Untying the knot: Material adverse change clauses

Practical Law UK Articles 6-101-6634 (Approx. 18 pages)

Untying the knot: Material adverse change clauses

by Kirsten Birkett, PLC

US

Mac clauses are very common in all types of US law public and private acquisitions. In the current environment, therefore, lawyers need to understand the purpose, content and form of mac clauses in public and private transactions and the differing roles of these clauses in each type of deal. They also need to understand how the New York law judgment in IBP v Tyson may affect US and cross-border M&A.

Public acquisitions

In negotiated public acquisitions mac clauses are common, but not universal. In hostile acquisitions (made by a tender or exchange offer), the bidder will almost always include a mac condition in the offer document, but if the offer subsequently becomes a negotiated deal, the target company will usually argue for deletion or amendment of the condition. It is common for the presence of a mac clause to be negotiated as part of the deal protection package, which will usually include mechanisms such as a break fee and the right for the target to take a higher bid.

Purpose

There tend to be two types of mac clause in US public acquisitions:

General mac clauses, which stipulate that there has been no material adverse change to the business, assets and profits of the target company since the last balance sheet date.
Specific mac clauses, which might stipulate, for example, that there has been no early termination of a key contract.

Content

In a negotiated deal the bulk of the wording in a general mac clause is fairly standard although the buyer and seller will usually negotiate the existence and scope of exclusions to the clause. The exclusions proposed are usually for general economic conditions, general industry conditions and for matters arising out of the transaction itself (see also "Interpretation"in the box "IBP v Tyson: New York law").

"The important thing," says Joseph Aragonés of Coudert Brothers, Paris, who specialises in cross-border mergers and acquisitions, "is that the buyer needs to be advised on what wording will best address his particular interests and on how the clause is likely to be interpreted." Specific mac clauses are usually very heavily negotiated.

Form

In a tender or exchange offer, the mac clause will usually be in the form of a condition to the bidder's obligation to close the offer. In a merger agreement, the mac clause may be one of the pre-closing conditions or, more usually, a warranty or representation, as in the merger agreement between IBP and Tyson. (See description of triangular mergers in the US in "Unilever and Bestfoods: the merger analysed (www.practicallaw.com/2-101-3265)", Global Counsel, 2000, V(9), 15

A mac warranty will state that there has been no material adverse change since the relevant accounting date (for example, the last set of audited or unaudited accounts). The agreement will usually contain a "bring down reference", which states that the warranties and representations given at signing are true at closing (the same practice as repetition of warranties in the UK). Occasionally the seller gives the buyer a certificate to the same effect. The buyer is not obliged to close if the representations and warranties are not true. Where there is no requirement for a certificate, the onus is on the buyer to continue its due diligence on the target company up to closing.

"A specific mac condition is, in my view, preferable to a mac warranty or representation," says Hall, "because it can be drafted to give more flexibility. But the effect of both types of clause is the same: the buyer doesn't have to close."

Regulation

US merger agreements and tender and exchange offers usually specify the choice of governing state law, with the most frequently chosen being the law of New York, Delaware or, occasionally, California. Mac clauses are generally interpreted under the contract law of the state law governing the acquisition agreement, with federal securities laws having no direct bearing.

Other get outs

Even if a buyer is not confident that it can successfully rely on a mac clause to terminate a public acquisition, it may find that one of the other pre-closing conditions has not been satisfied. A buyer may also have a cause of action under applicable US state common law. For example, the seller may have committed fraud in the inducement to contract in the provision of information requested by the buyer as part of the due diligence exercise.

Private acquisitions

The purpose of a mac clause in a private acquisition is to protect the buyer in the period between signing and closing against any events that are seriously detrimental to the target company. The protection is frequently given as a warranty or representation, which will be brought down at closing, but can also be a pre-closing condition (see "Form" above).

Public v private acquisitions

The use of mac clauses differs in public and private acquisitions, in particular in the areas of:

Renegotiation of the purchase price.
Post-closing relief.

If a buyer of a private company has a strong claim for invoking a mac condition before closing, the parties will probably renegotiate the purchase price downwards rather than allow the deal to fall apart. One reason is that the target company may be seen as "damaged goods". Another is that the seller may prefer to close the deal at a lower price rather than sue the buyer for damages.

In a public offer, on the other hand, it is extremely rare for the offer price to be reduced, because of the reputational and other risks to the bidder and the target. One exception to this was the renegotiation of the price of the merger of BT and US corporation MCI in 1997. The result was a discount of 15% in the original price (see News brief "BT/MCI: No way out (www.practicallaw.com/2-100-2752)" PLC, 1997, VIII(8), 8).

Post-closing relief is another area where public and private acquisitions diverge. "Another fundamental difference between public and private acquisitions is the fact that a buyer in a private deal can get post-closing relief for breach of a mac warranty," says Hall. "Where the adverse change was not apparent before closing, the buyer can, in theory, sue the seller after closing for breach of the warranty (although this is hard in practice from an evidential point of view and it is questionable whether the buyer ought to have the benefit of hindsight in establishing whether a mac had, in fact, occurred pre-closing)." In public offers that litigation is not possible and the bidder has to make an assessment at the time of closing whether or not a mac has occurred.

