Bylined article by William Kucera and Charles Wu discusses the importance of material adverse effect clauses for M&A deals, especially within the current credit market turmoil.

As a result of recent credit market turmoil and general adverse economic conditions, there has lately been a significant increase in buyers attempting to renege on previously announced mergers and acquisitions (M&A) deals. Though such buyers are advancing a variety of claims and legal theories to support their positions, many of these arguments are based, in whole or in part, on an assertion that the target business has suffered a material adverse effect (MAE), also referred to as a material adverse change.

Some of these deals have resulted in a reduced purchase price after renegotiations (e.g., the acquisition of the Home Depot Inc.'s supply unit by an investor group led by Bain Capital LLC and the acquisition of Accredited Home Lenders Inc. by Lone Star Funds), some have been terminated by the parties upon mutual agreement (e.g., the merger between MGIC Investment Corp. and Radian Group Inc.) and some have ended up in court (e.g., the acquisition of Genesco Inc. by Finish Line Inc., which resulted in the court decision described below). Though these broken transactions were resolved in a variety of ways, the MAE clause undeniably played a critical role in shaping the parties' strategies and positions in each of these matters.

The MAE clause is a mechanism for parties to allocate risk of adverse changes to the business being sold between signing and closing. Such clauses typically provide that if, between the signing and closing of the transaction, the business being sold suffers a material adverse effect (the definition of which is typically highly negotiated), the buyer is not obligated to close the transaction. Notwithstanding the prevalence of MAE clauses in M&A agreements, there have been only two significant court decisions on this topic: the seminal 2001 decision of In re IBP Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001), and the subsequent Frontier Oil Corp. v. Holly Corp., No. Civ.A. 20502, 2005 WL 1039027 (Del. Ch. April 29, 2005).

In IBP, the court, applying New York law, held that as a procedural matter the party seeking to terminate an agreement on account of the fact that the other party had suffered an MAE has the burden of proving that the MAE had occurred. In addition, the party seeking to prove an MAE must establish that the event in question was "unknown" to the terminating party prior to the execution of the agreement and the event substantially threatened the overall earnings potential of the target company in a "durationally-significant" manner. In light of this high bar, the court in IBP rejected Tyson Foods Inc.'s claim that IBP Inc. had suffered an MAE despite a downturn in IBP's beef business and significant accounting issues at one of IBP's subsidiaries.

The Frontier court, applying Delaware law, followed the IBP decision and reaffirmed the rule that the burden is on the party claiming that an MAE occurred to prove that it did occur. In applying this rule, the court in Frontier held that Holly Corp. had not established that the filing of a mass toxic tort lawsuit against Frontier Oil Corp. constituted an MAE even though the court acknowledged that it might be "difficult" for Frontier to pay the cost of defending the suit and the consequences of the suit could be "catastrophic" to Frontier. This holding was particularly eye-opening insofar as Holly had identified the risk of this potential litigation prior to signing and specifically attempted to mitigate this risk via the MAE clause. Thus, the Frontier decision amplified the message delivered by the IBP court: The bar of establishing an MAE is high and buyers should be cautious about relying on an MAE clause to get out of a deal.

The Tennessee Chancery Court's December 2007 decision in Genesco Inc. v. Finish Line Inc., No. 07-2137-II (III) (Tenn. Ch. Dec. 27, 2007), provides the most recent judicial guidance on MAEs. Genesco and Finish Line, both retailers in the footwear industry, entered into a merger agreement in June 2007 whereby Finish Line agreed to acquire Genesco for $1.5 billion in cash. Finish Line planned to finance the highly leveraged transaction with funds borrowed from UBS A.G. The agreement contained a relatively standard MAE definition. The definition included a "general economic conditions" carve-out that provided that changes in general economic conditions affecting Genesco's industry could not constitute an MAE unless such changes adversely harmed Genesco "in a materially disproportionate manner." A few weeks after the agreement was executed, Genesco sustained a significant drop in earnings in the second quarter of 2007, one of its worst in 10 years. At the same time, the credit markets began to feel the full effect of the credit crisis, causing UBS to admit in its court filings that funding the Genesco deal would result in a huge loss for UBS.

In light of these developments, Finish Line and UBS pressured Genesco to renegotiate a lower price for the deal. Genesco refused and sued Finish Line in the Tennessee Chancery Court, seeking specific performance. Finish Line responded that it was not obligated to complete the transaction because of the occurrence of an MAE on Genesco.

