Latest Thinking | Private Equity

Revisiting Material Adverse Change Clauses - Private Equity Buyers Should (But Mostly Can’t/Don’t) Special Order their MACs

By Glenn D. West 

During the “Burger Wars” of the 1970s, McDonald’s jingles indelibly imprinted the consistently exact ingredients of their Big Mac sandwich on the memory of an entire generation: “Two all beef patties, special sauce, lettuce, cheese, pickles, onions on a sesame seed bun.” Burger King, on the other hand, encouraged its patrons to freely alter the standard ingredients of its Whopper sandwich to suit their preferences, proclaiming that “special orders don’t upset us . . . have it your way!”1

Burgers and material adverse change clauses have more in common than the fact that they sometimes share the name “Mac.”2 While McDonald’s has since adopted a more flexible approach to the preparation of its burgers, the divide between standardization and flexibility that marked the 1970s differences between McDonald’s and Burger King continues to apply to the use of material adverse change clauses in acquisition agreements, except that, in the current market, all the sellers are McDonald’s and there is no Burger King. In fact, the basic material adverse change clause served up by sellers in an acquisition transaction has changed very little since the 1970s (except for the addition of an ever-expanding list of carve-outs). Deal custom and tradition have enshrined the standard language and woe to the potential buyer that challenges it. The fact that the standard language has been enshrined, however, does not mean that it is well understood by, or actually accomplishes the specific objectives of, all private equity buyers.

The Standard MAC Clause

The definition of “material adverse change” in the typical acquisition agreement (with certain standard variations bracketed, but before considering the evolving specific carve-outs described below) generally has read and continues to read as follows:

“Material Adverse Change [Effect] means [a material adverse change in or] any event, occurrence, fact or circumstance which has had [or is reasonably expected to have] a material adverse effect on the business, assets, condition (financial or otherwise), liabilities [, or] results of operations [or prospects] of Target and its subsidiaries taken as a whole.”

To say that these clauses are standardized is not the same as saying they do not vary or are not negotiated. Indeed, there is often serious negotiation over whether to include certain of the bracketed language. The standard definition may also be negotiated to include the phrase “individually or in the aggregate with all such other events, occurrences, facts or circumstances,” to make clear that an individual event, occurrence, fact or circumstance need not be material on its own but may be the “last straw” in a series of events, occurrences, facts or circumstances that result in a “Material Adverse Change.”

Regardless of the exact language used, the basic goal of the standard material adverse change clause is to (1) provide the seller a means of qualifying certain representations and warranties so that insignificant breaches become irrelevant, and (2) provide the buyer a means of clearly defining a significant negative event that might occur between signing and closing, the occurrence of which will allow the buyer to walk away from the deal. But by using language that has been handed down over time with no “special ordering” to meet the specific concerns or issues facing (or the buyer’s expectations regarding) a target’s business, buyers may not always be achieving their part of this goal.

Defining “Material”

Despite the negotiation around the edges of the standard clause, the term “material,” which is the key component of the definition of “Material Adverse Change,” is itself rarely, if ever, defined. While some acquisition agreements do define the term with reference to a specific dollar amount, the vast majority of agreements do not. Rather, like Justice Potter Stewart’s famous means of defining pornography (i.e., “I know it when I see it”), many deal professionals appear to believe that everyone knows how they value a deal and what would be deemed a material adverse change to them. In other words, while the purpose of a written contract is to clearly define the parties’ agreement or understanding with respect to a transaction, the material adverse change clause appears to be a consistent exception to the rule. As a result, courts have struggled over the years to define this term in the few cases that have addressed what adverse or negative events may properly be deemed to be “material.”

The standard dictionary understanding of “material” as being the equivalent of significant or substantial has rarely proved helpful in providing clear guidance to a court’s interpretation of this term. Events that would appear to be undeniably significant and substantially detrimental to a target company have historically proven to be insufficient to persuade a court that a buyer was justified in invoking a material adverse change clause to avoid closing.3 For example, a radio station’s decline in ratings indicating a loss of half of its listening audience was not deemed to be a material adverse change by one court, in part because the agreement made no mention of ratings nor did it contain any requirement that the station maintain its audience share during the pre-closing period.4 Also, a significant reduction in business from a key customer of a target was not found to be a material adverse change by another court due in part to the presence of a specific representation covering a loss of customers that was not breached because the customer in question did not deliver any notice of its intention to discontinue business with the target.5 Indeed, courts generally try to determine what the parties considered material by reference to specific items that were considered important enough to be the subject of specific conditions or representations. They do so notwithstanding an implied acknowledgment that a material adverse change clause is designed to provide for the unknown and unconsidered, but nevertheless significant, event. The understanding of “material” as being something that had it been known at signing would have altered a buyer decision to buy is probably closer to the way courts have tended to view the term when it is invoked as a means of walking away from a deal. As an undefined term within a defined term, therefore, “material” is surrounded with deal custom and tradition rather than clear legal standards.6