IBP v Tyson

The case of IBP v Tyson is relevant to more than just New York, or even US, lawyers advising on public and private mergers and acquisitions. The following will also need to understand its significance:

Lawyers advising on a cross-border disposal to a US buyer. The buyer will often request that New York law governs the agreement.
Lawyers advising on any cross-border acquisition or disposal that is influenced by New York law and/or US transactional practice. This is very likely in European cross-border public mergers and acquisitions.
Any M&A lawyer, because very few jurisdictions provide analysis of this type (although see also the discussion of the WPP/Tempus case in "UK" below and box "WPP/Tempus: the Takeover Panel's decision").

"New York law is relatively highly developed jurisprudence," says Aragonés. "With this judgment we get a rare and sophisticated view of a court reading the type of agreements we draft every day. Generally, some clauses are handed down like heirlooms, but this kind of decision reminds practitioners of the need always to look at them very carefully on a case by case basis."

Aragonés explains why the case is relevant in a European context: "From a strictly legal point of view the case has no bearing on most European public acquisitions, but on a practical level IBP v Tyson has wide ramifications. The case gives us a wonderful window into how a material adverse effect clause was interpreted in its home jurisdiction, which can be used to see how a different jurisdiction might analyse the same issues. A clause drafted on the basis of US practice may not be read the same way by a court or arbitral panel applying, say, French contract law."

A rule of thumb is that a cross-border acquisition will be governed by the law of the target company, because the acquisition may be subject to the securities law and tender offer (or takeover) law of the target company's jurisdiction, and because the target company's structure and operations are governed by the law of its home jurisdiction.

Although IBP v Tyson was heard in Delaware, by the Delaware Court of Chancery, the court applied New York law. A New York court is not bound by the decision but it would regard it as very influential because of the stature of the Delaware court. The decision is also likely to influence Delaware law.

Lessons of IBP v Tyson The main lesson is that the court understood New York law as placing a high burden on a buyer wishing to rely on a mac or material adverse effect clause (see box "IBP v Tyson: New York law"). The court held that a broadly drafted material adverse effect condition "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."

The high test may have an impact on parties' actions. For example, when USA Networks tried to pull out of its merger with US holiday and travel company, National Leisure Group, because, it claimed, the attacks of 11th September had had a material adverse effect on National Leisure's business, the case was settled shortly afterwards, at the end of October 2001.

There is another aspect to IBP v Tyson: "The case is about the distinction between an undisclosed problem and the unknown consequences of a disclosed problem," says Hall. "The case was a warning that when a problem is disclosed to the buyer, the onus is on the buyer to consider what the ramifications might be, because the buyer is treated as being on notice of the reasonably foreseeable consequences of that problem. The same issue may arise in the dispute between Dynegy and Enron." Enron has sued Dynegy for US$10 billion for wrongful termination of their merger agreement of November 2001.

The practical consequences of IBP v Tyson may be seen in changes to the wording of mac clauses. "Broad mac clauses won't always do the trick," says Aragonés, "unless you can meet the higher burden of proof. If the buyer is concerned about a specific event, such as the loss of the target's key client, the buyer's counsel will need to specify it in the clause." Aragonés doubts, however, that practitioners will react by drafting mac clauses that contain a shopping list of possible events, for two reasons:

In IBP v Tyson the judge said that to avoid excessive itemisation a New York court would want to read into a broadly drafted clause a high burden.
A common law rule of construction that what is not specifically included is excluded would apply to a clause containing an overly-itemized list. A buyer may therefore find that the mac clause does not cover events that it was not able expressly and specifically to foresee.

But as Hall says: "Leaving aside companies directly affected by the war or terrorism, such as those in the travel industry, in the US at the moment most public company deals are within the same sectors. The view is that in such cases there is no reason to allocate risk for an event that would affect both companies equally."

UK

In the UK, mac conditions in takeovers moved centre stage last year when WPP Group plc, the global communications services group, tried to pull out of its offer for Tempus Group PLC, a UK media buying agency. M&A lawyers need to understand the implications of the decision in that case and the use of mac clauses in takeovers and private acquisitions in general.

Takeovers

A UK regulated takeover offer will be made subject to various conditions of a commercial nature, including there being no material adverse change in the business, financial position, profits or prospects of the target group since a specified date, usually that of the last published accounts (a mac condition).

It is routine for a mac condition to be included in hostile takeover offer documents and the wording in such cases is fairly standard. In a recommended takeover, however, there is usually heavy debate as to whether the mac condition should include the word "prospects". Where a hostile offer becomes recommended, the mac condition is sometimes re-negotiated by the target and this may lead to amendment (although no amendment was made when WPP's hostile offer became recommended). As a matter of the contract between the bidder and accepting shareholders, if a mac condition is not satisfied, the bidder is not required to close the offer (but see comments below on the difficulty of relying on mac conditions following the WPP/Tempus decision).

Takeover offers for UK resident public (and some private) companies are governed by the non-statutory City Code on Takeovers and Mergers (Takeover Code), which is administered by the Panel on Takeovers and Mergers (Panel).

WPP/Tempus

The Panel's written decision on WPP/Tempus gave UK M&A lawyers their first detailed statement on mac conditions in a specific case, but its explanation of the circumstances in which a mac condition can be invoked has caused concern.

WPP believed that there had been a material adverse change in Tempus's prospects after the announcement of its offer and, in particular, following the attacks in the US on 11th September, 2001. The offer was conditional on "no material adverse change or deterioration having occurred in the business, assets, financial or trading position or profits or prospects of any member of the wider Tempus Group." The Panel, however, refused to allow WPP to invoke the mac condition.