Finish Line introduced experts who testified that Genesco's decline in earnings was due to intraindustry conditions (i.e., not general economic conditions) and were disproportionate compared to its peers in the footwear industry. Relying on its own experts, Genesco countered that its losses in 2007 were due to general economic conditions such as high gas prices, housing and mortgage issues and rising consumer debt; were not disproportionate compared to its peers; and, therefore, qualified under the general economic conditions carve-out. Chancellor Ellen Hobbs Lyle agreed with Genesco and ordered Finish Line to complete the acquisition.

Although the order of analysis in the opinion was reversed, in reading the opinion as a whole one finds that, as an initial matter, Lyle found that the adverse consequences suffered by Genesco were significant enough to constitute an MAE. Lyle reached this conclusion by applying the rules set forth in IBP, among other factors. However, before one reads the Genesco decision to undermine the high bar of establishing an MAE set by IBP and Frontier, one must note that Lyle applied a very broad reading of the general economic conditions carve-out and concluded that, although the problems suffered by Genesco were sufficiently bad so as to rise to the level of an MAE, these problems were attributable to general economic conditions and thus could not, in light of the general economic conditions carve-out, be taken into account in determining whether an MAE had occurred. Therefore, the Genesco decision, taken as a whole, is consistent with the message sent by IBP and Frontier: M&A practitioners should be wary of relying on MAE clauses to get out of a deal.

MAE clauses still play key role  

Despite the potential difficulty of establishing an MAE as illustrated by the judicial decisions described above, this should not be taken by M&A practitioners to mean that MAE clauses do not have value in M&A agreements. In fact, quite the opposite is true: Even though, based on the precedent, it may ultimately be difficult for a buyer to establish that a target business suffered an MAE in a fully litigated case, in many instances the mere claim by a buyer that an MAE has occurred may provide the buyer with sufficient leverage and instill in the seller sufficient uncertainty that the parties come to a negotiated resolution long before a court has a chance to rule on the matter.  

This phenomenon is illustrated by several recent deals. For instance, in June 2007, Home Depot agreed to sell its supply unit to an investor group led by Bain Capital for a purchase price of approximately $10.3 billion. The investor group later alleged that the collapse of the housing market and the implosion of the credit market constituted an MAE on the target business, even though both changes arguably fell under the carve-outs of the MAE definition in the agreement. The parties eventually settled their dispute, with the buyers agreeing to close in exchange for Home Depot agreeing to a 17% reduction of the purchase price. Though the details of the parties' negotiations are not public, it probably is fair to assume that the buyers' threat of an MAE, even if it ultimately may have been difficult to establish in court, was one of the key factors that contributed to the resolution.

Similarly, Harman International Industries Inc., the audio equipment manufacturer, agreed in April 2007 to be acquired by Kohlberg Kravis Roberts & Co. (KKR) and Goldman Sachs for approximately $8 billion. In August 2007, KKR and Goldman sought to terminate the deal. Though the exact reasons why the buyers wanted out of the deal and the details of the parties' negotiations are not publicly known, public statements about the transaction made it clear that one argument put forth by the buyers was that Harman had suffered an MAE (Harman had suffered substantial losses for two consecutive quarters and had stated in a public filing that it might lose its contract with a customer that accounted for a significant portion of its net sales).

After some back and forth, the parties publicly announced a settlement to their dispute. In exchange for agreeing to purchase $400 million in convertible notes from Harman, KKR and Goldman were permitted to terminate the merger agreement without paying the $225 million reverse-termination fee provided for in the merger agreement. Although, again, the details of the parties' negotiations are not public and there were undoubtedly a variety of factors that contributed to the settlement, it seems pretty clear that one of the key factors was the buyers' threat of an MAE even though, based on IBP and its progeny, it might have been a challenge for the buyers to ultimately establish that an MAE had occurred.

Based on IBP, Frontier and, most recently, Genesco, buyers may have a difficult time convincing a court they are not obligated to proceed with an M&A transaction on account of the fact that the target business has suffered an MAE. However, this should not be taken to mean that MAE clauses are not valuable and should not be included in M&A agreements. Rather, as illustrated by a series of recent deals, the mere threat of an MAE may provide a buyer with a means to renegotiate or terminate a deal that the buyer no longer wants to, or is able to, complete on the original terms.

William R. Kucera is a partner in the Chicago office of Mayer Brown, specializing in M&A transactions. He can be reached at Charles Wu is an associate in the firm's corporate group. He can be reached at Melissa Kilcoyne, a 2008 summer associate at the firm, provided research and drafting assistance in connection with this article.