• The MAC Effect - Recent Consideration in Drafting M&A Agreements
  • December 12, 2009 | Author: Morli Shemesh
  • Law Firm: Aird & Berlis LLP - Toronto Office
  • With the credit crunch restricting the availability of funds required to finance committed M&A deals, a growing number of acquirers are attempting to walk away from such deals by asserting the material adverse change (“MAC”) or material adverse effect ("MAE") clause provided for in the merger and acquisition agreements. Since there have not been any leading cases in Canada dealing with the interpretation of MAC or MAE clauses in the M&A context, Canadian companies and professionals are looking to U.S. court decisions for guidance in drafting and interpreting such clauses.

    A recent significant decision reviewing the assertion of the MAC clause was issued in late December in the case of Genesco and Finish Line/UBS Securities [1] by the Tennessee Chancery Court. On June 17, 2007, Genesco and Finish Line, both sellers of footwear, entered into a merger agreement pursuant to which the parties agreed that Genesco would be merged with and into a wholly owned subsidiary of Finish Line. Finish Line agreed to pay Genesco’s shareholders US$54.50 in cash per share in a highly leveraged transaction financed by UBS (the US$1.5 billion deal was to be financed with up to $1.14 billion in senior secured debt and up to $700 million in unsecured senior debt).[2] Shortly thereafter, Genesco’s quarterly earnings fell significantly short of projections and the share price dropped almost 25% below the purchase price. According to Genesco's complaint, Finish Line developed a "case of buyer's remorse" as it was concerned that it is overpaying for the Genesco shares, especially in light of general decline in the retail footwear industry.[3] In addition, Genesco argued that the problems in the U.S. subprime mortgage market and UBS' reported significant loan-related losses, made the transaction less attractive for UBS. While Genesco obtained shareholder approval for the merger and demanded that it be completed, UBS stalled and demanded more information about the decline in earnings. Genesco commenced proceedings in September 2007 and demanded specific performance of the merger agreement. Finish Line and UBS asserted a contractual defense relating to MAE based on Genesco’s weak quarterly performance and two tort defenses relating to fraud. The Tennessee Chancery Court, in a decision by the Chancellor Ellen Hobbs Lyle, dismissed Finish Line and UBS' defenses and ordered specific performance.[4]

    Chancellor Lyle’s analysis of the MAE clause begins with an analysis of whether Genesco’s decline in performance fit within one of the “carve-outs” or exclusions from the definition of MAE in the merger agreement. One of the contested carve-outs was a

    change in national or world economy or financial markets as a whole or change in general economic conditions that affect industries in which the Company [Genesco] and the Company Subsidiaries conduct their business, so long as such change or condition do not adversely affect the Company and the Company Subsidiaries, taken as a whole, in materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate.[5]

    Genesco asserted that its decline in earnings was due to general economic conditions, including high oil & gas prices and housing and mortgage markets, while Finish Line/UBS attributed the losses to intra-industry conditions such as fashion trends and a decline in the average selling price of footwear, factors not included in the carve-out. The Court attributed significant weight to Genesco’s retail expert testimony and concluded that Genesco’s decline was due to general economic conditions, and pointed out to UBS’ own performance as evidence of poor market conditions and the effect of weakened consumer spending.[6] Chancellor Lyle continued with an examination of whether Genesco’s decline was disproportionate to others in the industry and concluded that it was not, once again significantly relying on Genesco’s retail expert testimony. The Court therefore concluded that Genesco’s decline in performance fit within one of the carveouts of MAE provided for in the merger agreement.

