Keep your mergers from falling apart: recent deals bring scrutiny to "material adverse change" clauses

Following several record-breaking years of merger and acquisition activity, recently several buyers are threatening to back out of signed deals by relying on the material adverse change clause. The material adverse change or material adverse effect clause acts as a condition to the parties' obligation to close the deal.   

The deals include the $25 billion buyout of student lender SLM Corp. (Sallie Mae) by a consortium led by J.C. Flowers, Inc., and the buyout of Harman International Industries, Incorporated (Harman) by Kohlberg Kravis Roberts & Co. L.P. (KKR) and GS Capital Partners VI Fund, L.P. (GSCP).

MAC clauses in merger agreements

The material adverse change (MAC) clause in a merger agreement, when used as a closing condition, permits the parties to allocate economic risk between the signing of the agreement and the closing of the deal. Generally, sellers typically prefer the tightest MAC clause possible to ensure that the transaction closes. Buyers, on the other hand, prefer a broader MAC clause to provide greater flexibility to renegotiate price or avoid their obligations entirely.

• Detailed article on MAC clause recommendations

MAC clause recommendations:

In reviewing these situations and the relevant case law, consider the following in drafting your MAC clauses:

1. Pay attention to detail in order to accurately reflect the parties' intentions.
   The language in a MAC clause can be difficult to carefully parse, but it is imperative to do so. The Sallie Mae case, in particular, highlights the fact that the parties' intentions must also be accurately reflected in the language of the MAC clause to be effective.
2. Avoid a reverse termination fee.
   The inclusion of a reverse termination fee and the exclusion of specific performance as a remedy can significantly alter the risk that the buyer will simply walk away from the deal. These fees should not be considered lightly.
3. Resist the use of forward-looking language.
   Some MAC clauses contain forward-looking language. This may be incorporated by including the "prospects" of the company in addition to the typical language. In addition, the verb choice in the MAC clause will often contain forward-looking language such as, "would have," "would reasonably likely to have," would be reasonably expected to have," or "could reasonably be expected to have." Forward-looking language favors the buyer and should be resisted by sellers, if possible. Including a broad forward-looking language MAC clause increases the level of uncertainty in an already complicated area.
4. Establish the burden of proof in the language of the MAC clause.
   The burden of persuasion and the evidentiary standard are ultimately important in determining whether a MAC has occurred, and therefore in the drafting of a MAC clause. Unfortunately, the answer is not as simple or straightforward as relying on the choice of law. Different claims and different states can give rise to different burdens of persuasion or evidentiary standards. In order to avoid these challenges, the parties should assign the burden of proof detailing whether the party wishing to terminate the deal or requesting specific performance must show the presence or absence, respectively, of a MAC. In addition, the parties should state whether the clear and convincing standard or the preponderance of the evidence standard should be used.
5. Provide a materiality qualifier for disproportional effects.
   Recent practice has been for sellers to carve out from the MAC definition those changes that effect the industry generally, provided that the changes do not affect the seller disproportionally. However, many lawyers have not modified this disproportionality exception by a materiality qualifier. For example, in the Sallie Mae deal, the merger agreement carved out "changes affecting the financial services industry generally; that such changes do not disproportionately affect the Company relative to similarly sized financial services companies."

Conclusion

Entering into any merger transaction is not without risks. If those risks arise between the signing and closing of the transaction, the buyer and seller attempt to allocate them between the parties through the MAC clause. In addition to careful drafting of the MAC clause, buyers should seek to minimize the uncertainty by reducing the amount of time between signing and closing. While this goal may be possible in an all-cash private transaction, often there are a number of hurdles which are outside the parties' control, such as shareholder approval, Securities and Exchange Commission review of the registration statement, antitrust review or other regulatory approvals. The MAC clause is not a perfect technique to clearly allocate these risks. However, with careful and thoughtful drafting, it can be a useful tool to do so.

Allen Matkins Corporate Attorneys listed below have extensive experience representing companies in mergers and acquisitions.