Getting out is hard to do

Participants in merger transactions might once have noted a significant difference between transactions in the UK and those in the US: in the UK, it was harder for the buyer to wriggle out of the deal. The simple reason is that in the US, public transactions can be made subject to more conditions than are possible in the UK. Another important reason is the limited effectiveness in the UK of the material adverse change (MAC) clause, which provides buyers (and their financing sources) with an escape hatch if a MAC occurs prior to completing a transaction. However, recent US case law suggests that, like the global M&A market itself, the interpretation of MAC clauses is an area in which the UK and US approaches are beginning to converge.

The anatomy of the MAC
The importance of MAC clauses stems from the fact that it is often not possible to complete a transaction at the same time an acquisition agreement is signed, typically because of the need to obtain approval from dispersed shareholders (or the need to get shareholders to tender their shares or deliver acceptances), the need to obtain regulatory and competition authority clearances, and the need to obtain third-party consents or complete financing. These factors mean that, typically, only small private company acquisitions can be signed and completed (closed) simultaneously.

Because of this gap between signing and closing, parties to an M&A transaction frequently argue over who will bear the risk of adverse events occurring during the interim period. Buyers want the right not to proceed with an acquisition if a material adverse change occurs before closing. Sellers, on the other hand, want deal certainty. Buyers' financing sources have the same sorts of concerns: they do not want to be forced to lend if adverse events take place between the time they commit to lend and the time they actually advance funds.

MAC clauses are included in acquisition agreements both as representations and closing conditions. In a MAC clause, the seller represents to the buyer that there has been no material adverse change to the business being sold since a specified date – often the date of the business's most recent financial statements, but sometimes the date of the acquisition agreement. The absence of a MAC is frequently a condition to closing, meaning that if there has been a MAC, the buyer can refuse to complete the transaction.

Parties negotiating MAC clauses tend to devote only a limited amount of attention to arguing over what must be materially adversely affected before the buyer can walk away. A typical list might include some or most of the following: the business, condition (financial or otherwise), results of operations, properties, assets, liabilities or prospects of the business and its subsidiaries, taken as a whole. The main exception is with respect to the inclusion of the word ?prospects,? which is often heavily negotiated.

Arguments over exceptions to the MAC consume more attention. Exceptions for material adverse changes resulting from general economic, stock market or industry conditions that are not specifically attributable to, or that do not disproportionately affect, the company being sold are common in US public company deals, less so in private deals. In the UK, it's the opposite – these kinds of exceptions are common in private deals but not in public deals, although given the way the Panel on Takeovers and Mergers (the ?Panel?) operates they are effectively implicit in MAC clauses in public UK deals. Sellers in US transactions and in UK private transactions will often propose additional exceptions, depending on the business being sold and the identity of the buyer – for example carve-outs for MACs resulting from announcement of the transaction itself or the identity of the buyer (such as loss of customers or employees), or from the outcome of a particular contingent liability that has been disclosed to the buyer.

Buyers whose agreements are subject to financing conditions – which is typically the case for US private equity sponsors – often get the benefit of two MACs. That is because there is a MAC condition not just in the acquisition agreement, but also in the lender's financing commitment. As a result, the MAC condition in the buyer's financing is, in effect, incorporated in the acquisition agreement through the financing condition. This is one area of continuing difference between the US and the UK: in the UK, a public company takeover bid that cannot be conditioned on the buyer's ability to obtain financing for the transaction. In UK private deals, however, the buyer may have the benefit of two MAC clauses.

In both the UK and the US, the final form of any MAC clause will depend heavily on the negotiating leverage of the parties and the nature of the business being sold. Whatever the formulation, it still may be subject to a great deal of interpretation. A ?Material Adverse Change? is typically defined, rather circularly, as a material adverse change. In both the UK and the US, there is comparatively little case law interpreting MAC clauses. Moreover, parties often will disagree about what is, in fact, material.

Lessons to be drawn
While standards may be converging, it is still the case that it is harder to exercise a MAC clause in a UK public deal than it is in a US public deal. In US deals and in UK private deals, the lessons to be drawn from the cases do not come from new legal theories, but from a reminder of basic M&A contract principles, common to both jurisdictions. For example:

o A MAC has to be material.
A buyer should not assume that it will be able to walk away from an acquisition because of a problem with a seller's business unless the problem seriously impairs the value of the business. The standard for materiality in the context of a MAC is high.

