Material adverse effect (MAE) clauses have become highly negotiated and detailed provisions in acquisition agreements. MAE clauses generally are a condition to closing that may allow the buyer to walk away from a transaction if an event or condition adversely affecting the target company has occurred. They are often subject to exceptions for events such as a general deterioration in economic conditions, general market volatility or changes in the industry in which the target company operates.
The Delaware Chancery Court's recent decision in Hexion Specialty Chemicals, Inc. v. Huntsman Corporation, which involved a claim by Hexion that Huntsman had suffered an MAE, provides an opportunity to revisit MAE clauses. This article begins with an analysis of the insights Huntsman provides into the interpretation of MAE clauses, and concludes by highlighting critical matters buyers and sellers should consider when entering into a transaction and negotiating definitive acquisition agreements.
How to Interpret an MAE Clause
Buyer Bears the Burden of Proof
As an initial procedural matter, the Huntsman court decided which party bore the burden of proving that an MAE had (or had not) occurred. Allocating the burden of proof is significant because, as the court noted, a party faces a "heavy" burden when invoking an MAE clause. The court reaffirmed the prior Chancery Court decision of In re IBP, Inc. Shareholders Litigation by deciding that the party invoking the MAE clause (typically the buyer) must prove that an MAE has occurred. The court noted, however, that parties are free to explicitly allocate the burden of proof with respect to an MAE clause in an acquisition agreement. As economic conditions deteriorate and buyers' negotiating leverage increases, buyers may seek to contractually alter the default burden of proof that Huntsman provides. Given the burden of proving whether an MAE has or has not occurred, allocating the burden of proof to the target may make it considerably easier for buyers to successfully invoke an MAE clause.
EBITDA Determines Whether an MAE Has Occurred
After resolving that Hexion bore the burden of proof, the court discussed the metrics it would examine to determine whether an MAE had occurred. The court decided that, in a cash merger where all of the target's debt will be paid off, the proper benchmark for determining whether an MAE has occurred is earnings before interest, taxes, depreciation and amortization (EBITDA).
The court justified this rule because EBITDA is closely tied to results of operations, which is "what matters." The court's focus on EBITDA refines IBP, which examined both earnings per share (EPS) and earnings before interest and taxes in the context of a deal with an option for payment in cash or a combination of cash and stock. Although Delaware courts may consider EPS in addition to EBITDA in future deals if stock constitutes all or part of the merger consideration, EBITDA likely will be the primary default MAE metric Delaware courts will examine in Huntsman's wake.
First Determine Whether an MAE Has Occurred, Then Examine if any Carveouts Apply
Huntsman clarifies the framework courts may use when analyzing MAE clauses. The court first undertook an examination of whether an MAE affecting Huntsman's financial condition or business had occurred. Only if the court had found that an MAE had occurred would it then determine whether any of the MAE carveouts in the merger agreement were applicable.
The court fashioned this rule in the context of Hexion's argument that Huntsman's performance relative to the chemical industry at large demonstrated that Huntsman had suffered an MAE. The court ruled that Huntsman's performance relative to its industry peers could not in itself determine whether an MAE had occurred because the merger agreement includes a carveout for adverse changes to conditions affecting the chemical industry (which do not disproportionately affect Huntsman). The court reasoned that carveouts are intended to prevent a circumstance that would otherwise be an MAE from being found to be so. If Huntsman's underperformance relative to an industry peer group could necessarily constitute an MAE, then the carveout Huntsman negotiated would be meaningless. The court therefore first sought to determine whether an MAE occurred before focusing on facts primarily applicable to the carveout for adverse changes to industrywide conditions.
Huntsman varies from the framework previously used by a Tennessee court applying Tennessee law in Genesco, Inc. v. The Finish Line, Inc. The Genesco court ruled that an MAE occurred, but found that the closing condition at issue had not been satisfied because the cause of the MAE fell within a carveout similar to the one considered in Huntsman. However, in contrast to Huntsman, the Genesco court determined that the carveout applied before deciding whether an MAE had occurred and "include[d] its MAE analysis for completeness" only. Huntsman provides a principled approach for applying MAE clauses that will likely serve as a basis for courts applying the laws of Delaware and other states in the future.
