Will the MAC Clause Become a Permanent Deal Stopper? Dealmakers are struggling to prevent newly prominent material adverse change provisions from becoming automatic escape valves for fearful buyers and sellers

When m&a agreements are struck, the goal of both the buyer and the seller is to complete the deal as quickly as possible. Short of unexpected revelations about the condition of a target’s business, or, in some cases, the acquirer’s business, both sides typically follow a short timetable because there are strategic and financial advantages to wrapping up a deal expeditiously. Rarely have the parties attempted to use faltering general economic conditions or short-term downward swings in the target’s operating results as reasons to kill a deal. Tactics changed in many deals in 2001, a year that was anything but usual, as acquirers challenged the bounds of common practices by testing their ability to walk away from m&a transactions because of the economy or extraordinary developments at the target. To an almost unprecedented degree, buyers were testing the value and the limitations of the material adverse change (MAC) clause, an escape valve that, while a common feature in acquisition contracts, was rarely invoked in the past to break a deal. As manifested by the legal battle between Tyson Foods Inc. and IBP Inc., WPP Group PLC’s attempt to walk away from its acquisition of Tempus Group as a result of the September l1 terrorist attacks, and Dynegy Corp.’s disappearing act from a deal with Enron Corp., the 2001 m&a environment was marked by buyer’s regret, uncertainty, and wild gyrations in valuations. As a result, new tensions have been injected into deal negotiations and buyers, sellers, and their advisers must cope with new issues in framing and handling the MAC clause. The first major “MAC event” of the year was the Tyson Foods versus IBP litigation in the Delaware Chancery Court in which the court compelled Tyson to complete its merger with IBP in the face of Tyson’s argument that IBP’s business had suffered a material adverse change. The second was the apocalyptic day of September 11th. For the first time in history, the financial markets of the United States closed for four consecutive business days and the business world, chilled by the savagery of terrorism, put all bets on hold, prompting many buyers to raise MAC issues in pending deals. The third major MAC event was a return to the fundamental purposes of the clause as demonstrated by Dynegy’s “not a moment too late” termination of its merger agreement with Enron, just before the energy trader crashed into bankruptcy. This article examines lessons to be learned from the m&a activity of 2001 from both the acquirer’s and the target’s perspective by analyzing certain transactions that were impacted by MAC controversies. A MAC Primer Typical MAC clauses allow a buyer or seller to walk away from a transaction in the event of “a material adverse change in the business, operations, or financial or other condition of the other party.” A material adverse effect on the “prospects” of a party also may be included in that formulation. In most instances, targets will negotiate exceptions to a MAC clause to protect against material adverse changes that are not in the target’s control, such as changes in the general economy, the relevant industry, or the stock market. Most parties view MAC clauses as a key “worst-case scenario” provision; much like an insurance policy, you have it because it’s prudent but you hope to never use it. What’s Their Beef?: Tyson Foods vs. IBP From a lawyer’s perspective, beef packer IBP did everything right in its negotiations to be acquired by Tyson, the nation’s largest poultry firm. After putting the company “in play” by launching a management-led leveraged buyout, IBP’s management enticed Tyson into an auction for IBP’s business against Smithfield Foods Inc., a pork products firm looking to diversify across the food chain. Once Tyson was in, IBP’s management cozied up to Tyson’s senior management as IBP’s suitor of choice, disclosed its problems at an early stage, played competing bidders Smithfield and Tyson off each other, and did a good job of documenting the deal. In March 2001, with the closing of the merger in sight and after months of touting the synergies of the union that would create the world’s “leading protein producer,” Tyson “flipped the script” and sued IBP for breach of the merger agreement. Tyson was countersued by IBP to complete the merger. Tyson claimed that IBP’s management fraudulently induced Tyson into the deal and, further, that IBP’s problems with a subsidiary, DFG Foods, and IBP’s poor operating results for the fourth quarter of 2000 and the first quarter of 2001 caused the target to suffer a material adverse change. As a result, Tyson claimed that IBP breached the merger agreement giving Tyson the right to walk away from the deal. Tyson’s suit might have been successful had the company negotiated an agreement that clearly allocated the risks underlying the alleged material adverse change to IBP and built a record that showed its management’s concern over deteriorating conditions at IBP. However, Tyson failed to register its concern about these issues in a significant way and was hurt in the subsequent litigation by the abruptness of its change in position. Tyson management’s access to all relevant information regarding IBP’s business and its actions and statements to important constituencies throughout the negotiations and after signing the agreement belied its later claims of surprise at IBP’s operating results, fraudulent inducement, and breach. The result was the ruling by Delaware Vice Chancellor Leo Strine Jr. that Tyson must complete the merger. The main factor in IBP’s successful countersuit to compel the merger was its timely disclosure to Tyson of the condition of its business. IBP prepared internal projections of future results, which were shared with Tyson and which ultimately were inconsistent with IBP’s actual short-term results. IBP’s interim results were reported in its periodic filings with the Securities and Exchange Commission (SEC) and made available to Tyson. Those reports showed that IBP’s operations were slowing, but in a manner that was consistent