Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion
Page 8
The exact wording of a MAC clause traces back to bond indentures negotiated in nineteenth-century Britain.The substance of the wording has largely remained the same for this past century, but the actual wording varies from transaction to transaction and can be quite nuanced. For example, the Accredited MAC clause defined a MAC as “an effect, event, development or change that is materially adverse to the business, results of operations or financial condition of the Company and the Company’s Subsidiaries, taken as a whole.”14 Translating this language, it means that a MAC for Accredited was whenever a single event or group of events, viewed collectively, negatively and materially impacted the entire business being sold.
Historically, this would be the entire clause. However, in the past two decades, practitioners have begun to negotiate carve-outs to this definition. These carve-outs define events that while materially adverse are excluded from the definition of a MAC clause. It is these exclusions that have become the focus of attorneys and are now the principal place in a MAC clause where buyers and sellers allocate closing risk.
The parties can agree to any carve-out they wish, but generally parties negotiate carve-outs that allocate market and systemic risk to the buyer and allocate closing risk to the seller for adverse events that particularly and disproportionately affect it. The reason for this is that the buyer is buying into an industry and an economy. The seller should not have to bear general risk that it cannot control and that the buyer would probably be subject to, no matter what its investment. Rather, the seller should only be responsible for the risks it can affect.
Two prominent academics have also speculated that MAC clauses generally incentivize a seller to maintain appropriate investment levels during signing and closing by allocating individualized risk to them.15 The carve-outs are presumably merely an extension of this theory through their allocation of general risk to the buyer. However, the majority of takeovers are completed in one to three months, and therefore, these clauses appear unnecessary for ensuring investment. Moreover, other clauses in the agreement make certain that the company is operated in the ordinary course during this time period. Nonetheless, a MAC does place responsibility on the seller to ensure to the best it can that no adverse events occur. Another theory for the existence of MACs is that they are a symmetrical device. Target shareholders have a right to vote down the transaction or otherwise refuse to support it if the deal is no longer economical. A MAC provides a similar option to a buyer.16 This latter explanation, though, does not fully explain the reason for MAC exclusions.
Whatever the reason for their inclusion, these carve-outs are privately negotiated and therefore can cover any exclusion the parties specify. Typically, these exclusions cover such acts as weather, terrorism, or war. But the two most significant carve-outs are the ones that exclude from a MAC any adverse events generally affecting the economy and the industry in which the company operates. Both of these exclusions provide broad ground for a seller to claim that a material adverse event has not occurred because it is something happening to other companies in its industry or the economy. Carve-outs particular to the seller are also often included. Common exclusions are for a failure of the seller to meet earnings projections and changes in the price of the securities of the issuer. In each such case, the actual adverse events causing such fluctuations are typically excluded from the carve-out but can still be exempted from being a MAC by another carve-out. Table 3.1 sets forth a study by the law firm of Nixon Peabody of the most common MAC exclusions utilized in acquisitions agreements during the period from June 1, 2007 through May 31, 2008.
Here, the Accredited MAC clause was unique for the strength of its exclusions. Accredited’s MAC clause contained 13 carve-outs and excluded from the MAC definition (1) changes in conditions in the United States or global economy or capital or financial markets generally, (2) changes generally affecting the industry in which Accredited operated, and (3) any deterioration in the business of Accredited substantially resulting from circumstances or conditions known or previously disclosed to Lone Star.The auction for Accredited had been a hot one, and Accredited’s lawyers had leveraged that demand to negotiate what they thought was a very tight MAC clause.
Table 3.1 Common MAC Exclusions
SOURCE: Nixon Peabody 2008 MAC Survey www.nixonpeabody.com/publications_detail3.asp?ID=2474
Like many remorseful buyers in this initial period, Lone Star thus had an uphill battle to prove a MAC. It was not only going to have to show a material adverse event but also have to prove that the decline in Accredited was unanticipated and that Accredited was uniquely impacted by these events in disproportion to the economy and Accredited’s industry. Given the state of the subprime industry by September 2007, it was questionable whether even bankruptcy was a disproportionate event under Accredited’s MAC clause.
The Law Governing MACs
Lone Star’s case, though tough to establish, still had a chance at success. The facts as understood to Lone Star may indeed have established a MAC, or at least a colorable claim of one.This was not unique. A buyer invoking a MAC clause in an agreement is almost always uncertain of the ultimate validity of its claim.This is due to two reasons. First, MAC clauses are typically defined in qualitative terms and speak of adverse events. MAC clauses do not typically set forth quantitative thresholds, such as any event resulting in a loss of x dollars. Second, there is an unusual lack of case law setting forth what exactly is and is not a MAC.
