Some Free Advice: Is a MAC Clause the Answer?

The perennial question of whether to use a MAC clause in transaction agreements constitutes, at its heart, a problem of how to allocate a potential risk that could kill the project before it is even consummated. And each time this question arises, you go over the main risks and benefits of the various available solutions that only partially address the problem. And so (again) you must ask: What is the best answer?

Outside counsel has suggested that possibly the best way to cut this Gordian knot is to just throw a material adverse effect (“MAE”) or material adverse change (“MAC”) clause at the problem and move on. Your first instinct is to concur and tackle the next issue; however, you recall an article you read highlighting some tips regarding the uses of MAEs and MACs. You remember that MACs and MAEs[1] have developed over time to address unforeseen and (usually) unenumerated risks to a business or entity. These provisions are intended to shift risk from one contract party to another. Without a MAC or MAE clause to protect oneself, a party would have to rely upon whatever due diligence it can get out of the other side and the often heavily negotiated representations, warranties, disclosure schedules and conditions precedent in the main transaction documents. As the Delaware Court of Chancery described it in the case of In re IBP, Inc. Shareholders Litigation,[2] the MAE clause is a “backstop protecting from the occurrence of unknown events that substantially threaten the overall earnings potential of the [company].” Even though you may have a backstop available, this type of backstop is subject to a very high threshold. In fact, the Delaware Chancery Court in In re IBP said that the party claiming a MAE would have the burden of proving materiality and would have to make a “strong showing” that the MAE was applicable.[3]

Taking a step further back, you recall that MAC clauses are a subset of MAEs and that MAEs can be defined differently depending on the type of transaction or contract at hand. For example, one typical definition from a loan agreement is: “‘Material Adverse Effect’ means a material adverse effect on (a) the business, assets, operations, prospects or condition, financial or otherwise, of the Company and its Subsidiaries taken as a whole, (b) the ability of [the company] to perform any of its obligations under the loan documents to which it is a party, (c) the collateral, or the lender’s liens on the collateral or the priority of such liens, or (d) the rights of or benefits available to the lender thereunder.” The following variation is from a merger agreement: “. . . any event, 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 [the company] or its subsidiaries, taken as a whole.” As can be seen from the above examples, there are some major parts to the definition: “What happened?” and “Whom is it happening to, and what is being affected?” The focus of the first part is on the type and specific facts of the occurrence or change in facts that have happened since the signing of the agreement. As we will see below, prior conditions that have already occurred are usually not found to be the basis for a MAE. The latter part of the definition focuses on what is being affected. For example, should the definition focus on the overall business or a particular asset or the future earning potential of the company? Or should the focus be on the main revenue-producing subsidiary or the entire corporate family?

As these concepts are necessarily amorphous and vague to provide the most protection, in the published cases on these clauses, courts have used a variety of interpretation strategies. One of the main interpretative strategies is to use extrinsic evidence, that is, evidence from outside of the agreement. Courts have examined extrinsic evidence in many situations in order to define the meaning of “material.” The analysis may include evidence ranging from information on the negotiation process[4] to telephone conversations discussing the alleged MAC[5] to email conversations.[6] One tip to increase the likelihood of obtaining a desired interpretation is to include very specific parameters to define “material” (e.g., attach to the agreement a schedule including specific events that would constitute a MAC:[7] a decline in profits greater than 10 percent, or an adverse change that causes overall costs greater than $1,500,000). While this approach leaves little doubt as to what the parties consider material, it can create problems when an event not specifically mentioned in the MAC occurs. Courts have interpreted very narrow definitions of “material” to be all-encompassing and are thus unwilling to accept the occurrence of some unforeseeable event as a MAC.[8] Accordingly, if there are specific and definite parameters outside of which a party would want to terminate the agreement, it is probably better to use a condition precedent to performing its contractual obligations or a continuing covenant/ event of default as opposed to simply relying on the MAC clause.