  • ? Disclosure schedules are important. The seller's representations are typically limited by exceptions disclosed in a disclosure schedule. The seller will want to be sure that the exceptions are broad enough, and qualify all of the relevant representations. The seller will also want to be certain that the buyer has enough knowledge of the business – and the issues raised by the representations – to understand the relevance of the exceptions.
  • ? Fairness counts. A buyer will have a much better chance of terminating an agreement if the facts indicate material misstatements or omissions by the target, or the post-signing emergence of a major negative development affecting the target, than if the facts suggest that the buyer has developed what Vice Chancellor Strine refers to as ?buyer's regret? – second thoughts that it may have agreed to pay too much for the business. In the words of the London Takeover Panel, an adverse change in ?general economic, industrial or political circumstances? must be borne by the purchaser absent truly exceptional circumstances affecting long-term value.12 And in the words of Vice Chancellor Stine, ?Caveat emptor is still the basic law of New York.?13
  • ?Caveat emptor is still the basic law of New York?

    MACs in the UK
    In the UK, the small number of disputes relating to MAC clauses in the context of private acquisitions have predominantly been about the sufficiency of disclosure and/or the extent to which the purchaser had prior knowledge of the problem. The main focus of attention has been on MAC conditions in public takeovers. Paradoxically, because of the nature of the UK takeover regime, this is the one area where the pre-September 11 position remains largely unchanged.

    A UK regulated takeover offer is governed by the provisions of the City Code on Takeovers and Mergers (the ?Code?) issued and administered by the Panel. Although the provisions of the Code are not legally binding, in practice, the Code is enforced in the UK market.

    A UK takeover offer is made by way of the offer document mailed to target shareholders, and will be made subject to various conditions. Invariably, the offer will be conditioned on the absence of any material adverse change in the business, assets, financial or trading position, profits or prospects of the target group since a specified date, usually that of the last published accounts. (In a recommended bid there may be debate as to whether the MAC condition should include the word ?prospects?). The offer will be subject to English contract law. As a matter of contract between the offeror and accepting shareholders, if the MAC condition is not satisfied, the offeror is not required to close the offer. However, the circumstances in which an offeror can invoke a MAC condition in a UK takeover offer are severely curtailed by the provisions of the Code.

    The MAC condition by implication carries the caveat that the circumstances constituting the MAC would not have been discovered by an offeror who had carried out the preliminary due diligence investigations that were reasonable in the circumstances.

    It is a specific requirement of the Code that ?an offer must not normally be subject to conditions which depend solely on subjective judgments by the directors of the offeror or the fulfillment of which is in their hands?. Note 2 to Rule 13 provides that ?an offeror should not invoke any condition so as to cause the offer to lapse unless the circumstances which give rise to the right to invoke the condition are of material significance to the offeror in the context of the offer?.

    Practitioners familiar with the Code and the interpretation placed upon it by the Panel are aware of the great difficulty of invoking a MAC condition to withdraw a takeover offer. It is unusual for an offeror to seek to withdraw from a takeover offer by invoking such a condition or, indeed, any other commercial condition in the offer document.

    Fortunately, there is usually a more straightforward way for an offeror to avoid proceeding with an offer: by making use of the acceptance condition.

    For a UK takeover offer to succeed, acceptances in respect of the number of shares specified (the ?acceptance condition?) must be received within 60 days of the posting of the offer document, failing which the offer must lapse, unless either the required acceptance threshold is reduced by the offeror to a level (not being less than 50 per cent.) which has been received or the Panel consents to the offer remaining open.

    In practice, the acceptance condition is usually set initially at 90 per cent of the shares sought in the offer. This is an important threshold because it represents the shares a bidder must acquire consensually in order to compel the minority to sell.

    It is, however, unusual for an offeror to receive acceptances in respect of over 90 per cent of the target shares by the first closing date (usually 21 days from the posting of the offer document) or, indeed, any of the closing dates in the bid timetable. In the great majority of cases an offeror has to lower the 90 per cent threshold (the acceptance condition will permit the offeror to set a lesser percentage, not being less than 50 per cent) and the offer is declared unconditional as to acceptances somewhere between 50 per cent and 90 per cent. Sufficient acceptances will then typically be tendered during the next couple of weeks to reach the 90 per cent. threshold.

    Clearly, if an offeror has a change of heart and no longer wishes to proceed with an offer, perhaps because new information has come to light after the making of the offer, the offeror may be able simply to wait for the next closing date and allow the offer to lapse on the basis of non-satisfaction of the acceptance condition. The Code makes it clear that there is no obligation to extend an offer the conditions of which are not met by the first or any subsequent closing date. Crucially, Note 2 to Rule 13 does not apply to the acceptance condition.

