Beware of the MAC

Recent testimony by Bank of America Corp.'s CEO Ken Lewis before a House committee in connection with BofA's acquisition of Merrill Lynch & Co. has focused renewed attention on material adverse change clauses. Lewis testified that when BofA became aware of significant, accelerating losses at Merrill, it contemplated declaring a material adverse change, which would have allowed it to avoid closing the deal. Without a doubt, the current economic climate has increased the likelihood of detrimental effects on any target, and like Lewis, other remorseful purchasers may be looking at MAC clauses as a means to terminate a deal.

It is unlikely that BofA could have successfully invoked the MAC clause as an exception to its obligation to close the transaction. The BofA-Merrill clause expressly excluded factors such as general business, economic or market downturns from conditions constituting a MAC, but added that a MAC could be deemed to have occurred if such downturns had caused a "disproportionate effect" on Merrill. (The "disproportionate effect" clause is often a carve-out to the statement that general economic downturns do not constitute a MAC.) However, Delaware courts have been reluctant to allow a purchaser to rely on a MAC exception to avoid its obligation to close.

In the Hexion Specialty Chemicals Inc.-Huntsman Corp. case, brought in 2008, the Delaware court relied on its 2001 decision in In Re IBP Inc. Shareholders Litigation in noting that "a buyer faces a heavy burden when it attempts to invoke a material adverse [change] clause in order to avoid its obligation to close. Many commentators have noted that Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement. This is not coincidence." In finding that Hexion could not rely on the MAC exception to avoid closing the deal, the court again echoed IBP and stated that a MAC clause should be viewed as providing "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. A short-term hiccup in earnings should not suffice; rather [an adverse change] should be material when viewed from the longer-term perspective of a reasonable acquirer." Further, and notwithstanding that the MAC clause had been set out as a condition precedent to closing, the court saddled Hexion with the burden of proving the occurrence of a MAC.

Purchasers should thus be wary of relying solely on a MAC clause as a "catch-all" of negative events, which could form a basis for terminating a transaction. Given the fact that bargaining power has shifted in favor of purchasers, the better course may be for purchasers to minimize preclosing risk (and the possibility of buyer's remorse) through the use of alternative deal structures such as earnouts. By tying a portion of the purchase price to the future performance of a target, earnouts reduce a purchaser's initial financial exposure at the closing. However, purchasers must exercise caution because earnouts are tricky to negotiate and may increase the risk of post-closing litigation if not structured properly. One should therefore ensure that they are well-crafted and include sufficient details with respect to the post-closing operations of the target company.

Although the courts have made clear a reluctance to allow parties to use MAC clauses as a means to escape closing on a negotiated transaction, that is not to say that the MAC clause should be disregarded completely. While Delaware courts have not found a MAC to have occurred in the context of an M&A deal, they have not explicitly rejected the use of MAC clauses either. As such, a MAC clause could give the purchaser significant leverage in renegotiating the terms of the deal if a MAC occurs after an agreement has been signed. Based on the court's prior decisions concerning MAC clauses, in order for a purchaser to bolster the enforceability of a MAC clause, purchasers should attempt to (i) set out explicit descriptions of each event that are intended to constitute a MAC, (ii) unambiguously allocate the burden of proof with respect to the occurrence or absence of a MAC, and (iii) to the extent general business, economic or market downturns are intended to constitute a MAC, define the specific time period to be considered in determining whether or not a MAC has occurred.

Scott M. Coffey is a partner and Shubham V. Arora an associate with Squire, Sanders & Dempsey LLP. They focus their practice on mergers and acquisitions, corporate finance, and project finance matters.