Practical Consideration for Negotiating and Using MAE Clauses
The Huntsman court ultimately ruled that Huntsman had not suffered an MAE. The court's decision and prior cases such as IBP and Genesco highlight the following issues buyers and sellers should consider when entering into an acquisition transaction.
If Buyers Intend to Rely on Due Diligence Materials, They Should Include Specific Provisions in the Definitive Agreement
It is critical for buyers to obtain specific representations or closing conditions regarding any diligence materials, such as projections, that are important to the buyer's investment decision. The initial document most parties sign before entering into acquisition negotiations is a confidentiality agreement, which typically provides that the buyer may not rely on any of the diligence materials provided by the target. Definitive agreements also may (and, from the target company's perspective, should) include a provision stating that a party is only making the representations and warranties set forth in the definitive agreement. The Hexion-Huntsman agreement, for example, disclaims any representation or warranty with respect to projections Huntsman provided to Hexion prior to signing and any representation or warranty not explicitly set forth in the agreement. These provisions are intended to eliminate any argument that one party relied on materials produced by the other to enter into a transaction, and are so interpreted by courts. If any materials produced during the diligence process are of particular importance to a party—such as projections of future performance by the target—that party should negotiate to include a specific representation in the definitive agreement regarding the accuracy of those materials. Otherwise, a party relying on those materials may not have a remedy if its reliance on the materials is misplaced.
If Buyer Has Identified an Issue, Buyer Should Negotiate a Specific Clause Relating to the Issue
Delaware courts have consistently stated that the purpose of an MAE clause is to serve as a "backstop" to protect against unknown risks. Huntsman reaffirms this position. To the extent that a party is aware of an issue and does not address it specifically in one of the numerous representations and warranties that is included in a typical definitive acquisition agreement, a court may find that the identified issue was not fundamental to the transaction. This is especially the case where, as in IBP, the buyer was aware of certain potential problems and continued to increase its purchase price after it attained knowledge of those potential problems. Therefore, if a party has identified an issue that the party views as fundamental to the transaction, the best course is to negotiate a specific closing condition or representation and warranty to address the issue. Otherwise, there is a significant risk that the issue will be ignored—or, even worse, used as evidence that the buyer was not concerned about the issue—when a court analyzes whether an MAE has occurred.
Delaware Choice of Law Makes It More Difficult for Buyers to Prove that an MAE Has Occurred
As noted in Huntsman, no Delaware court has ever found an MAE to have occurred in the context of a merger agreement (including in IBP, which interpreted New York law). According to the Delaware courts, this is due primarily to the backstop nature of an MAE provision and the knowledge buyers often have of problems a target faces at the time the transaction was signed. By choosing Delaware law to govern a definitive agreement, the parties make it difficult for a buyer to successfully terminate the agreement based on the occurrence of an MAE. To the extent a buyer wants to increase its likelihood of terminating an agreement based on an MAE, it may be better off negotiating for the agreement to be governed by the laws of a state other than Delaware.
Changes That Could Make MAE Clauses More Favorable to Buyers
Huntsman and its predecessors provide helpful pointers regarding negotiating and drafting MAE provisions.
The definition of MAE in the Hexion-Huntsman agreement defines an MAE to be "any occurrence, condition, event or effect that is materially adverse to the financial condition, business or resolutions of operations of [Huntsman]." From the buyer's perspective, there are several changes that could make this language stronger. First, if a buyer is concerned about the future operations of a target, the word "prospects" could be added to the definition. A second change that could be made is to state that an MAE is "any occurrence . . . or effect that is or is reasonably likely to be materially adverse." This would also add a forward-looking component to the definition. Delaware courts also have hinted that use of the word "could" rather than "would" or "is" may, on the margins, make it easier to prove that an MAE has occurred. Finally, if a buyer has identified particular areas of concern regarding a target, it should seek to incorporate specific provisions that define an MAE to include a failure to achieve express metrics that provide comfort on areas of concern.