Even with regard to deal custom and tradition, however, few deal professionals appear to appreciate that the traditional rule of thumb is that a negative economic impact of somewhere between 10% to 20% is required before an event or change is likely to be deemed to be sufficiently “material” to constitute a material adverse change. If a private equity firm is pricing a deal based on a multiple of EBITDA, whether historical or projected, a 10% decline in EBITDA will result in an exponentially larger decline in value of the target company. Moreover, this rule of thumb is just that, a rule of thumb. There are no court rulings clearly supporting 10%, 20% or any other number as the appropriate threshold of materiality for every transaction.7

Negotiations have Shifted to the Carve-outs

Although the case law is decidedly on the side of the seller in limiting a buyer’s ability to successfully invoke the standard material adverse change clause, deal dynamics have been such that sellers have been able to further erode the limited comfort provided by these clauses by inserting numerous exclusions or carve-outs. Here are some examples of the more frequent events or changes, the occurrence of which are commonly excluded from the definition of material adverse change:

  • changes in general political, economic or financial market conditions;
  • changes in industry conditions that do not disproportionately effect the target company;
  • changes resulting from the announcement of the transaction;
  • changes resulting from the parties’ compliance with the terms of the agreement;
  • changes in generally accepted accounting principles;
  • changes in law;
  • acts of terrorism or war; or
  • the failure of the target company to meet its financial projections or a decline in the target’s stock price.8

The loss by the target company of a key customer or a significant decline in revenue is a good example of the problems created by these carve-outs. Were there problems with the company’s products or services that caused the loss or decline or was this loss or decline instead due to a bad economic environment or somehow related to the fact the company was being sold and a deal announced? Similarly, if there are required consents to consummate a transaction and the representation regarding the lack of any breach of contract resulting from the consummation of the transaction is qualified by any breaches that will not result in a material adverse change, what does that representation mean when “changes resulting from the parties’ compliance with the terms of the agreement” (i.e., closing the transaction without obtaining any such required consent) is a carve-out from the definition of material adverse change? Using a carve-out for “the failure of the target company to meet its financial projections” is also troubling, especially to a financial buyer. While it may be fair to exclude meeting financial projections “in and of itself” from the definition of material adverse change, the future impact of currently missed financial targets (or the events leading to the missed financial targets) may be very material and exactly what the buyer wants to address.

So, while commonly used carve-outs may appear to be reasonable and innocuous, they should be tailored or avoided altogether by buyers due to their limiting effects. But avoiding the carve-outs is only half the battle for a buyer. Even in the absence of these specific exclusions, courts have been reluctant in the past to read a material adverse change clause such that it would cover external factors that did not directly relate to the conduct of the target company’s business.9

Tyson Puts the Spotlight on MAC Clauses

Following the much discussed 2001 Delaware Chancery Court decision in IBP, Inc. v. Tyson Foods, Inc.,10 there was widespread speculation that material adverse change clauses would undergo a make-over as a result of buyers’ insistence on negotiating clauses that were more specific and less vague.11 Indeed, much has been written since the Tyson Foods decision concerning the vagaries of standard material adverse change clauses, their limited utility as an “out” for a buyer notwithstanding a potentially material misrepresentation by a seller or a significant decline in the business being purchased (particularly interim results), and the potential need for more focus on customization and clarity in the negotiation of these clauses.12 Considering a fairly standard material adverse change clause (similar to the example provided above and with none of the now popular carve-outs), the Tyson court held that such a clause is only intended to be “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.” 13 Missing short-term earnings projections, even though significant, was not considered material by the Tyson court for the purpose of this articulated standard.