    Nevertheless, Chancellor Lyle continued her analysis as to whether MAE had, in fact, occurred and concludes that it had.[7] In reaching this determination, Chancellor Lyle relies on recent MAC cases, including IBP, Inc. v. Tyson Foods, Inc.[8] and Frontier Oil Corporation v. Holly Corporation[9]. The determination in these cases hinged upon the measure or quantification of the change in a company’s performance, the significance of the duration of the change (“durationally significant”) and whether the change related to an essential purpose that was intended by the parties by entering into the merger agreement.[10] Chancellor Lyle finds that due to Genesco’s decline in earnings during the months of May and June of 2007 (which were the lowest in 10 years), Genesco was not able to offset its decline in the second and third quarters of 2007 and therefore concluded that Genesco’s change in performance was, in fact, material. Chancellor Lyle then analyzed the significance of the duration of the change and found that the continuing poor performance and decline in earnings throughout the second and third quarters, was not just a “short-term hiccup”. In reaching this finding, the Court referred to subsection 7.2(b) of the merger agreement which states that:

    since the date of this [merger] Agreement, there shall not have occurred a Company Material Adverse Effect with respect to the Company and the Company Subsidiaries, considered as a whole, that has not been cured prior to the Termination Date. (emphasis added).

    Accordingly, Genesco had the opportunity to cure the MAE by December 31, 2007 (the termination date), but was not able to offset the decline it sustained with the results achieved during the months of May and June of 2007. With respect to the essential purpose of the merger, the Court considered the context and purpose of the transaction and whether the decline in Genesco’s earnings would affect the ability of the merged entity to repay the financing of the transaction and grow the company. While the Court found that the latter was a secondary purpose of the agreement,[11] it nevertheless acknowledged that in such a highly leveraged transaction, the company’s poor performance in the second and third quarters could not be underestimated, and therefore she concluded that a MAE had occurred, even though it was excluded by the carve-outs.

    It is doubtful whether the IBP and Frontier decisions intended this interpretation for “durationally significant”, as it appears that both of these decisions considered MAC or MAE as events that are significant in terms of the long-term value of the target or merged entity to the purchaser, thereby noting the significance of the purpose of the transaction without placing a specific cut-off date. However, from the points of view of purchasers and their lenders’ points of view, the interpretation in Genesco is welcome, as it takes into account not only the primary (long-term strategic) purpose of the transaction, but also the circumstances surrounding it. It acknowledges that financing is not merely incidental to the transaction, but that it has a considerable role in the success of the merged entity.

    The main lesson from the Genesco decision is similar to those in previous MAC decisions. Since financing-out clauses have become rare in acquisition agreements and reverse break-up fees have become increasingly common and bear high price tags, all for the sake of certainty for the target, the current credit crunch imposes all the risk on purchasers, especially in highly leveraged acquisitions. MAC clauses, as well as the allowance of specific performance and the inclusion of a reverse break-up fee as easy “out” from the purchaser’s obligation in the absence of MAC, will increasingly become highly negotiated clauses in drafting merger agreements,[12] especially in volatile markets such as at present.

    Three recent disputed merger agreements support this proposition,[13] one of which (Sallie Mae) is currently being litigated in the Court of Chancery in Delaware.[14] All three agreements contain a reverse break-up fee provision which caps the damages for termination by the purchaser (in the absence of a MAC) and specifically disallows specific performance as a remedy. In the Harman transaction, KKR and GSCP asserted a MAC based on decreased earnings and informed Harman that they would not complete the $8 billion acquisition. Despite the $225 million reverse breakup fee, the parties agreed to terminate the merger agreement without litigation or the requirement to pay the reverse break-up fee and an agreement was entered between the parties for the purchase of $400 million of 1.25% convertible senior notes of Harman. Alternatively, in the Acxiom transaction, the purchasers ended up paying a $65 million reverse break-up fee (below the original $111,250,000 available under the merger agreement)[15] for walking away from the $2.25 billion takeover.[16]

    At issue in the Sallie Mae case is the meaning of the MAE clause, specifically the carved-out exception relating to the change in law relating to the education finance industry that are “in the aggregate more adverse” to Sallie Mae and its subsidiaries than as disclosed in its 10-K filing form with respect to the legislative and budget proposals.[17] In September 2007, President Bush signed into law the College Cost Reduction and Access Act of 2007 which included a reduction in direct subsidies to student lenders, thereby affecting Sallie Mae’s core business. The Court has been asked to determine whether the purchasers can walk away by asserting MAE based on the proposition that the new legislation is “in the aggregate more adverse” than what has been disclosed in the 10-K form. The purchasers assert MAE claiming that the new legislation will materially reduce for a durationally significant period Sallie Mae’s future income,[18] while Sallie Mae contends that no MAE has occurred and that the impact of the new legislation is not materially more adverse to its business.[19] Sallie Mae is seeking damages in the amount of $900 million, the cap reverse break-up fee provided for in the merger agreement for breach of the purchasers’ representation and warranties or failure to perform its covenants.[20]