The Panel said that "meeting [its material significance] test requires 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" (see News brief "WPP/Tempus: MAC clauses in public takeover offers" PLC, 2001, XII(11), 11 (www.practicallaw.com/8-101-6082)

"The decision was right when viewed from the perspective of institutional investors," says Charles Randell of Slaughter and May. "But when considered as the impartial decision of a tribunal interpreting the wording of the Takeover Code, the decision swings far too much against the bidder. As the decision stands there are almost no circumstances in which a mac condition could be invoked" (see box "WPP/Tempus: the Panel's decision").

A key part of the Panel's decision was an interpretation of Note 2 to Rule 13 of the Takeover Code, which provides that the circumstances that give rise to the right to invoke a condition must be "of material significance to the offeror in the context of the offer." The only conditions that the Note does not apply to are the acceptance condition and the typical EC and UK antitrust conditions. "It is not absolutely clear whether the Panel's reasoning only applies to mac conditions about general economic circumstances or to offer conditions as a whole," says Randell. "Although my view is that the Panel may not apply the very strict 'frustration' test to more specific and objective conditions."

Practitioners have queried whether, from a strictly legal point of view, the Panel's frustration analogy makes sense. In a takeover a conditional contract is formed between the bidder and each accepting shareholder. If the Panel's requirement for a change analogous "to something that would justify frustration of a legal contract" is satisfied, it could be argued that each conditional contract may, in any event, be frustrated and that there would therefore be no need to invoke an express mac condition.

Other get outs."The Panel's decision underlines the difficulty of relying on mac conditions to withdraw from a UK takeover offer," says Mark Gearing of Allen & Overy. "The straightforward way for a bidder to get out of an offer is to invoke the acceptance condition, provided it remains unsatisfied at a closing date. Other conditions that may also provide a less contentious exit are non-satisfaction of a shareholder approval condition or of the EC or UK antitrust condition, where these are relevant."

Most frequently bidders will invoke the acceptance condition if they wish to get out of an offer, regardless of whether other reasons are driving the decision not to proceed. For example, Havas Advertising allowed its competing offer for Tempus to lapse on 24th September, 2001 by virtue of not reaching the 90% acceptance threshold, citing the deteriorating market conditions and events in the US as reasons for not submitting a higher bid.

For a bid to succeed, acceptances in respect of the requisite number of shares specified in the acceptance condition must be achieved within 60 days of the posting of the offer document, failing which the offer must lapse, unless the Panel consents to it remaining open (Rule 31.6, Takeover Code). In practice, this condition is usually set at 90% of the shares to which the offer relates. That percentage is the same percentage a bidder must acquire in order to take advantage of sections 428 to 430F of the Companies Act 1985 for the compulsory acquisition of holdings of any outstanding minority shareholders (the "squeeze-out" provisions) (see "Squeezing out minority shareholders", Global Counsel, 1998, III(3), 29 (www.practicallaw.com/5-100-7885)).

WPP's offer for Tempus was unusual in that the 90% acceptance level was met on the first closing date (that is, 21 days after the offer document was posted). The exceptional sequence of events was as follows:

One day after WPP posted its offer document, the terrorist attacks occurred in the US, which added to the already uncertain economic outlook.
The advertising sector (along with the airline industry) was perceived to be particularly affected in the aftermath of September 11th.
Havas Advertising subsequently declared its intention to lapse its offer, ten days before the first closing date of WPP's offer (the earliest date that WPP could withdraw its offer), leaving only WPP's offer on the table.
At the same time, the Tempus board recommended WPP's offer, and shareholders were left with sufficient time to accept WPP's offer so as to satisfy the acceptance condition by the first closing date.

More usually, the 90% acceptance level is not met at the first closing date. Indeed, bidders, especially hostile ones, frequently have to lower the 90% threshold (subject to a minimum level of more than 50% of the voting capital of the target company) if they wish their offers to succeed.

Developments. "Greater awareness following the events of 11th September and the WPP decision will probably result in mac clauses being increasingly heavily negotiated in the UK in recommended transactions," says Randell. "We are likely to see more US style wording and carve outs. The condition may be negotiated in much the same way as mac clauses in private acquisition agreements although the Panel's decision in WPP/Tempus suggests that the bidder will not be able to rely on the clause whatever its wording" (see also "Private acquisitions" below).

Practitioners doubt whether the typical 90% acceptance levels will be raised: "In a recommended deal the target company would not accept a higher threshold (indeed it may seek to lower it)," says Gearing. "In a hostile takeover, it would be easy for the target to attack the bidder for making its offer so conditional. There is also the question of whether the Panel would allow it."

Further, it appears that, despite the high test set by the Panel in WPP/Tempus, mac conditions are here to stay. "Bidders will always wish to include what protection they can," says Gearing, "but there may be an increasing tendency for bidders to include more specific conditions as well, to cover particular areas of concern, and perhaps to define what they will consider to be material. For example, in the takeover of Foseco by Burmah Castrol in 1990 a specific condition was included relating to the oil price and in the takeover of TLS by GE Capital in 1997 the bidder sought to define material for the purposes of its environmental condition." A mac could also be defined by reference to, say, a certain percentage fall in profits or a certain defined external economic indicator.

One practical suggestion is that where a bidder wishes to include a specific condition in its offer, it should consult the Panel in advance and put it on notice that, if the prescribed circumstances arise, they will be considered to be of material significance, at least by the bidder. This might make it more difficult for the Panel to refuse to allow the bidder to invoke the condition. It will still be necessary, however, to persuade the Panel that the bidder should be allowed to withdraw its offer in the circumstances which actually arise.