The lack of case law interpreting MAC clauses is indicative of the pressures on parties to settle out of court. Most MAC disputes are settled before an opinion of a court is provided as to whether a MAC occurred. Nonetheless, parties still largely leave MAC clauses in an acquisition agreement undefined, referring to “material adverse effect” rather than a dollar amount to specifically define what material means. There is much speculation about why this practice continues, but a likely reason is that parties want to maintain the incentives and bargaining power an undefined MAC clause provides. When a MAC is undefined, there is uncertainty; this creates incentives on both sides to renegotiate the transaction, thereby saving it. Historically, these incentives were self-reinforcing because of the continued use of vague MAC clauses and the prior lack of significant and clear case law on the subject.
These uncertainties create a unique situation when an adverse event occurs. Because MACs are defined by reference to an adverse qualitative standard, a buyer may claim that a MAC has occurred for strategic reasons, perhaps because of buyer’s remorse. In other words, a buyer like Lone Star may decide after the negotiation of a transaction that it no longer wishes to complete the acquisition. A buyer may invoke the MAC clause as an excuse to exit the transaction and as a way to limit its liability to the target. In this paradigm, the buyer will find an ostensible reason to claim a MAC to justify this position, but the validity of its ultimate claim in any litigation will be uncertain.This was the case of Accredited and Lone Star. Despite Lone Star’s seemingly poor position, Lone Star no doubt invoked this MAC as a bargaining tool designed to leverage a renegotiation or exit from the deal. Lone Star’s assessment of the validity of the MAC claim was a nonissue. It had enough evidence to invoke a MAC and thereby commence the rebargaining process.17
Lone Star may have still even wished to acquire Accredited, albeit at a lower price than first negotiated. Here, both parties were incentivized to renegotiate toward this lower price. Accredited would not want to risk the uncertainty of litigation and an adverse decision leaving its shareholders with no acquisition and premium for their shares. Conversely, Lone Star would not want to risk having to pay the full price for the seller if it was required to specifically perform under the agreement and complete the acquisition. These opposing forces worked toward a settlement.
This MAC strategy, the common one, allows a buyer to drive the price of an acquisition down by taking advantage of either changed market conditions or adverse events affecting the company to be purchased. Conversely, even though t
he buyer may utilize a MAC clause in this manner, a seller may also prefer a qualitative MAC clause in order to provide it with leeway to argue that an adverse event does not constitute a MAC. In both instances, the ambiguous wording of the MAC drives the parties toward settlement of their dispute, albeit at a lower, negotiated price. Contrast this with a MAC where an adverse event is defined in dollar terms. The bargaining incentives just described are absent, as the determination of a MAC can be ascertained numerically. The foregoing reasons are probably why MACs remain drafted in qualitative rather than quantitative terms.
This is not to say that there is no case law. Perhaps the most important decision prior to the financial crisis on the law of MACs was the 63-page opinion issued in 2001 by Vice Chancellor Leo E. Strine, Jr. of the Delaware Chancery Court in In re IBP, Inc. Shareholders Litigation.18 This litigation arose over the agreed acquisition of IBP Inc., the largest U.S. meat producer and second largest pork producer, by Tyson Foods Inc., the poultry company. Tyson Foods had beaten back a competing bid by Smithfield Foods Co., the largest U.S. pork processor, and a management-led leveraged buy-out proposal to obtain a January 1, 2001, agreement to acquire IBP for approximately $4.7 billion.19
The Tyson Food win was short-lived. Soon thereafter, IBP announced its first quarter earnings; the figures were well below analysts’ and Tyson Foods’ estimates. Tyson Foods didn’t take the failure well. It subsequently refused to close the acquisition and claimed that the earnings failure was a MAC to IBP, releasing Tyson Foods from its obligation to complete the deal. IBP responded by suing Tyson Foods in Delaware Chancery Court. This was one of the rare MAC cases not to settle before going to trial. The likely reason: Tyson’s founder and controlling stockholder, Don Tyson, had decided that he no longer wanted to acquire IBP. He had ordered his son, Tyson’s CEO John Tyson, to find a legal way to exit Tyson Foods’ obligations. The MAC claim had followed.20
In his posttrial decision, Vice Chancellor Strine sided with IBP, agreeing that this was a case of buyer’s remorse. In his opinion, Strine waxed eloquently about the role and meaning of MAC clauses, to conclude that:
A buyer ought to have to make a strong showing to invoke a Material Adverse Effect exception to its obligation to close. Merger contracts are heavily negotiated and cover a large number of specific risks explicitly. As a result, even where a Material Adverse Effect condition is as broadly written as the one in the Acquisition agreement, that provision is best read as a backstop protecting the buyer 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 the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable buyer.21
In other words, a MAC was a safety valve, and a buyer would have to meet a high hurdle to establish one. The MAC had to be a significant, adverse event that was long term and durational in nature. Here, IBP’s one quarter of earnings failure was a mere “hiccup,” a “short-term” speed bump.22 A specific failure to meet earnings projections without more was probably not a MAC. Vice Chancellor Strine further reinforced the high hurdle to invoke a MAC by finding that Tyson Foods should not be ordered to pay the usual remedy of monetary damages for breaching the contract by inappropriately claiming a MAC. Rather, Tyson Foods would be forced to specifically perform, that is, complete the acquisition. This was despite the fact that the acquisition agreement contained no clause providing for this remedy. 23
Vice Chancellor Strine’s decision finding no MAC was not a terrible surprise. His words largely reflected what practitioners thought was the law on MACs. By setting a relatively high threshold to establish a MAC, Strine allowed for the MAC test to be met only when the buyer was purchasing what it did not expect. If a buyer wanted a looser standard, it was welcome to negotiate one. In the wake of IBP, some speculated that MACs would be drafted in terms of dollar figures to ensure buyer certainty. This did not occur. The preference for qualitative MACs remained unchanged, and the only real shift was that sellers began to negotiate specific exclusions in MAC clauses for a failure to meet earnings projections.
The IBP decision was decided under New York law, the law selected by the parties in the acquisition agreement. Four years later, in Frontier Oil Corp. v. Holly,24 the Delaware Chancery Court adopted IBP’s holding as Delaware law.Vice Chancellor Noble, the judge in Frontier, echoed the common notions of MAC jurisprudence when he stated: “The notion of an MAE is imprecise and varies both with the context of the transaction and its parties and with the words chosen by the parties.”25 Vice Chancellor Noble then adopted the holding of IBP as the law of Delaware. In doing so, he reiterated the requirement that the burden of proof rests on the party seeking to rely on the MAC clause. In the case of Frontier, it meant that “substantial” litigation costs and the potential of a “catastrophic” judgment of “hundreds of millions of dollars” did not constitute a MAC.26 The reason was alarmingly simple. The substantial defense costs could be borne by the buyer without a MAC, and the buyer had not borne its burden to prove that the speculative nature of the potential damages in this case actually resulted in an adverse effect under the MAC definition. A MAC needed to be concrete in measure.
Taken together, IBP, as interpreted by Frontier, placed a substantial burden on a remorseful buyer attempting to prove a MAC. But the opinions left open a number of questions:
How bad did the adverse event have to be? Vice Chancellor Strine implied in his opinion that adverse equated with quite bad, and Frontier appeared to set an even higher watermark by failing to find a MAC because of a potential catastrophic loss. Though the cases left this open, the general practitioner thinking in light of both IBP and Frontier was that an adverse event resulting in a 10 percent or more decline in income would be sufficient to sustain a MAC claim. Here, some practitioners argued that before IBP the measure of materiality for a MAC was analogous to the measure under U.S. Generally Accepted Accounting Principles (GAAP) rules, or a 5 percent drop in earnings. This difference of opinion again reflected the insufficient case law on MACs and their qualitative nature.27
When could specific performance be ordered? Vice Chancellor Strine stunned the takeover community by ordering specific performance of Tyson’s merger obligations. This was the first time that a judge had ordered specific performance in a MAC case. But historically under the common law, specific performance was a remedy to be awarded only when monetary damages were inadequate. If a deal involved cash, presumably specific performance was not warranted unless the parties preagreed to such a remedy. Vice Chancellor Strine’s opinion instead relied on Tyson’s failure to argue the issue and the complications of determining a monetary remedy to justify an order of specific performance. Still, the IBP opinion left open the issue of when specific performance could be awarded in a MAC case or in an acquisition agreement involving cash consideration generally. Moreover, the IBP case also provided an additional incentive for a buyer to assert a MAC. The worst case scenario for a buyer asserting a MAC appeared to be that it had to complete the buy-out it had already agreed to.28