Making Adverse Effects Material Again
In the wake of Donald J. Trump's election, the financial markets have reacted positively, and some commentators have expressed cautious optimism that a Trump Administration might achieve some of its stated goals in "supercharging" the US economy. Wall Street pundits may be comforted by the presence of familiar faces such as Wilbur Ross and Steven Mnuchin in President-elect Trump's cabinet, but the potential impact of the election on international trade and the regulatory environment, coupled with the fallout from the Brexit vote and looming political unrest across Western Europe, may result in uncertainty in deal markets in the near term.
Against this volatile backdrop, the risk of broken deals may increase, and deal makers may look anew at the practical utility of customary termination rights in M&A agreements. Among the provisions that should be revisited is the Material Adverse Effect (or MAE) clause, which conditions a buyer's obligation to complete an acquisition on the absence of an MAE in the target company's business since the signing of the definitive agreement. Since the Delaware Chancery Court decision in In re IBP, Inc. Shareholders Litigation,1 the conventional wisdom among many M&A lawyers has been that MAE clauses are, at best, a bargaining chip for price renegotiations and, at worst, a purely academic topic for lawyerly nitpicking. When the definition of MAE becomes a contested issue during deal negotiations, counsel to one of the parties will inevitably recite the now-familiar mantra that "no Delaware court has ever found an MAE to have occurred" and move on to the next item. But is the analysis that simple? Does IBP in fact create an impossibly high bar such that an MAE clause is of limited utility for practical purposes?
The facts of IBP will be familiar to most corporate lawyers: having entered into a merger agreement to acquire IBP, Tyson Foods later sought to terminate the merger on the basis that IBP had suffered an MAE. In particular, Tyson cited a material decline in IBP's performance during the last quarter of 2000 and the first quarter of 2001, and a US$60 million asset impairment charge incurred by an IBP subsidiary, DFG, which accounted for less than 1% of IBP's sales and less than 2% of its pre-tax earnings. Then-Vice Chancellor (and now Chief Justice) Strine ruled in favor of IBP, holding that an MAE had not occurred, noting that an MAE clause is best understood 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" (emphasis added).
What is perhaps more easily overlooked amid Chief Justice Strine's many memorable quotes in IBP is that he believed that the case was a close call. Indeed, he was "confessedly torn about the correct outcome"—he believed that the decline in IBP's performance would have been "consequential to a reasonable buyer" and that the financial impact of the DFG impairment charge (representing US$0.50 to US$0.60 per share in the context of a US$30 per share offer) was "not trivial." Revisiting the decision, the outcome appears to have been driven as much by Tyson's apparent commercial motivations as by the relative materiality of the specific financial issues cited by Tyson to support its MAE claim. Chief Justice Strine believed that Tyson had been fully informed prior to the signing of the merger agreement as to both the cyclical nature of IBP's business and the accounting improprieties at DFG, had not referred to an MAE (or to DFG at all) in its public statements, and was simply using "post-hoc…arguments" as a result of "having buyer's regret."
If IBP was indeed a close case, what might tip the scales in a future litigation? Although it is true that, in the intervening fifteen years since IBP, no Delaware court has held that a MAE has occurred in such a manner as to excuse a buyer from completing an acquisition, IBP and subsequent cases suggest potential means by which a successful MAE claim might be made.
Strategic vs. Financial Buyers
Central to Chief Justice Strine's reasoning in IBP was the requirement that an MAE must be "consequential to the company's earnings power over a commercially reasonable period, which one would think would be measured in years rather than months"—and not, by contrast, the result of a "short-term blip in earnings." While a "short-term speculator" might consider it material that IBP had missed its projected earnings for one or two financial quarters, Chief Justice Strine did not think that such short-term performance trends should be as important to a strategic buyer such as Tyson, which was familiar with (and subject to) the cyclicality of the industry and was pursuing the acquisition as part of a broader long-term strategy.
What IBP did not address, and subsequent cases appear not to have considered, is whether a financial buyer would be subject to the same analysis. While a private equity investor may not be considered as a "short-term speculator" per se, one might also argue that a customary private equity investment horizon of three-to-five years is not a "long-term strategy." Moreover, the steep decline in IBP's earnings in the relevant financial quarters—a 64% shortfall against the comparable prior-year period—may well have had a material impact on Tyson's ability to finance its acquisition, had it been a private equity investor.
While a private equity investor may be more inclined for reputational reasons to renegotiate price and terms than to terminate and litigate, and while such an investor may still have to demonstrate the systemic impact of the alleged MAE on the target company's overall earnings potential, it is certainly conceivable that it would be subject to a much less onerous interpretation of the "durationally significant" prong of the IBP test.