Another practical issue is that, absent regulatory or contractual requirements, there is usually no obligation on a UK target to produce the necessary information to the bidder to enable it to verify whether a condition is satisfied. This raises the question of whether, in a negotiated takeover, the bidder should seek to impose an obligation on the target to provide relevant information before the bidder will declare its offer unconditional. It would require a side agreement between the bidder and target company. This is not, however, current UK practice.

In the UK, the circumstances in which a break fee may be expressed to be payable have not typically covered material adverse change (see feature article "The break fee: A useful negotiating tool", PLC, 1999, X(11), 31 (www.practicallaw.com/5-201-9972) ). This is perhaps unsurprising, however, given how unlikely it is that a mac condition could be invoked.

Private acquisitions

A mac clause is only relevant in private acquisitions where there is a gap between exchange and completion. That apart, whether or not an agreement for a private acquisition contains a mac clause will usually depend on:

The negotiating position of the parties, which in turn may be dependent on which party is responsible for the delay between exchange and completion.
The nature of the target company's business.
Whether the purchaser is relying on externally provided finance, in which case a mac condition may be required to match the finance terms.

Randell estimates that: "The majority of private acquisition agreements will contain a mac clause in some shape or form."

Form. A mac clause may be expressed as a warranty that no mac has occurred since the date of the latest audited accounts. Typically, the buyer will insist on the mac warranty being repeated on completion, to which the seller will sometimes concede. The agreement will normally contain a condition, or give the buyer the ability to terminate, if the warranties, when repeated on completion, are not true.

A seller may, however, refuse to repeat the mac warranty at completion, on the grounds that the matters warranted are out of its control, and instead offer covenants through to completion and, occasionally, a mac condition.

Content. The mac condition will usually be negotiated. Typically, the seller will wish to strike out the word "prospects". The buyer, on the other hand, will argue for its retention, to keep its options as wide as possible. A seller will also probably wish to carve out changes in general economic circumstances and changes generally affecting the industry, on the basis that general market risk should be the buyer's and not the seller's. The buyer may concede but request an exclusion for changes that disproportionately affect the target company in ways that do not affect other companies in the market (see box "Specimen private acquisition mac clause").

Interpretation. A mac clause in an acquisition agreement governed by UK law will be interpreted in accordance with contract law. There is, however, very little UK case law directly on mac clauses in acquisition agreements. IBP v Tyson may provide some guidance on how a UK court would approach a similar case.

Germany

The takeover regime in Germany changed radically on 1st January, 2002, leading to a reappraisal of mac clauses in public offers. By contrast, the use of mac clauses in private acquisitions is well established.

Takeovers

There are fewer public takeovers in Germany than in the US and the UK, but this may change because of the takeover and tax law reforms introduced at the start of 2002 (see "Boomtime in Germany" Global Counsel, 2000/01, V(10), 15 (www.practicallaw.com/2-101-3388) and "Law and regulation of public takeovers: Germany" Mergers and Acquisitions Handbook, 2001). "Mergers and acquisitions activity could increase greatly because the tax road blocks have been removed," says Maximilian Schiessl of Hengeler Mueller, "although that only gets going the deals that had been on hold pending reform." Burkhard Bastuck of Freshfields Bruckhaus Deringer is optimistic about the outlook: "Key German industries, such as banking, energy and telecoms, and also traditional ones, such as chemicals manufacturing, continue to undergo drastic changes which generate M&A activity."

There is also a lower incidence of mac conditions in German regulated takeovers than in the US and UK. "It is not usual for an offer document for a German corporation to contain a mac condition," says Schiessl. He acknowledges, though, that practice may change: "In the two public takeovers that I negotiated in the last 12 months, the buyers wanted a standard US mac condition. In both cases the conditions were dropped before they were discussed with the regulator."

Regulation. The Federal Supervisory Office for Securities Trading (Bundesaufsichtsamt für den Wertpapierhandel) succeeded the German Takeover Commission as regulator of takeovers on 1st January, 2002. The regulator has governmental powers to enforce its decisions.The Federal Supervisory Office for Securities Trading (Bundesaufsichtsamt für den Wertpapierhandel) succeeded the German Takeover Commission as regulator of takeovers on 1st January, 2002. The regulator has governmental powers to enforce its decisions.

On the same date a new binding Act on the Regulation of Public Takeovers (Wertpapiererwerbs- und Übernahmegesetz) replaced the voluntary Takeover Code. Compliance with the Code had been compulsory only for stock corporations that wished to be admitted to the DAX or MDAX indices and to the Neuer Markt. Therefore, less than two thirds of German listed companies had agreed to subject themselves to the Code.

The new takeover law applies to public takeover offers for stock corporations (Aktiengesellschaften) or partnerships limited by shares (Kommanditgesellschaften auf Aktien) which:

Have their principal place of business in Germany.
Are listed on a regulated market of at least one stock exchange in the European Economic Area.

Takeovers by non-German companies will therefore be subject to the new law. Under the old Takeover Code, foreign bidders intending to takeover a German listed stock corporation were not bound, although many agreed to be bound by it (partly in order to gain positive press coverage)

An offer document must be submitted to the regulator for review before publication and the main focus of the regulator's review will be the offer conditions. The new takeover law prohibits a bid from being conditional on events that the buyer may control, which in practice means subjective conditions. "In my view, the broader the condition, the more difficult it would be for the regulator to approve it," says Schiessl. "It must contain an objective standard which can be reviewed by a court."

