concluded that Tyson was a strategic investor, it had to determine whether IBP's business downturn was temporary or cyclical (and, thus, not "material" for a strategic investor) or indicative of a more serious, long-term, problem. The court found that IBP's business downturn did not represent a significant, long-term, problem with IBP.

The data provided shows that IBP has been consistently profitable, but subject to strong swings in annual EBIT and net earnings. The data also points out that such swings in IBP's performance are a part of its business reality and considered typical in its industry.

Also, in May 2001 (just after Tyson decided to terminate the merger), IBP's performance began to improve as the supply of cattle held back during the harsh winter was being released into the market. This provides further evidence as to the cyclical nature of IBP's business. As for Tyson's concerns with the SEC and accounting problems of IBP's subsidiary, the court did not find the subsidiary's operations material to IBP taken as a whole.

Next, the court found Tyson's claim that IBP breached the MAC clause as merely a pretext for Tyson's true reason for ending the merger — buyer's remorse. When Tyson announced its intention to terminate the merger, the company did not include an assertion that IBP had suffered a MAC. The court also stated that the "post-hoc nature of Tyson's arguments bears on what [Tyson] felt the [merger agreement] meant when contracting [that is, a strategic merger], and suggests that a short-term drop in IBP's performance would not be sufficient to cause a [MAC]."

Facts leading up to Tyson's termination of the merger, including the fact that Tyson too was experiencing a significant business downturn, support the supposition that Tyson was experiencing buyer's remorse and looking for a way out of the deal.

Finally, in addition to those fact-based reasons, the court also cited certain policy considerations in its decision. The court sought to determine on which party (buyer or seller) the burden of uncertainty falls when faced with difficulty in interpreting a MAC clause. The court did not find existing case law helpful in that it cuts in both directions. Therefore, the court concluded that "[p]ractical reasons lead [the court] to conclude that… a buyer ought to have to make a strong showing to invoke a [MAC] exception to its obligation to close."

The court reasoned that merger agreements are heavily negotiated and cover many specific risks explicitly. Thus, a party invoking a MAC clause should expect to encounter the difficult task of overcoming a strong public policy in favor of closing a merger agreement.

Because of this, when a MAC provision is broadly written, like this one, it should only be considered 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." Short-term performance swings and known accounting improprieties experienced by an IBP subsidiary did not fall into this category.

The court also noted that a contrary rule would encourage the negotiation of extremely detailed MAC provisions with many carve-outs and qualifiers. Therefore, by interpreting broad clauses, such as here, as addressing fundamental events that would materially affect the value of a target to a "reasonable acquiror" eliminates the need for drafting such extremely detailed MAC provisions. The court stated that a policy decision emphasizing a short-term approach would lead to merger agreements more difficult to negotiate and lead to MAC clauses that are overly complex.

Unlike most prior case law interpreting MAC clauses that provides little practical precedential assistance, the Tyson court seems to be sending a clear message. Merger agreements, by their nature, are heavily negotiated documents, and public policy is in favor of making sure the parties honor the spirit of such agreements.

Therefore, any party wishing to terminate a deal on the basis of the broad language of a MAC clause must be able to demonstrate that the "adverse change" is of such a quality and magnitude to overcome a strong presumption in favor of closing the transaction. That will be particularly difficult if the court suspects that the true reason for the termination is buyer's remorse.

The following provides some helpful advice to consider when drafting MAC clauses in purchase or merger agreements. Ideally, an effectively drafted purchase or merger agreement will reflect the factual circumstances of each party at the time of the agreement and a broadly written MAC clause will provide "backstop" protection for events outside the scope of reasonable consideration by either party. Such drafting is less likely to be litigated, thereby allowing the parties, not the courts, to decide the meaning of their agreement. Practically, however, this needs to be considered in light of the perspective of the parties drafting the MAC clause.

The "buyer" should specifically address risks of which the buyer is aware. Ratios, performance benchmarks and other financial tests (objective criteria) are common methods used to determine thresholds for such specifically identified risks. Care should be taken, however, to not be "overly" specific (as courts could find that such a high level of specificity rules out other risks not otherwise specified).

The buyer should also include potential adverse events not within the seller's control. Courts often find the following events to fall outside the scope of a MAC (unless specifically included):

• events from the announcement or consummation of the transaction;

• business turndowns (generally or industry wide);

• enactment of legislation;

• cancellation of a significant contract; and

• future prospects of the seller.

Therefore, if the buyer wishes such events to trigger the MAC clause, they should be specifically included. After the buyer includes those risks that can be reasonably identified, the most comprehensive, general language should be included to cover unknown risks (both within and outside the seller's control).

Remember the lesson from the Tyson case — courts are not likely to allow a buyer to back out of a transaction due to buyer's remorse. If a buyer is concerned about something specific, it should include that concern in the agreement. The broad language of a general MAC clause should only be triggered by a "durationally significant" event.

The "seller" should attempt to limit all of the specific carve-outs proposed by the buyer — especially those over which it has no control (that is, general or industry economic conditions and adverse effects resulting from the performance of the purchase agreement). The seller should seek to eliminate the remaining specific carve-outs, such as financial benchmarks (over which it does have control), or at least negotiate the benchmarks so that the risks of such benchmarks triggering a MAC are low.

The seller will likely encounter heavy resistance to eliminate (or limit) these financial benchmarks. The seller might also propose specific carve-outs that do not trigger a MAC. Finally, the seller should attempt to limit the scope of the MAC clause by a qualification requiring "knowledge" of material adverse events.

Both the buyer and seller should consider whether disputes relating to the MAC clause (or the purchase/ merger agreement generally) should be resolved by the courts or through binding arbitration. This decision is often driven by the specific facts of the transaction (such as, the court of competent jurisdiction, the arbitrator, etc.). Dispute resolution concerns are beyond the scope of this article because of the highly factual nature of such considerations, but are nonetheless important.

The objectives of the buyer and seller in drafting MAC clause language are typically at odds — as with most other elements of the negotiation process. The resulting agreement is usually a combination of negotiating and drafting skill as well as who has the most leverage (that is, the party more willing to walk away from the deal). Therefore, the corporate lawyer should draft the best scenario for his or her client and negotiate from that point. Too often, seemingly small advantages are either overlooked or not otherwise asserted.

With the recent guidance provided by the court in the Tyson case and the practical advice contained in this article, putting your best foot forward in negotiating the MAC clause is an excellent opportunity to gain such an advantage for your client — especially in today's environment.