    There is one situation where an offeror may well come unstuck and be obliged to seek to invoke a MAC condition. If an event occurs that is or is perceived to be seriously adverse to the target, and that event is public knowledge, then target shareholders are very likely to accept the offer and there will be a far greater chance that acceptance levels will reach 90 per cent by the next closing date.

    The case of WPP and Tempus
    The refusal by the Panel to allow WPP group to withdraw its bid for the Tempus Group is a salient reminder of the limited effectiveness of MAC conditions in UK takeovers.

    On August 20, 2001, advertising group WPP announced a cash offer for media buying agency Tempus, valuing it at approximately £434m. WPP already owned approximately 22 per cent of Tempus. On September 10, WPP posted its offer document. The offer contained a MAC condition and the customary acceptance condition of 90 per cent of the shares to which the offer related, with WPP having the right to designate a lower percentage of more than 50 per cent. On September 17, WPP bought another 3 per cent of Tempus on the market, bringing its overall holding to 25 per cent.

    On October 2, WPP announced that as of the first closing date of the offer it had acquired 90 per cent of the Tempus shares to which the offer related and that the offer was unconditional as to acceptances. WPP would therefore be obliged to acquire the Tempus shares unless it could rely on the non-satisfaction of another condition to its offer. On October 10, WPP announced that it was seeking a ruling from the Panel that it was entitled under the Code to invoke the MAC condition and lapse its offer. WPP contended that there had been a material adverse change in the prospects of Tempus after the announcement of WPP's offer and, in particular, following the events in the United States on September 11.

    In the statement published by the Panel giving reasons for its decision (Panel Statement 2001/15, 6 November 2001), the Panel stated that its approach and underlying reasoning had remained unchanged over many years and quoted an extract of a statement issued at the time of major market decline in 1974 in which the Panel said:

    ?In general ? the Panel considers that a change in economic and industrial conditions, or even in legislative policy, which may suggest that a proposed acquisition will not be as advantageous for the offeror company as was hoped when the intention to offer was first announced, is one of the hazards which has to be accepted in a takeover situation? The Panel considers that a change in economic, industrial or political circumstances will not normally justify the withdrawal of an announced offer. To justify unilateral withdrawal, the Panel would normally require some circumstance of an entirely exceptional nature and amounting to something of the kind which would frustrate a legal contract?.

    Although the 1974 statement was concerned with the period between announcing an offer and posting the offer document itself, the Panel stated that the same principle should be taken into account when considering whether or not the material adverse change condition could be invoked. The Panel states that this test required ?an adverse change of very considerable significance striking at the heart of the purpose of the transaction in question, analogous ? to something that would justify frustration of a legal contract?.

    The Panel accepted that the events of September 11 were both exceptional and unforeseeable but further stated that in the context of the offer, such effects as they may have on the prospects of Tempus over anything other than the very short term remained very unclear. The Panel stated that in order to allow the material adverse change condition to be invoked, the adverse change itself has to be of a more longer lasting nature specific to the target company and not just the effect of a general and sectoral decline.

    WPP was unable to discharge the onus upon it to show specific adverse consequences for Tempus' prospects caused by the September 11 events and the aftermath, as opposed to effects of a known general and sectoral decline existing prior to September 11. The Panel also considered that the strategic benefits of proceeding with the offer remained available to WPP and were significant in deciding whether or not to allow the MAC condition to be relied on in the context of WPP's offer.

    The Panel did not consider it necessary to consider whether the purchase of shares by WPP in the market after September 11 – which WPP argued was made for strategic reasons in order to achieving a blocking 25 per cent – had any bearing on WPP's ability to invoke the material adverse change condition. The Panel did however observe that WPP's purchase sent a signal to the market and to Tempus shareholders that, notwithstanding the events of September 11, WPP intended to proceed with the offer. An offeror who is considering the possibility of relying on a material adverse change condition to lapse its offer will need to consider very carefully whether market purchases would fatally prejudice its ability to invoke such a condition.

    Self help for offerors?
    Clearly an offeror in a UK regulated takeover has a very high bar to clear before the Panel will allow it to invoke a MAC condition. Nonetheless, offerors will always want to include a MAC condition for what it's worth. Indeed, it is possible that more specific conditions will be included in offers to highlight to target shareholders and the Panel in advance adverse changes which the bidder would consider material. In recommended bids, the MAC condition may now also be negotiated more heavily to include specific carve-outs of the type commonly found in private deals. In reality, however, the approach taken by the Panel suggests that the result will more than likely be the same, irrespective of the precise terms of the MAC condition.