    The tentative Sallie Mae trial date is set for July 2008 and M&A practitioners will be closely watching for the decision. In the meantime, purchasers appear to have found a “cheaper” way out of M&A transactions by including provisions in merger agreements which specifically disallow specific performance as a remedy and including reverse break-up fees. Target companies, on their part, will be negotiating for higher break-up fees to provide either a greater degree of certainty that the transaction will be completed or adequate remuneration for the company and its shareholders if it does not. Nevertheless, purchasers will continue asserting MAC or MAE in order to walk away without having to pay heavy break-up fees and protect their reputations. The significance of MAC or MAE clauses in merger and acquisition agreements does not appear to be fading and therefore, the specific risks and concerns of the parties must particularly be addressed through the drafting of such clauses, especially in the current volatile markets where the temptation to assert the MAC clauses is prevalent.


    [1] Genesco, Inc. v. The Finish Line, Inc. et al., No. 07-2137-II(III), (Tenn. Ch. Ct. Dec. 27, 2007) (Available: http://www.genesco.com/images/litigation_library/genesco-pdf.pdf).
    [2] Genesco’s Complaint for Specific Performance of Obligations under Agreement and Plan of Merger (November 13, 2007), at 38.
    [3] Ibid. at 56.
    [4] The order is subject to a determination of the solvency of the merged entity, which application was brought by UBS in New York federal court. UBS argues that its commitment to finance the transaction be declared void on the basis that the combined entity would go bankrupt and default on its debt payments.
    [5] Subsection 3.1(a)(B) of the merger agreement (emphasis added).
    [6] See supra note 1, at 31-32.
    [7] See supra note 1, at 33.
    [8] Re IBP Inc. Shareholders Litigation ,789 A.2d 14 (2001 De. Ch.) (“IBP”).
    [9] 2005 WL 1039027 (Del. Ch. Apr. 29, 2005) (“Frontier”).
    [10] See supra note 1, at 34.
    [11] Finish Line’s fundamental purpose was long-term and strategic.
    [12] Jonathan D. Honig, “The Decline and Fall of Material Adverse Effect Clauses”, New York Law Journal, Vol. 238, October 16, 2007.
    [13] Ibid. Harman International Industries, Incorporated merger agreement with Kohlberg Kravis Roberts & Co. L.P. (KKR) and GS Capital Partners VI Fund, L.P. (GSCP) dated April 26, 2007 (“Harman”); SLM Corporation merger agreement with Mustang Funding I, LLC dated April 30, 2007 (Sallie Mae”); and Acxiom Corp. merger agreement with ValueAct Capital Partners and Silver Lake Partners dated May 16, 2007 (“Acxiom”).
    [14] SLM Corporation v. J.C. Flowers II L.P.et al. case no. 3279-VCS, filed October 8, 2007.
    [15] Section 9.8 of the merger agreement (SEC Form 8-K, filed May 22, 2007).
    [16] Section 8.3(f) of the merger agreement provides for a termination fee of $66,750,000 for failed financing, however, it remains unclear as to the exact reason for the termination by the purchaser and so it appears that the $65 million reverse break-up fee was negotiated to avoid litigation.
    [17] Sallie Mae filed its 10-K Form with the SEC on March 1, 2007 (following which the bidding process for Sallie Mae has begun) where it described the potential for federal legislation that might adversely affect Sallie Mae by reducing or altering payments to lenders.
    [18] See supra note 10, Answer and Counterclaims, at 55 and 81.
    [19] See supra note 10, Verified Complaint, at 49-50.
    [20] Section 11.05(c) of the merger agreement (SEC Form 8-K, filed April 18, 2007).