The second portion of a typical MAE definition contains the carveouts to the general MAE definition. From a target's perspective, it is important to negotiate carveouts for those events that are of particular concern to the target. It is important for both parties to an agreement to make sure that the carveouts appropriately limit the scope of the MAE definition, but (at least from the buyer's perspective) do not go so far as to exclude events that are intended to be covered by the definition. For example, in SLM Corporation v. JC Flowers, the target negotiated for certain changes in applicable law to be carved out from the MAE definition, but the actual legislation adopted was different from the changes in law incorporated into the MAE definition. Ultimately, the limited scope of the carveout arising from its specificity may have caused the target to receive a less favorable settlement in the case.
Overall, an MAE clause with carefully considered carveouts and clear criteria for what constitute an MAE is most likely to yield a result consistent with the parties' expectations.
A Buyer Should Act in Good Faith if It Thinks an MAE Has Occurred
Absent an express agreement on clear, identifiable metrics for an MAE, determining whether an MAE has occurred is a fact-specific inquiry. Identifying an MAE in any particular instance can therefore be difficult.
If a buyer believes that an MAE has occurred, it should first communicate that belief to the target soon after deciding not to close on the basis of the MAE. Waiting to communicate the alleged occurrence of an MAE exposes a buyer to the argument that declines in the target's business at the time of the decision were not sufficiently significant to justify finding an MAE. A court may conclude that if the declines were significant in the context of the deal, the buyer presumably would have sought to avoid acquiring the adversely affected target sooner. The IBP court, for example, discounted the significance of the decline in the target's business in part by noting the buyer's failure to assert an MAE with the other bases initially communicated to the target for refusing to close.
A failure to promptly communicate an alleged MAE also may violate a buyer's covenants in the acquisition agreement and a buyer's obligation to act in good faith. Acquisition agreements, such as the Huntsman agreement, commonly require each party to make certain efforts to close the transaction. A buyer that withholds information that it does not plan to close, without informing the target of its intent not to proceed, will likely run afoul of the spirit and the letter of any such covenant. Moreover, a failure to inform a target that the buyer intends not to proceed can be seen as violating the general duty to perform an agreement in good faith. The Huntsman decision contains an overtly negative tone in describing Hexion's actions leading to the suit. Hexion's actions included a preliminary MAE analysis that was not communicated to Huntsman prior to Hexion's transmittal of an insolvency opinion for the combined company to potential lenders. Hexion's failure to consult with Huntsman prior to sending the opinion was the basis for the court's finding that Hexion "knowing and intentionally" breached the agreement and seemingly did not leave the court inclined to resolve any ambiguity in Hexion's favor.
Finally, given the ambiguity in determining whether an MAE has occurred in most instances, Huntsman serves as a reminder that buyers should not feel secure in relying on an MAE clause to refuse to close. Even in Delaware, MAE issues have not yet been litigated to an extent where buyers or their counsel will typically feel comfortable that an MAE is clearly identifiable. Buyers likely will be on safer ground trying to renegotiate a deal that has not proceeded as anticipated rather than terminating. Although sellers may be emboldened by Delaware courts' refusal to find an MAE in the acquisition context, the prospect of expensive litigation that typically will require a trial could provide strong motivation to renegotiate a deal even if a seller's perceived chances of a favorable judgment seem high.
Huntsman provides several key insights into how courts should interpret MAE clauses. Overall, like its predecessors, the case serves as a reminder that, despite the negotiating effort and detail surrounding MAE provisions, the provisions are inherently ambiguous and buyers should not rely on them if there are specific concerns that have surfaced during the diligence process. Rather, buyers should negotiate specific clauses to address their concerns.