Bastuck comments: "The law does not permit subjective or discretionary conditions. If a mac clause is necessary, I would advise that it contains an appropriate objective standard. For example, a regulatory condition could refer to a public index, such as the DAX, dropping below a certain level. Or if the target company operates in a particular sector, the mac clause could refer to movement of prices in that sector. Of course, one has to be very careful to ensure that the condition is acceptable to the markets."

There is no formal process for invoking a mac condition, but it is likely that the regulator would need to be consulted, especially in a contentious situation. "It is too early to say how difficult it would be for a bidder to invoke a mac condition under the new regime," says Schiessl. "The matter will stir a public debate and is exactly the sort of issue that we will be raising with officials of the regulator early on in a transaction. My expectation is that there will be a high standard if mac clauses are accepted at all."

Practicalities. On a practical note, lawyers advising a bidder should try to reach a clear understanding with the regulator about the content of a mac condition at the review stage, because this may assist their client if it later wishes to rely on the condition. The same comment is made in relation to UK regulated takeovers (see "UK" above).

If a bidder withdraws from an offer, shareholders who have accepted the offer would have a claim against the bidder for the consideration owing to them.

Other get outs. Failure to satisfy any of the other offer conditions would also entitle a bidder to withdraw. This would be this case if, for example, the level of acceptances specified in the acceptance condition is not reached. Acceptance levels are set at between 75% and 90% of the voting capital of the corporation. A 75% shareholder can guarantee corporate control by entering into a "domination agreement" with the target company, which permits the shareholder to give instructions to the management. Higher acceptance levels may be used for tax reasons.

There is a question whether the threshold may be raised to 95%, which, under new corporate law introduced in connection with the Takeover Act, on 1st January, 2002, is the level of ownership that entitles a bidder to buy out any dissenting shareholders. "The introduction of squeeze-out provisions with a 95% threshold certainly makes a 95% acceptance level in public offers more attractive," says Bastuck, "and it remains to be seen whether it would be used in practice." There is, however, another view on the matter: "I don't think that bidders would set the level that high," says Schiessl. "The 75% threshold is very well established."

A bidder wishing to remove or lower the threshold for fear of failure to meet the acceptance condition must do so one day before the offer expires. It must therefore estimate in advance of expiry the number of acceptances it is likely to have received, because counting is traditionally carried out on expiry of the offer.

Future. Bastuck gives his view on the future of mac clauses: "There has been much discussion amongst practitioners on how to craft new mac conditions. There is bound to be change in this area and new standards will develop. Development will probably be made through discussion at a transactional level, amongst bankers and clients with experience of the approach in other jurisdictions. The lawyers will then test the proposed clause against the new takeover law."

Private acquisitions

Where the target company of a private acquisition is German, German law will generally apply. A mac clause in a German governed private acquisition agreement gives the buyer grounds for termination or rescission if an event that is fundamentally detrimental to the target's business occurs between signing and closing.

Incidence. "Mac clauses have quite a long history in private acquisitions in Germany", says Schiessl. "For example, sophisticated mac clauses were already in use in the early Nineties." He recalls an unsuccessful attempt to invoke a mac condition in an agreement for the sale of the Japanese subsidiary of a German company to a US buyer at the time of the earthquake in Kobe, Japan, in 1995.

Bastuck comments that the size of acquisitions has increased over the years, which has made it more common for there to be a gap between signing and closing (previously signing and closing would often be simultaneous). In his view, this has led to an increase in the use of mac clauses.

Schiessl estimates that nowadays: "In one out of every two major cross-border deals, the buyer's lawyers will try to introduce a mac condition." Major in this context means US$100 million and above. Mac conditions are also reasonably common in agreements for domestic private acquisitions in Germany.

Mac conditions are frequently used in private equity transactions, where the purchase is generally dependent on external financing. The financing documents themselves almost always contain a mac clause.

Content. In a leveraged acquisition, the purchase agreement should either repeat the mac clause agreed in the finance agreement or be made subject to the buyer receiving the necessary funds. This is to prevent a buyer remaining committed to complete the transaction where the funding has been withdrawn. In practice, repeating the financing mac clause is not always possible because the acquisition agreement is signed before the financing is formally agreed.

For a buyer, it is essential that the mac condition is carefully drafted and, especially, that it covers a risk relevant to the buyer. In the Kobe example, above, the mac condition allowed the buyer of the Japanese subsidiary to terminate the agreement if the business of the entire group suffered a material adverse change. The earthquake materially affected the business of the Japanese subsidiary, but not the group as a whole, and the attempt to invoke the clause was therefore unsuccessful.

Some mac clauses cover specific concerns of the buyer about the target company (such as environmental liabilities) or legislative or regulatory changes in the sector in which the target company operates that may be detrimental to its business. Bastuck gives an example: "If the target company is, say, a media company, the buyer may wish to protect itself by a mac clause that gives it a right to terminate the agreement if the policy of the media commission materially changes."

Interpretation. Mac clauses in a German law agreement are governed by German contract law. There is, however, little German case law on mac clauses. Schiessl suggests two reasons for this:

Parties have traditionally preferred to settle disputes out of court.
Roughly half of the agreements for private acquisitions provide for arbitration of disputes rather than litigation.

"The main advantage of arbitration is that it avoids the creation of a public record", says Schiessl. "In a dispute of this kind, where sensitive financial information is likely to be in issue, the parties, and in particular the seller, will wish to keep it confidential." Other reasons are that arbitrators are generally perceived to have greater experience of the complexities of acquisitions than the judiciary and that arbitration proceedings can be completed in a shorter time than those before the ordinary courts.