    As an alternative, practitioners have speculated whether offerors could improve their position by increasing the typical 90 per cent acceptance level. However, the 90 per cent threshold is justified for good strategic reasons. It is the level at which the offeror knows that it will be able to squeeze out the minority and acquire 100 per cent of the target. There is little strategic reason for setting the threshold higher. Raising the acceptance level above 90 per cent, therefore, would merely be seen as a device to ensure that a takeover offer could only become unconditional as to acceptances at a closing date if an offeror so chose. In a recommended deal, the target company is most unlikely to accept a higher threshold and in a hostile situation an offeror would, at best, leave itself open to criticism. In practice, however, offer conditions need to be agreed with the Panel, and it is extremely doubtful that the Panel would allow a threshold in excess of 90 per cent except in truly exceptional circumstances.

    MACs in the US
    In the US, interpretation of MAC clauses is generally a matter of state contract law. The federal Williams Act, which regulates tender offers, and the Securities Act of 1933, which regulates offerings of securities in stock-for-stock transactions, do not address the interpretation of a MAC condition in a tender offer, exchange offer or stock merger. However, the US Securities and Exchange Commission will object if a MAC condition (or, for that matter, any other condition) in a tender offer is stated to be able to be invoked in the buyer's sole, rather than its reasonable, discretion.

    Tyson v. IBP
    The leading US case discussing the application of the MAC clause in a public company acquisition is the Delaware chancery court's June 2001 decision in IBP v. Tyson.1

    In that decision, Delaware's Vice Chancellor Leo Strine held that Tyson Foods, Inc. was not justified in terminating its merger agreement with IBP, Inc., and ordered Tyson to complete the merger. The decision, applying New York contract law, hinged on the facts before the court – but it is a reminder of the importance of careful drafting of representations and of disclosure schedules, and that not every downturn in a target company's business will be deemed to have a material adverse effect, permitting the buyer to walk from an acquisition.

    After IBP, the biggest US beef distributor, announced a proposed leveraged buyout of the company, Smithfield, the leading pork distributor, and Tyson, the leading chicken distributor, announced competing bids for IBP. During due diligence, Tyson was told of reductions in IBP's projected operating income for 2000, and was also told that charges of $30-35m would have to be taken because of accounting irregularities at IBP's subsidiary DFG. Nevertheless, Tyson continued increasing its bids for IBP, and eventually won the bidding contest with a part-cash, part-stock bid of $30 per share, or a total of about $3.2bn.

    Tyson and IBP signed their merger agreement on January 1, 2001. A schedule to the merger agreement contained an exception to the representation as to no undisclosed liability for any liabilities arising out of accounting improprieties at DFG. The SEC questioned IBP's financial statements because of the problems at DFG. Nevertheless, Tyson's board and shareholders approved the merger agreement. In March 2001, as operating results did not look good either at IBP or at Tyson, Tyson's founder and controlling stockholder decided to abandon the merger. After some discussion of a possible lowering of the price per share, Tyson notified IBP that it was terminating the agreement, and also brought suit for rescission on the basis that it had been induced to enter into the agreement by material misstatements and omissions.

    While a schedule to the merger agreement carved out problems relating to DFG from the representation as to undisclosed liabilities, there was no such express carve-out from the representations about IBP's financial statements and SEC filings. Vice Chancellor Strine found the contract and the schedule were ambiguous as to whether the reference in the schedule was intended to qualify these other representations – and he found the evidence of the witnesses favored IBP's reading.2 Among other things, he found it significant that the schedule mentioned not only liabilities but also restatement of financial statements, and that Tyson did not put forward as witnesses any of its representatives who participated in the discussion of the disclosure schedule.3

    Had IBP suffered a material adverse effect? Tyson also argued that it was justified in terminating the agreement because there had been a breach of the representation that IBP had not suffered a material adverse change since December 1999. Tyson pointed to poor results in 2000 and the first quarter of 200l and a $60m impairment charge IBP took with respect to DFG.