with past performance. In the merger agreement the term “material adverse effect” was defined as “any 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.” Strine’s opinion makes clear that a cyclical downturn in what is historically a volatile business does not by itself amount to a material adverse change. He noted that neither IBP’s viability as a business nor its solvency were in jeopardy as a result of the facts that Tyson pointed out and, in fact, IBP continued to function in a manner consistent with previous years, although seemingly in a down year. With respect to DFG, IBP informed Tyson early on that its accountants had uncovered accounting irregularities at the newly acquired subsidiary. In the initial disclosure, Tyson treated the problems at DFG – then valued at approximately $9 million – as insignificant to IBP’s overall business. Prior to the execution of the merger agreement, IBP disclosed to Tyson that the DFG problems had grown to approximately $35 million and that its accountants were still reviewing the matter. Tyson accepted the continued deterioration of DFG’s results without protest. Significantly, Tyson permitted IBP to carve out from its representations and warranties regarding IBP’s liabilities “any further liabilities (in addition to IBP’s restatement of earnings in its third quarter 2000) associated with certain improper accounting practices at DFG Foods, a subsidiary of IBP.” By not objecting to that disclosure language, Tyson effectively gave IBP a blank check for liabilities associated with IBP. The DFG impairment charge ultimately grew to more than $100 million. Had Tyson negotiated for a cap on the liabilities related to DFG – to a reasonable expectation of the depth of the impairment charge at the time of the disclosure, e.g., $45 million – Tyson would have had a better argument that the merger agreement had been breached and that it had a right to walk away. At the end of the day, Strine was not persuaded by Tyson’s claim that a material adverse change had occurred in IBP’s business. Tyson demonstrated to the court that IBP had suffered a decline in operating results; however, Strine found that a modest decline in results was not sufficient to invoke a MAC clause and thus derail a deal that was entered into for long-term strategic reasons. Further, the judge pointed to Tyson’s failure to negotiate for the protections that it ultimately asked the court to grant, including its failure to object to the “blank check” given to IBP for liabilities associated with DFG. The Tyson/IBP decision should teach acquirers and m&a practitioners that agreements will be enforced. Therefore, acquirers should protect themselves not only against unknown risks but also against intolerable changes in identified risks. The Effects of September 11 A number of acquirers pointed to the catastrophic events of September 11th and their subsequent effects as reasons to invoke MAC clauses to terminate acquisition agreements. USA Networks Inc. brought a suit against National Leisure Group Inc. seeking a declaratory judgment regarding its ability to invoke a MAC clause to walk away from their July 2001 acquisition agreement in part as a result of “the effects and reasonably foreseeable future effects on National Leisure Group of the events of September 11, 2001…and their aftermath.” National Leisure Group, a provider of cruise and vacation packages, is in the industry perhaps hardest hit by the fear of further terrorist acts. The companies later agreed to terminate the deal when USA Networks made an equity investment in National Leisure and named it a preferred provider of travel services to one of its cable affiliates. National Leisure could have challenged USA Networks’ termination based on the theory established by the Tyson case, i.e., that a downward swing in short-term results should not constitute a material adverse change. The ability to invoke a material adverse change would be seriously narrowed if a court determined that invoking a MAC clause so soon after a calamity like September 11th doesn’t give either the acquirer or the target sufficient evidence of the consequences of the events on the target’s business to determine whether a true material adverse change has occurred. Nevertheless, a strong argument could be made that invocation of the MAC clause by USA Networks would be justified because the travel industry was materially affected by the events of September 11, as demonstrated by immediate cancellations of travel plans and the imposition of new security measures by Congress. In the WPP/Tempus case, the United Kingdom’s Takeover Panel seemingly did narrow the scope of MAC clauses in such a fashion. WPP Group, an advertising agency group, attempted to invoke a MAC clause to rescind its offer to acquire media buyer Tempus Group, as a result of the blow to the world economy by the September 11th events. Advertising suffered an immediate but not necessarily long-term disruption. Under U.K. law, WPP Group’s offer had become binding and the bidder needed the permission of regulatory authorities to terminate it. The panel rejected WPP’s request to terminate the offer, concluding that WPP failed to demonstrate that the events of September 11th would have a lasting impact on Tempus Group’s business. Like Strine in the Tyson case, the authorities found that invocation of a MAC clause requires the showing that “exceptional circumstances have arisen affecting the offeree (target) company which could not have reasonably been foreseen at the time of the offer. The effect of the circumstances…must be sufficiently adverse to meet the high test of materiality…” WPP simply failed to meet the burden of that test. Thus in the U.K., acquirers and practitioners have a “chicken and egg” problem because the buyers are hard-pressed to demonstrate long-term deleterious effects immediately after a catastrophic event like the terrorist attacks. In deals struck in the weeks after September 11, a number of merger partners specifically dealt with the continued effects of that day in drafting their MAC clauses. One innovation was developed in the Reliant Resources Inc. acquisition of Orion Power Holdings Inc. Orion negotiated for an exception to a MAC clause that specifically carved out