Other get outs. In addition to the role of a mac clause in enabling a buyer to terminate an agreement where a material adverse event is identified after signing, it can be used as a tool to negotiate a lower purchase price (see also "Public v private acquisitions" in "US" above). However, renegotiation may not be possible in a leveraged acquisition because of restrictions imposed by the lending banks.

A buyer may withdraw from a private acquisition if any of the conditions, such as approval of the competition authorities, are not met. Another escape route may be available where the parties have agreed to a clause allowing the buyer to terminate the agreement if there has been a fundamental breach of one of the buyer's representations or warranties. "This type of clause is usually hotly negotiated," says Bastuck, "because the seller wants transactional certainty. It is also quite rare. But the buyer can argue that if there is a long period to bridge, it does not want the risk of a major event happening that seriously affects the value of the company. The sort of event that would trigger the clause might be the insolvency of a major subsidiary of the target company."

Another method for protecting the buyer is sometimes employed where the buyer has not been able to carry out a full due diligence exercise before the acquisition agreement is signed. The reasons for this vary, but may include:

Where the acquisition has to be made very quickly (for example, pre-insolvency sales).
Where the target company is sold by way of an auction.
Where the acquisition is subject to a review by the competition authorities and the seller is unwilling to provide confidential information to the buyer (its competitor) until competition clearance is given.

The parties may therefore agree that the acquisition agreement is conditional on no major problems in the company's assets and finances (usually itemized) being uncovered during the post-signing due diligence exercise. If the condition is not satisfied, the buyer is not required to close the transaction.

Developments. An increased use of mac clauses is expected in one particular area: "Private equity investors tend to need the protection of mac clauses," says Bastuck, "and because these investors are becoming more prominent, we will see more and more mac clauses in the private equity part of the market."

The author would like to thank those listed below for their assistance with this article.

Joseph Aragonés, a partner in the Paris office of Coudert Brothers. He is a member of the New York bar.

Burkhard Bastuck, a partner in the Frankfurt office of Freshfields Bruckhaus Deringer.

Mark Gearing, a partner in the London office of Allen & Overy.Richard Hall, a partner in the New York office of Cravath, Swaine & Moore.Charles Randell, a partner in the London office of Slaughter and May.

Maximilian Schiessl. a partner in the Düsseldorf office of Hengeler Mueller.

IBP v Tyson: New York law

The decision of the Delaware Court of Chancery in IBP v Tyson in 2001 includes a detailed discussion of the interpretation and application of "material adverse effect" (MAE) or "material adverse change" clauses to terminate agreements (IBP, Inc. Shareholders Litigation v Tyson Foods, Inc., No CIV. A.18373.2001 WL (Westlaw) 675330 (Del. Ch. June 18, 2001). The agreement in question was governed by New York law.

Background. Tyson Foods, Inc., the leading poultry provider in the US, entered a bidding war for IBP, Inc., the US's leading beef supplier, in December 2000. In the course of due diligence certain problems with IBP's business became evident. First, one of IBP's subsidiaries was discovered to have been the victim of fraud and secondly, the report on Form 10-Q filed by IBP for the third quarter of 2000 showed that the company was far behind projected earnings, due largely to an especially cold winter resulting in reduced live stock supplies.

Despite these and other worsening signs, on 31st December, 2000 Tyson won the bid for IBP and the next day the parties entered into a US$4 billion merger agreement.

The US Securities and Exchange Commission (SEC) reviewed and commented on a proxy statement that had been filed in connection with one of the failed bids for IBP. Shortly before the parties entered into the merger agreement, the SEC requested that IBP should revisit its reporting of its different business segments in view of certain inconsistencies. IBP was unaware of this at the date of entry into the merger agreement. The proxy statement contained the same financial statements that IBP represented and warranted in the merger agreement with Tyson.

In due course, IBP concluded that it would have to restate the warranted financial statements to take a significant additional charge of US$60.4 million to the earnings of its troubled subsidiary. A public announcement to this effect was made at the end of February 2001.

Termination. Without warning, on 29th March, 2001 Tyson announced the termination of the merger agreement and filed suit against IBP to rescind or terminate, citing IBP's restatement of its warranted financial statements as constituting a breach of its warranty that the warranted financial statements were accurate in all material respects. Tyson also argued that it could terminate the merger agreement because IBP had breached Section 5.10 of that agreement, a representation and warranty that IBP had not suffered a "material adverse effect" since the "Balance Sheet Date" of 25th December, 1999 except as set out in the warranted financial statements or Schedule 5.10, which qualified the scope of the warranty.

Material adverse effect. The merger agreement defined an MAE 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 ..."

Tyson argued that the decline in IBP's performance in the last quarter of 2000 and the first quarter of 2001 demonstrated a material adverse effect (as did IBP's taking of an additional charge related to the problems at its subsidiary). The court admitted that interpreting and applying the MAE clause to the facts before it was "dauntingly complex".

Interpretation. The court held that: "On its face, Section 5.10 is a capricious clause that puts IBP at risk for a variety of uncontrollable factors that might materially affect its overall business or results of operations as a whole. Although many merger contracts contain specific exclusions from MAE clauses that cover declines in the overall economy or the relevant industry sector, or adverse weather or market conditions, Section 5.10 was unqualified by any such express exclusions."

IBP argued that the warnings in the warranted financial statements that emphasized the risks that IBP faced from wide swings in livestock supply operated as implicit carve-outs. The court agreed with Tyson, however, pointing out that those disclaimers were far too general to preclude industry wide or general economic factors from constituting an MAE, noting that had IBP wished such an exclusion from the broad language of Section 5.10, IBP should have bargained for it.