Another common judicial strategy when courts analyze MAE or MAC provisions is to not establish bright-line rules. This makes the analysis of MAEs and MACs so fact-specific that motions for summary judgment or motions to dismiss are typically denied, even in situations where the materiality level seems quite clear.[9] For example, the Pine State Creamery v. Land-o-Sun Dairies, Inc. court examined the following facts: One company was acquiring another company and the target company delivered outdated financial statements that were so wildly off that they showed the target company making $41,000 in profits for the month of August and $44,000 in year-to-date profits, when in fact the correct financial statements showed a $150,000 loss for August, a $150,000 loss for each of September and October, and a total loss of $700,000 for the year to date.[10] This swing in value was in excess of $700,000. In more concrete terms, the loss was 13 times the amount of the supposed profit. The Fourth Circuit found that profitability was material to the consummation of the acquisition after looking at the context of the agreement. Accordingly, the Pine State court found that it was simply a question of degree whether the amount of Pine State’s nonexistent operating profits were material. Here, the court found that it was a fact question for jury whether an operating loss of more than $400,000 over a two-month period was material enough since the business to be sold was seasonal (evidently, in this industry sales normally plunge in the fall of every year). Given the above, if you have to litigate or arbitrate, inter alia, the existence of a MAE, do not plan on winning a swift victory by having a court grant your client’s motion for summary judgment, motion to dismiss or other similar dispositive motions.

The last judicial strategy we will discuss is the analysis of the duration of the material adverse effect. In the case In re IBP, Inc. Shareholders Litigation,[11] Tyson sought to acquire IBP and subsequently learned of accounting fraud that had occurred at an IBP subsidiary.[12] At the time the parties signed the initial agreement, Tyson was aware of the problems with the IBP subsidiary, as well as general cyclical financial difficulties encountered by IBP itself. [13] The MAE clause read simply “any event, occurrence, or development of a state of circumstances or facts which has had or reasonably could be expected to have a Material Adverse Effect.” Tyson argued that the two consecutive quarters of financial difficulties at IBP and the accounting fraud at its subsidiary both constituted MACs. The Delaware court, applying New York law in accordance with the forum selection clause, held that no MAC had occurred and that specific performance was appropriate.[14] The court, faced with a broadly worded MAC that did not include the now common global economic or market condition exclusions or “carve-outs,”[15] noted that the context in which the merger is consummated (i.e., a short-term speculative purchase versus a long-term, strategic acquisition) matters in determining the meaning of “materially adverse.”[16] In the case of a strategic purchaser, “short-term blips” in financials could not constitute a MAC. As stated earlier, the In re IBP court held that MACs “are best read as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earning potential of a target in a durationally significant manner.”[17] Durational significance, of course, is not itself terribly specific, but depends on the context of the transaction. Another case that turned on the length of the material adverse effect is Hexion Specialty Chems., Inc. v. Huntsman Corp.[18] In Hexion, between the time a merger agreement was signed and the merger was consummated the Great Recession occurred. The target company’s economic performance saw a year-over-year decline of 19.9 percent, which caused it to be 22 percent below its projected earnings before interest, taxes, depreciation and amortization (“EBITDA”) for the rest of the year.[19] The Hexion court held that no MAE occurred due to (i) an event that can be classified as a “short-term hiccup” and (ii) financial performance that fell short of financial forecasts that the target explicitly neither warranted nor guaranteed.[20] Accordingly, you will be better served with a specific continuing covenant or event of default focused on a counterparty’s economic performance to address non-performance risk (for example, “Party B shall maintain EBITDA in excess of $17,000,000 at all times”).

In conclusion, MAE and MAC provisions have the potential to be useful in allocating risk for unknown future risks. While there are some hurdles to clear in terms of convincing a court about any particular event constituting a MAE or MAC, these provisions can at least start or reignite conversations among the parties to come to a mutually acceptable resolution of the allocation of risk. However, if there is a specific risk or event you feel must trigger the ability to terminate a deal, the best course of action is to specifically include that occurrence as a covenant, condition precedent or event of default rather than a MAE.