Carve-outs are not Cure-alls
The operative MAE definition has not changed significantly in the years since IBP, but the customary list of exceptions or carve-outs from that definition—i.e., the specified categories of adverse changes or effects that would not be considered an MAE—has expanded gradually over time. M&A agreements now commonly exclude a long laundry list of potential events from the definition of MAE, including changes in general economic, industry, and political conditions, the failure to meet projections or forecasts, and the effects of the public announcement of the transaction. In principle, this trend should make it all the more difficult to assert an MAE. However, a more recent Delaware Chancery Court decision in Cooper Tire & Rubber Co. v. Apollo (Mauritius) Holdings Pvt. Ltd.2 suggests that such carve-outs, even if clearly applicable to a specific set of facts, may not prevent a court from finding that an MAE has occurred.
Following the announcement of the transaction in Cooper, labor unrest resulted in a management lock-out at CCT, Cooper's Chinese subsidiary, by its local joint venture partner. In claiming that Cooper had not satisfied its conditions to closing, and therefore could not terminate the merger agreement and recover damages, the buyer argued that the Chinese labor disruption resulted in both an MAE and in the failure by Cooper to cause CCT to operate its business in the ordinary course prior to closing. Vice Chancellor Glasscock relied solely on the latter argument in ruling in favor of the buyer and accordingly did not definitively reach the question of whether an MAE had occurred.
In analyzing whether Cooper had breached the relevant operating covenants, the Court considered Cooper's argument that, by including the introductory phrase "except as…otherwise expressly contemplated by [the Merger] Agreement," the covenants incorporated the definition of MAE located elsewhere in the agreement, including its carve-out for the impact of the announcement on Cooper's relationships with its employees and labor unions. Cooper argued that this carve-out allocated the risk of any labor unrest to the buyer, and that it would be "illogical" if the same event (i.e., the CCT management lock-out) would not be grounds for termination of the agreement under the MAE clause but would permit Apollo to terminate for breach of the operating covenants.
Vice Chancellor Glasscock looked to the entire definition of MAE in ruling in favor of the buyer: in addition to a material adverse effect on Cooper's business, MAE was also defined to include events that would "reasonably be expected to prevent or materially delay or impair the ability of [Cooper] to perform its obligations under [the Merger] Agreement." As a result of the CCT management lock-out, Cooper was not able to comply with its obligation to provide financial information about CCT required by the buyer for its financing process. Accordingly, while the labor situation did fall neatly within one of the carve-outs to the first clause of the MAE definition, it still ran afoul of the second clause of the definition insofar as it impaired Cooper's ability to comply with its financing-related obligations.
While Vice Chancellor Glasscock based his ruling solely on Cooper's failure to cause CCT to operate its business in the ordinary course—thereby keeping the Delaware Chancery Court's "no MAE" streak alive—the Cooper decision is a helpful reminder that the fairly anodyne "materially prevent or impair" prong of a standard MAE definition may provide M&A practitioners with a useful tool in the face of unforeseen events, even if the MAE definition otherwise contains the full panoply of customary carve-outs.
Closing Conditions vs. Post-Closing Remedies
In evaluating Tyson's claims in IBP, Chief Justice Strine concluded that a buyer must "make a strong showing to invoke a Material Adverse Effect exception to its obligation to close" (emphasis added). Is an equally "strong showing" required to invoke an MAE in connection with a post-closing breach of contract claim? A more recent case, Osram Sylvania Inc. v. Townsend Ventures, LLC,3 provides another potential wrinkle to the common understanding of IBP and suggests that a less stringent standard may apply in such circumstances.
Osram involved certain post-closing breach of contract and indemnification claims made by the buyer of a business, and the sellers' related motion to dismiss for failure to state a claim. Due to this procedural posture, Vice Chancellor Parsons only needed to determine whether the claims had been sufficiently well-pled and, giving the buyer "the benefit of all reasonable inferences," whether such claims would entitle the buyer to relief "under any 'reasonably conceivable' set of circumstances." As in Cooper, the Court was not required actually to determine whether an MAE had occurred.
That said, taking Osram's factual allegations as true, Vice Chancellor Parsons found that it was "reasonably conceivable" that certain of its breach of contract claims would be successful, including that changes in the target company's business practices between signing and closing could have been expected to result in an MAE. In reaching that conclusion, Vice Chancellor Parsons cited, among other things, a precipitous decline in the target company's sales results in the third quarter of 2011 as compared to the prior quarter. But recalling the IBP standard, would such a decline not be considered a "short-term blip in earnings" that should not be material to a strategic acquirer such as Osram?
Even bearing in mind its procedural limitations, Osram suggests that Delaware courts may not require quite as "strong [a] showing" to establish an MAE for a breach of contract claim as compared to an MAE termination claim—which in turn suggests that sell-side M&A lawyers should not assume that, by liberally sprinkling the seller's reps and warranties with MAE qualifiers, they have fully availed themselves of the protections of IBP for purposes of a post-closing indemnification claim.
Revisiting the mantra mentioned above, it is still true that "no Delaware court has ever found that an MAE has occurred," at least to allow a buyer to terminate a merger agreement. But if nothing else, recent political events at home and abroad may perhaps remind us never to say never—the fact that there has never been a successful MAE claim does not mean that there never will be one, and a careful reading of IBP, Cooper, and Osram may provide M&A lawyers with useful arguments in uncertain times.