Still, Tyson's argument that Section 5.10 gave it a right to walk away simply because of a decline in cattle supply was equally untenable. To succeed, Tyson would have to show that the event had the required materiality of effect.

Application. Part of the difficulty in interpreting the MAE clause was the ambiguity of applying it over time, since by its own terms the clause referred to any MAE that occurred to IBP "since 25th December, 1999" unless that effect were covered by the warranted financial statements or Schedule 5.10.

In addition, Tyson's right to refuse to close was also qualified by the other explicit disclosures in Schedule 5.10, by virtue of:

The language of the annexes allowing Tyson to refuse to close for breaches of warranty (unless the breach resulted from actions specifically permitted by the merger agreement).
The language of the merger agreement that made all disclosure schedules apply to Schedule 5.10 where that was the reasonably apparent intent of the drafters.

The court read these provisions as requiring that it examine whether an MAE had occurred against the condition of IBP as at 25th December, 1999 as adjusted by the specific disclosures of the warranted financial statements and the merger agreement itself. In addition, the court considered that this approach would make commercial sense to the extent it established a baseline that roughly reflected IBP's condition as known to Tyson at the time it executed the merger agreement.

The court applied this approach by comparing IBP's earnings from operations and earnings per share before extraordinary items over the five year period, 1995-1999 (see box "IBP's earnings" below).

The figures revealed that IBP was consistently profitable, although subject to wide swings in annual earnings and net earnings. These business characteristics were already evident in the data contained in the original warranted financials for fiscal year 2000. IBP's financial statements also showed that certain IBP business units that Tyson claimed were critical in its analysis were, in fact, not as important as claimed to IBP's overall operations, and certain other projections available to Tyson showed that IBP would not reach original profit expectations until fiscal year 2004. These and other financial considerations suggested that Tyson, as an investor with strategic and long term goals in acquiring IBP, was both aware of the lowered and cyclical economic expectations over the near term and less interested in these results as compared to the long term synergies.

Long term view. As the court said, to an investor with Tyson's longer-term perspective: "the important thing is whether the company has suffered a Material Adverse Effect in its business or results of operations that is consequential to the company's earning power over a commercially reasonable period, which one would think would be measured in years rather than months. It is odd to think that a strategic investor would view a short-term blip in earnings as material, so long as the target's earnings-generating potential is not materially affected by that blip or the blip's cause."

Conclusion. The court reviewed both New York and non-New York case law on the subject in some detail and concluded in the following terms: "Practical reasons lead me to conclude that a New York court would incline toward the view that a buyer ought to have to make a strong showing to invoke a Material Adverse Effect exception to its obligation to close. Merger contracts are heavily negotiated and cover a large number of specific risks explicitly.

"As a result, even 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 acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner...

"A contrary rule will encourage the negotiation of extremely detailed 'MAC' clauses with numerous carve-outs or qualifiers. An approach that reads broad clauses as addressing fundamental events that would materially affect the value of a target to a reasonable acquiror eliminates the need for drafting of that sort ...

"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. In this regard, it is worth noting that IBP never provided Tyson with quarterly projections ... When examined from this seller-friendly perspective, the question of whether IBP had suffered a Material Adverse Effect remains a close one ... I am confessedly torn about the correct outcome ...

"In the end, however, Tyson has not persuaded me that IBP has suffered a Material Adverse Effect. By its own arguments, Tyson has evinced more confidence in stock market analysts than I personally harbor. But its embrace of the analysis is illustrative of why I conclude that Tyson has not met its burden [emphasis in original]."

Burden of proof. The court recognised that the resolution of this issue depended heavily on the initial position one took with respect to the allocation and standard of the burden of proof under New York law. The Vice Chancellor did not find that New York law provided clear guidance, although he concluded that New York would choose to hold a buyer such as Tyson to a "strong showing" to invoke an MAE exception to its obligation to close.

On this basis, he held that Tyson failed to demonstrate that IBP had breached Section 5.10. Nevertheless, the Vice Chancellor recognised that if, in fact, he were wrong, and if, in fact, New York would require IBP to show the absence of an MAE by the more demanding "clear and convincing evidence" standard applied in Delaware in order to obtain specific performance, then in that case IBP would not have met the burden.

The court, applying New York law, found that Tyson had improperly terminated the merger agreement and granted IBP specific performance of the agreement.

Joseph Aragonés and Nora Newton-Muller, Coudert Brothers, Paris

IBPs earnings

	1999	1998	1997	1996	1995
			US$
Earnings from operations (in thousands)	528,473	373,735	226,716	322,908	480,096
Net earnings per share	3.39	2.21	1.26	2.10	2.96

WPP/Tempus: the Takeover Panel's decision

The UK Takeover Panel (Panel), upholding an earlier ruling of the Panel Executive, refused to allow WPP to invoke the material adverse change (mac) condition in its offer for Tempus. The Panel's decision provides a revealing insight into the way in which it will judge any future attempt to invoke a mac condition (Panel Statement 2001/15, 6th November, 2001).

WPP had argued 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 US on 11th September, 2001. It sought to invoke the mac condition in paragraph (g)(i) of the conditions in its offer document.

