Private Equity

The sea squirt is an animal that begins life with a brain and a tail.  Immediately after it is born, it uses its brain and tail to propel itself through the water until it finds some rock to attach itself.  Once it attaches itself to that rock it consumes its brain, absorbs its tail, and thereafter never moves again; it lives out its remaining life as a brainless water filter.^[1]

Many of the standard terms of M&A agreements also began their existence with a brain—the brain of a smart lawyer who perceived an issue that needed to be addressed and drafted a clause to address it.  And then other smart lawyers recognized the value of that newly drafted clause, and adapted and improved it until it became a standard part of most M&A agreements.  But once that clause became attached to the “market” it became divorced from the brain or brains that created it, and soon everyone was using it regardless of whether they truly understood all the reasons that prompted its drafting.  Even worse, market attachment is so strong that even after a standard clause has been repeatedly interpreted by courts to have a meaning that differs from the meaning ascribed to that clause by those who purport to know but do not actual know its meaning (mindlessly using the now brainless clause), it continues to be used without modification.  Such is the case for many with the ubiquitous Material Adverse Change (“MAC”) or Material Adverse Effect (“MAE”) clause.

It’s been 16 years since then Vice Chancellor Leo Strine ordered Tyson Foods to complete its merger with IBP despite claims by Tyson Foods that an MAE clause had been tripped as a result of a significant drop in IBP’s earnings for the last few quarters, as well as some alleged accounting irregularities at one of IBP’s subsidiaries.  In a decision that has been cited by virtual every court that has considered the meaning of MAE or MAC clauses around the common-law world, In re IBP, Inc. Shareholders Litigation,^[2] then Vice Chancellor Strine said:

[E]ven where a Material Adverse Effect condition is as broadly written as the one in the Merger Agreement, that provision is best read as a backstop protecting the acquirer 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 the acquirer.^[3]

Despite that interpretation of a broadly written MAE clause, the wording of most MAE or MAC clauses has largely remained unchanged, except for the ever increasing number of exceptions that are negotiated to clarify things that would not be a MAC or MAE regardless of their materiality; e.g., changes in general economic, political or financial markets, changes in general industry conditions not disproportionally affecting the target, changes in law, failure to meet projections, ect.  Unfortunately, focusing on the negotiation of carve-outs has led some to believe that by not including a carve-out to the MAC or MAE clause they have somehow included that un-excluded matter in the events that would in fact result in a MAC or MAE.  But narrowing exclusions does not mean that the un-excluded matters are necessarily captured by the actual definition of MAE or MAC—a basic definition that still remains pretty much what it was when then Vice Chancellor Strine considered the MAE clause at issue in the IBP case.  And courts continue to interpret the basically unchanged MAE or MAC clause, which has brainlessly attached itself to the market, consistent with the approach of IBP and its progeny.

Thus, in a recent Delaware Court of Chancery decision, The Mrs. Fields Brand, Inc. v. Interbake Foods LLC, C.A. No. 12201-CB (Del. Ch. June 26, 2017) efforts to terminate a License Agreement based on an interpretation of an MAE provision that sought to ignore IBP and its progeny were rebuffed.  Despite the fact that a similarly worded MAE provision to that used in countless M&A agreements contained no requirement that the material event be unknown, and no specific “durational element or requirement that the alleged ‘material adverse’ fact threaten ‘overall earning potential[,]’” the court interpreted the License Agreement’s MAE provision consistent with IBP and its progeny to have just such elements and requirements.  According to the court, because the persons drafting the MAE clause in the License Agreement “had the benefit of the doctrine developed in IBP and its progeny when they negotiated the text of [the MAE clause in the License Agreement], … the same factors underlying its approach—knowledge, magnitude, and duration—are relevant to construing [the MAE clause in the License Agreement].”

The facts of the Mrs. Fields case are not particularly important for our purposes.  Instead, what is important is the fact that standard clauses have to be interpreted in light of caselaw.  And if you want a clause to have a meaning different than that provided by caselaw, you need to modify the clause in light of that caselaw.   In a 2006 Weil Private Equity Alert article we offered the following guidelines for private equity buyers respecting the standard MAE or MAC clause (and they seem as apt today as they did then):

• Standard material adverse change clauses are important back-up protection for the truly significant but unknown event, so they should not be ignored or eliminated.  However, don’t expect more from them than that.
• In no event should a private equity buyer rely on a standard material adverse change clause as protection from a general decline in performance or from an adverse development caused by external factors.  If there are specific areas of concern with a target or its business, these should be addressed up front and perhaps even apart from the concept of the material adverse change clause (and inserted as a separate closing condition).
• Carve-outs should be negotiated or removed to the extent possible, but even the absence or elimination of carve-outs can be deceptive.  In other words, just because a carve-out is not present does not mean that it is actually deemed to be included in the main definition.  For example, is there a specific law that could change that would materially affect your decision as to whether to buy a business?  If so, make it a condition to the closing that no such change shall have occurred; do not simply rely upon having successfully eliminated a “changes in law” carve-out from the definition of material adverse change.
• Carefully consider the contexts in which the defined term, “Material Adverse Change” is used throughout the acquisition agreement. For example, if a lawsuit is filed against the target seeking a potentially company-ending judgment, has a “Material Adverse Change” occurred?  The answer is not necessarily.  Even in the most forward looking definition of Material Adverse Change, the buyer would be required to show that it’s reasonably likely that the lawsuit will be decided unfavorably to the target—an awkward position to be forced to take if there is a chance the buyer has to close on the transaction and inherit the lawsuit.
• Private equity buy-outs have always required a lot of hard work by the deal professionals with respect to due diligence.  Ask the hard questions.  What could go wrong?  What have I assumed in my model and what impact would there be if one or more of those assumptions is not realized?  Make sure your counsel understands those assumptions and has advised whether you are protected if those assumptions are not realized between signing and closing. Do not assume everyone will see material the way you do based on your own model.^[4]

Don’t let “it’s market” ever be an acceptable explanation for the inclusion or lack of inclusion of any provision of an agreement.  Know what every provision of your agreement means on its face, as well as how any standardized provisions have been interpreted by the courts that could ultimately be involved in any dispute over your agreement. And when it comes to the brainless MAC clause in particular, understand that regardless of what the words seem to say, IBP and its progeny suggest that it may provide little protection from even materially disruptive or negative events that occur between signing  and closing, unless those events were unknown to the buyer at the time of signing and fundamentally make the business significantly less valuable over the long term.