    The merger agreement in question contained a very simple MAC clause. The merger agreement defined a material adverse effect as ?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 [IBP] and [its] Subsidiaries taken as a whole…?4

    In the Tyson case, the representation as to the absence of a MAC did not have a carve-out for general industry conditions. The court read the representation, however, as being qualified by disclosures in the merger agreement itself and in IBP's financial statements. The Vice Chancellor found it to be significant that: IBP's profitability had swung widely in recent years; results for the third quarter of 2000 were well below those for the third quarter of 1999; and the projections IBP had prepared at the time of its LBO discussions showed a worse 2001 than 2000.5 While all of this is highly fact-specific, Vice Chancellor Strine gave his general views that the MAC representation:

    ?? is best read as a backstop protecting the acquiror 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 acquiror.?6

    The court found it a close question whether there had been a MAC, but concluded there had not been – in part because of the cyclicality of the business, a recent upturn in IBP's operating results, and the fact that DFG was a very small part of IBP.7 While the court had before it a strategic buyer making a long-term investment, it is an open question whether a different result would obtain if the buyer had been a private equity fund with a shorter investment time-horizon.

    The court indicated that deciding the case differently would ?encourage the negotiation of extremely detailed ?MAC? clauses with numerous carve-outs and qualifiers.?8 The court may have intended for their ruling to streamline MAC clauses, but the effect has been quite the opposite as buyers of businesses try to negotiate detailed MAC clauses that are distinguishable from the broad MAC clause in the Tyson case.

    Having found that Tyson was not justified in terminating the agreement, the court found that IBP was entitled to specific performance – that is, an order requiring Tyson to go ahead with the merger. The court found the merger involved a unique opportunity for IBP and IBP stockholders, in part because of the part-stock aspect of the merger: stockholders might want to participate in the upside of the combined company that Tyson had touted when the deal was announced. The court also noted the difficulty of calculating damages and that ?the amount of any award could be staggeringly large.?9

    Tyson did not appeal the decision, and completed the merger as ordered in 2001.

    Private company M&A
    Because the interpretation of MAC clauses is a matter of state contract law rather than federal tender offer or securities law regulation, the analysis of the meaning of a MAC clause is the same for a private company deal as for a public company deal. In the past, there was usually less emphasis on the MAC clause in negotiating private deals than in public deals. In public company deals, the buyer usually would be excused from completing the transaction unless the representations and warranties of the seller are true and correct, with such exceptions as would not cause a MAC. In private deals, the closing condition as to representations and warranties was usually more strict, giving the buyer an out if the representations are not true and correct or, alternatively, if they are not true and correct in all material respects. However, we have noted a trend toward using a MAC threshold in private company transactions – which leads to the same spirited negotiation over the scope of the MAC clause as is seen in public deals.

    An important difference between public and private deals relevant to the MAC clause is that private deals, especially those in which the buyer is a fund sponsored by a private equity firm, are often subject to financing contingencies. In those cases, the seller has two MAC clauses to worry about, and the seller needs to understand the MAC clause contained in the buyer's financing arrangements in order properly to evaluate the risk of non-completion. Sellers sometimes devote considerable attention to negotiating a narrow, seller-favorable MAC provision in an acquisition agreement, only to discover that the commitment letter for the buyer's financing contains a much broader MAC out.

    Of the relatively few US cases interpreting MAC clauses, several interpret the clauses surprisingly narrowly.

    Enron v. Dynergy
    The recent well-publicised accounting and corporate governance scandals involving U.S. public companies have provided another opportunity for companies to litigate, and courts to examine, the application of MAC clauses. The most prominent example is the lawsuit involving Dynergy's aborted purchase of Enron in fall of 2001, in which the court was to assess when a significant worsening of a company's existing problems will rise to the level of a MAC.

    Dynergy announced an agreement to purchase Enron on November 9, 2001, when Enron had already begun its precipitous decline. The purchase agreement contained a detailed and specific MAC clause, with particular financial thresholds for different events triggering it. Dynergy could walk away from the deal, for example, if, in its ?reasonable judgment,? Enron was ?reasonably likely? to suffer more than $3.5bn in losses from litigation.10 Within a month, Dynergy backed away from the deal, arguing that Enron had experienced further declines such that these financial thresholds were met. Enron responded to Dynergy's decision by seeking to force it to complete the deal as part of Enron's pending bankruptcy case.

    Can a regretful purchaser-to-be invoke their MAC clause when an already ailing enterprise simply increases its rate of decline – for reasons known to all parties at the time they signed the purchase agreement? The abandoned Enron/Dynergy merger did not provide an opportunity for a court to answer this question, as the parties settled their dispute in August 2002 for $25m.11