the prospects of industry decline resulting from war or terrorism. The exception seemingly prevented Reliant from invoking the MAC clause “to the extent [industry changes were] caused by material worsening of current conditions caused by acts of terrorism or war (whether or not declared) occurring after the date of the agreement.” However, Reliant managed to exclude from the exception long-term material adverse changes to Orion Power’s business or the electric power industry that resulted from war or terrorism. Similarly, in the merger between First Merchants Corp. and Lafayette Bancorp, Lafayette excluded “events and conditions relating to the business and interest rate environment in general (including consequences of the terrorist attack on September 11, 2001)…” from its MAC representation. Finally, in a private deal that the authors worked on involving a public company’s acquisition of a small private company, the acquirer negotiated a MAC clause that captured material adverse effects on the target’s business or condition that were “the result of war or acts of war.” An informal survey of m&a practitioners demonstrated that a number of deals that were in the negotiation stage on September 11 were derailed by that day’s events. Interestingly, a sampling of MAC clauses in other m&a agreements reached in December 2001 showed the parties ignoring the specific risks of war or terrorism and including only standard MAC formulations. These included Comcast Corp.’s agreement to acquire AT&T Broadband from AT&T Corp., the management buyout of NCH Corp., and Novometrix Medical Systems Inc.’s merger agreement with Respironics Holdings Inc. This is not entirely surprising since those transactions were entered into as the markets began to stabilize, it became more apparent that the threat of terrorism had been contained, and the military campaign in Afghanistan was succeeding. Perhaps the best way for acquirers that are concerned with the effects of terrorism, war, or natural disasters is to adopt the MAC clause language used by Berkshire Hathaway Inc. in terminating its offer to buy notes of FINOVA Group Inc. The provision, which is common in financing deals but not in mergers and acquisitions, allowed Berkshire to pull out in the event of: *A general suspension of trading in securities on any national securities exchange or *The commencement of war or armed hostilities or other national or international calamity involving the United States. FINOVA did not contest Berkshire Hathaway’s termination of the tender offer because those conditions were clearly satisfied after September 11. This type of provision was probably more acceptable in the context of a tender offer for note obligations because it is reasonable for Berkshire Hathaway to be concerned about the liquidity of the notes and because debt obligations are typically very sensitive to uncertainty, especially uncertainty from market closings and military actions. The Big MAC: Enron In perhaps the most storied financial collapse of recent years, it can be of no surprise that Dynegy terminated its merger agreement with Enron because the target’s deteriorating financial condition allowed Dynegy to invoke the MAC clause. The clause was a standard formulation and, from Dynegy’s perspective, worked perfectly to permit it to void the deal amid Enron’s rapid downward spiral. Dynegy’s invocation of the MAC clause was an appropriate use of a MAC clause. In the words of Vice Chancellor Strine in the Tyson opinion, MAC clauses are intended “as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner.” When Dynegy terminated the merger agreement, the full scope of Enron’s problems had not been de-tected. Dynegy terminated the merger agreement as a result of Enron’s disclosure of its weak cash position that was reported for the first time in its third quarter 10-Q filing with the SEC. The report showed an extremely high burn rate triggered in part by the loss in value of Enron’s common stock. Enron’s cash position was a symptom of its deeper troubles, which at that point, were not clearly understood. Without the MAC clause, at that stage, Dynegy would be hard pressed to point to a specific breach of the merger agreement by Enron. The MAC clause gave Dynegy the ability to walk away from Enron without having to identify with particularity Enron’s breaches of specific representations. Nevertheless, Enron has filed suit against Dynegy in the New York bankruptcy court supervising Enron’s reorganization efforts, charging that Dynegy’s exit was instrumental in touching off the bankruptcy. Many lessons can be learned from the experiences of 2001 in terms of m&a transactions and MAC clauses. Perhaps the most significant clarification of when a MAC clause can be used to terminate a deal was provided by Tyson’s and WPP’s attempts to jettison their respective agreements to acquire IBP and Tempus Group. Both the Delaware Chancery Court and the U.K. Takeover Panel, in separate opinions, stated that MAC clauses are intended to protect acquirers in the event of long-term, fundamental material adverse changes in the target’s business, rather than short-term swings in operating results. For targets, both the Tyson Foods and Enron cases teach that timely and full disclosure of all material facts is the preventive medicine and the cure for an acquirer’s claim of unfair surprise caused by buyer’s regret. IBP disclosed the condition of its business and negotiated to allocate risks to Tyson, which Tyson ultimately was compelled to accept by the Delaware court. In the Enron case, despite Dynegy’s legal and accounting diligence of Enron’s business, Enron simply failed to disclose all of the material facts of its business, according to Dynegy. The result was that Dynegy’s offer to acquire Enron, which was the escape hatch for Enron’s self- created financial morass, quickly was dropped as a direct result of Enron’s own bad judgment. For both acquirers and targets, the events of 2001 teach that it is incumbent on the parties to determine their appetite for the risks associated with their transactions and to proactively negotiate risk allocations. Priscilla C. Hughes is a Partner, and B. Seth Bryant an Associate, in the New York office of the law firm of Morrison & Foerster.