Material significance. The key test to be applied under the Takeover Code when seeking to invoke a mac condition is in Rule 13, Note 2. This provides that the circumstances that give rise to the right to invoke a condition must be "of material significance to the offeror in the context of the offer." It is this provision that gives the Panel jurisdiction to determine whether or not an offeror should be permitted under the Takeover Code to invoke a condition and thereby lapse its offer. The only conditions this provision does not apply to are the acceptance condition and the typical EC and UK antitrust conditions.

Exceptional circumstances. The other rule that the Panel considered in the context of the WPP/Tempus case was Rule 2.7. In particular, Note 1 to Rule 2.7 provides that "A change in general economic, industrial or political circumstances will not justify failure to proceed with an announced offer: to justify a decision not to proceed, circumstances of an exceptional and specific nature are required."

This rule was originally aimed at situations where an offeror might seek to withdraw its offer otherwise than on the basis of its offer conditions. The context in which it appears in the Takeover Code also suggests that it is now only intended to apply in the period between announcement and posting of the offer document. The Panel appears to have acknowledged this when it said in its decision on the WPP/Tempus case that "the history and wording of Rule 2.7 make it difficult to argue that it is of direct application to the operation of a material adverse change condition contained in an offer which has been posted."

Frustration analogy. The Panel also referred in its decision to two Panel statements issued in early 1974 (Panel Statement 1974/2, January 1974, and Panel Statement 1974/4, March 1974). Like Rule 2.7, which followed them, these statements were released at a time when offers were generally subject to very few conditions (normally just an acceptance condition and, where relevant, a regulatory or listing condition) and the Panel was assessing whether it would allow an offeror to withdraw its offer for reasons not covered by any of its offer conditions.

It was against this background that the Panel said, in its January 1974 statement, that, "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." Requiring something akin to legal frustration was justified in this context on the basis that the circumstances envisaged were not those where the offeror was seeking to rely on an express condition.

Interpreting the material significance test. Offer conditions have expanded considerably since 1974. In particular, mac conditions have become, but were not then, standard. The ever expanding scope of offer conditions led to the introduction of Rule 13, including the material significance test in Note 2.

Notwithstanding the history behind the Panel's 1974 statements, and its views on the applicability or otherwise of Rule 2.7 as referred to above, the Panel decided in the WPP/Tempus case that the same thinking should be taken into account when considering the material significance test in Note 2 to Rule 13, "so that meeting this test requires an adverse change of very considerable significance striking at the heart of the purpose of the transaction in question, analogous, as the 1974/2 Panel statement put it, to something that would justify frustration of a legal contract."

This sets an extremely high hurdle for seeking to invoke an express condition. Frustration under English law "requires that without default of either party a contractual obligation has become incapable of being performed because the circumstances in which performance is called for would render it a thing radically different from that which was undertaken by the contract" (Davis Contractors Ltd v Fareham U.D.C.[1956] AC 696, at 729). An event such as destruction of the subject matter of the contract or of something essential for its performance could amount to frustration; financial loss in performing the contract would, of itself, be insufficient.

The Panel's interpretation of the test applied by Note 2 to Rule 13 raises the question whether circumstances could ever arise which it would consider sufficiently significant to permit the invocation of a mac condition. On its own terms the test is subjective (in the sense that the relevant circumstances must be of "material significance to the offeror in the context of the offer"), but the Panel reserves to itself the right to determine objectively whether its test is met.

Practicalities. One difficulty for an offeror seeking to invoke a mac condition is that the burden of proof falls on it but there is no right to information from the offeree company and no formal discovery process. The WPP/Tempus case shows that the Panel will be very reluctant to require an offeree company to disclose information that could possibly substantiate the offeror's case. An offeror is therefore likely to be dependent on extraneous evidence and any limited information that the offeree company cares (or is otherwise obliged, for example, by listing rule requirements) to disclose.

Although the Panel said that an offeror may rely on a change in general economic circumstances when seeking to invoke a mac condition (provided the material significance test is satisfied), it is also clear from the Panel's decision that an offeror cannot rely on a general and/or sectoral economic decline that was known to, or should have been foreseen by, it in advance of making its offer. This presents an offeror seeking to invoke a mac condition, particularly in volatile market conditions, with the considerable difficulty of having to distinguish between the effects of foreseeable and unforeseeable events.

In addition, in order to show a material adverse change in an offeree company's prospects, a change in the longer term prospects (that is, beyond the current financial year) of the offeree company must be shown. The long term effects of particular events will, however, almost always be uncertain and open to different interpretations. The WPP/Tempus case suggests that an offeror will be hard pressed to satisfy the Panel in circumstances where the offeree company is able to challenge its views as to the future, without necessarily having to provide direct counter evidence as to its own longer term prospects.

Mark Gearing, Allen & Overy, London

Specimen private acquisition mac clause

The following is a typical mac clause used in a UK law private acquisition. The bracketed wording may be subject to negotiation.

"There shall not have occurred any material adverse change in the business, operations, assets, position (financial, trading or otherwise), profits [or prospects] of the Target Group, taken as a whole [or any event or circumstance that may result in such a material adverse change]

[excluding, in any such case, any event, circumstance or change resulting from (i) matters disclosed in [the Disclosure Letter or the Acquisition Documents], (ii) changes in stock markets, interest rates, exchange rates, commodity prices or other general economic conditions, (iii) changes in conditions generally affecting the [industry], (iv) changes in laws, regulations or accounting practices or (v) this transaction or the change in control resulting from this transaction]

[except to the extent that the matters in paragraphs (i) to (iv) have an impact on the Target Group that is disproportionate to the effect on other [similar] companies operating in the [industry].]"

Untying the knot: Material adverse change clauses | Practical Law