February 2008

A number of current stalled deals involve material adverse change clauses. Litigation in this area will increase because of uncertainties involving (i) the credit markets and (ii) operating disappointments associated with an economic downturn. Regardless of whether you represent sellers, buyers, or lenders, lawyers are well-advised to pay greater attention to these “standard” provisions.

A material adverse change (aka a material adverse event) contingency clause is frequently found in both mergers and acquisitions contracts, and in financing agreements. Particularly with larger transactions, lengthy periods occur between the agreement negotiation and transaction completion (closing) because of government approvals, shareholder or labor agreement approvals, and/or completion of acquirer/lender due diligence. A material adverse change provision allows a purchaser or lender to refuse to complete a transaction if the acquisition target or borrower suffers a change that significantly affects the economics of the deal.

The ABA’s model stock purchase agreement contains an example of a broadly-worded material adverse change clause:

“No Material Adverse Change – Since the date of the Balance Sheet, there has not been any material adverse change in the business, operations, properties, prospects, assets or condition of any Acquired Company, and no event has occurred or circumstances exist that may result in such material adverse effect.”

The fact that theses provisions are standard does not mean they are well understood. While everyone agrees that the purpose of a written agreement is to clearly define the parties’ agreement, the material adverse change clause appears to be a notable exception where ambiguity is consistently tolerated. The challenge involves the meaning of the word “material”. Despite negotiation of the provisions in the “standard” provision, definition of the word “material” rarely occurs. Some agreements define “material” in terms of specific dollar thresholds, but most agreements do not.

Courts have endeavored to interpret the meaning of these clauses as pertaining to something that, had it been known at the signing, would have altered the very essence of the transaction. However, in practice, case law has typically favored the seller or borrower who desires the transaction to continue/close. Notable cases include:

  1. IBP, Inc. vs. Tyson Foods, 789 A.2d 14 (Del Ch. 2001) – IBP’s earnings for the first quarter of 2001 were 64 percent behind its earnings for the first quarter of 2000, but this was not sufficient to trigger a material adverse change clause. In denying that a material adverse change occurred, the Court concluded:

    “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 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 earning potential of the target in a durationally-significant manner. A short-tern hiccup in earnings should not suffice; rather, the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquirer.”

  2. Frontier Oil Corp. vs. Holly C.A. No. 20502 (Del. Ch. Apr. 29, 2005) – The Court concluded that “the notion of a materially adverse event is imprecise and varies both with the context of the transaction and its parties and the words chosen by the parties.” The Court then held that the burden of proof rests on the party seeking to rely on the material adverse change clause to prove both that the event exists and that it would have a material adverse effect.
  3. Borders vs. KRLB, 727 S.W.2d 357 (Tex. App. – Amarillo, 1987) – A radio station’s rating decline that indicated a loss of half of its listening audience was deemed to be not material because the (i) the provision did not mention ratings, and (ii) the provision mentioned the word “operations” and the loss of ratings was judged as having nothing to do with the station’s broadcasting activities.
  4. Genesco Inc. v. Finish Line Inc., 07-2137, Chancery Court for the State of Tennessee (Nashville) – The Court ruled that a federal probe into alleged fraud, and Genesco’s loss (vs. a substantial expected profit) were not sufficient to evoke a material adverse change clause in a $1.5 billion acquisition and related financing.

In all of these cases, courts have failed to define “material” in terms of percentage amounts. Financial experts are also loathe to provide strict guidelines, but will generally have guidance regarding to what the word “material” means. In each case, financial professionals are likely to be quicker than the courts in the above cases to agree that a material adverse change has occurred. For example:

  1. The standard auditors’ report on financial statements expresses, “In our opinion, the financial statements referred to above present fairly, in all material respects, …” Similarly, corporate officers (the CEO and CFO) are personally liable for attesting that the financial statements “do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements … not misleading”. In both of these contexts, it is generally agreed that changes in the range of five to ten percent might be material.
  2. When valuing a company, a change in earnings, EBITDA, or other measure of profitability will have a disproportionate effect on the value of the enterprise because the decrease affects the calculated growth rate. In this context, a change of 10 percent could easily be considered material.

Because of the cases listed above, it is now generally agreed that material adverse change excludes general changes in the economic climate. Buyers wishing to limit this result have negotiated the addition of the word “disproportionate” to the definition, such as in the following example:

Material Adverse Effect shall mean any change in or effect on the business of Company that, individually or in the aggregate (taking into account all other such changes or effects), is, or is reasonably likely to be, materially adverse to the business, assets, liabilities, financial condition or results of operations of Company, taken as a whole, except to the extent any such change or effect results from or is attributable to (i) changes in general economic conditions or changes affecting the industry generally in which Company operates (provided that such changes do not affect Company in a materially disproportionate manner) or (ii) any litigation or loss of current or prospective customers, employees or revenues as to which Company furnishes reasonable evidence that it occurred primarily from the announcement of Company entering into this Agreement; provided, however, that in no event shall (x) a decrease…

There are not yet any substantial cases that address the meaning of this additional qualification. Stay tuned; some of the cases now being litigated contain this language.

Fulcrum Inquiry is financial consulting firm that performs business appraisals, acquisition due diligence, and forensic accounting. Fulcrum’s personnel include those who have previously provided expert testimony regarding the financial meaning of the word “material”, and “material adverse change”.