Although Tyson involved a strategic merger between two businesses and not an acquisition of a company by a financial buyer (and the difference appears to have been appreciated by the court), following this decision private equity sponsors were sent a strong message to never rely on a standard material adverse change clause as a basis for walking away from a deal. Instead, private equity sponsors were advised to negotiate customized material adverse change clauses or, better yet, specific closing conditions that identify changes or events, such as missed financial targets or loss of customers, the occurrence of which would provide an objective basis for them to terminate an acquisition agreement.

Interestingly, a review of publicly available information as well as our own knowledge of private equity transactions shows that, despite the loud and clear message in 2001, private equity sponsors have not acted (or have not been able to act) on the popular advice since Tyson. Buyers have been largely unsuccessful in “special ordering” their material adverse change clauses to make clear, for example, that short term declines in financial performance matter, especially when a company is being purchased at a high multiple. Buyers have been equally unsuccessful in negotiating even a “standard” MAC clause in their agreements. Instead, the only “special ordering” of material adverse change clauses that has occurred since 2001 appears to be the ever-expanding list of carve-outs inserted by sellers in their continuing effort to eliminate whatever modicum of protection the standard clause may have otherwise provided.

I Know I Should Special Order, but No One is Taking the Order—Now What?

With the prevalent case law cautioning buyers to not overly rely on standard material adverse change clauses, and notwithstanding the comfort sellers should have taken in these decisions, we find ourselves in an environment where a standard material adverse change clause with a long list of exclusions appears to be the normative starting point for negotiations. In fact, in highly competitive transactions, many lenders are conforming the material adverse change clauses in their commitment papers to match the versions of these clauses found in the acquisition agreement. This evolution in the market respecting material adverse change clauses is consistent with that seen in other core items of deal documentation (such as financing closing conditions and direct exposure of sponsors to liability for all or part of the purchase price) that have all tipped in the favor of sellers in recent years in connection with high profile, highly-competitive transactions.14 Unlike strategic buyers who know the industry and are often subject to the same risks in their own business, private equity buyers generally have a much different outlook on how external factors impact the business and how they view purported short term swings in a company’s performance. If a standard material adverse change clause with multiple exclusions is used, neither of these considerations may be covered. Indeed, when it comes to today’s standard material adverse change clause with multiple exclusions, private equity buyers have the same declaratory power that Clara Peller had in the 1980s Wendy’s commercials regarding the other burger companies - the right to claim “Where’s the beef?” But doing so is hardly practical or helpful given the current competitive landscape. So what should a private equity sponsor do?

In balancing the current competitive deal dynamics with the appropriate caution and diligence on which private equity sponsors build their reputations, the following guidelines are offered:

  • 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-outis 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.15
  • 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.
  • While this is not market in today’s environment, we offer as a point of reference the following thoughtfully customized and “specially ordered” material adverse change clause (with some alternative suggestions to deal with the concept of “materiality” in the private equity context): “Material Adverse Change” shall mean any result, occurrence, fact, change, event or effect (whether or not constituting a breach of a representation, warranty or covenant set forth in this Agreement) that, individually or in the aggregate with any such other results, occurrences, facts, changes, events or effects, is or would reasonably be expected to be materially adverse to the Company’s historical or near-term or long-term projected (i) business, (ii) operations, (iii) assets, (iv) liabilities, (v) financial condition or (vi) results of operations (including EBITDA or cash flow), in each case, of the Company and its Subsidiaries taken as a whole. [A Material Adverse Change shall be determined in light of the Buyer’s intended capital structure for this transaction as reflected in the Financing Commitment Letter.] [A Material Adverse Change shall be deemed to have occurred if the applicable event, change, effect, or occurrence (or aggregation thereof) would reasonably be expected to result in liability to the Company (or its subsidiaries) or diminution in the value of the Company (including its subsidiaries) (including but not limited to, as a result of a diminution of the revenues, earnings or net asset value of the Company (including its subsidiaries)) of US $_____ or more in the aggregate.]”

Just because the only burgers being sold are standard Big Macs, doesn’t mean you have to buy one. If you do buy one, however, at least know what it is you are getting. The current competitive landscape should not be an excuse for failing to “box” identifiable risks. If there are specific events that if they occur between signing and closing you will not want to close or you will want to seriously reconsider valuation, provide for them or accept the fact that you may be buying the potential realization of that risk.

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  1. See M. Eric Johnson, David F. Pike & Anita Warren, Food Fight: The Day McDonald’s Blinked, Case Study No. 1-0049, Tuck School of Business at Dartmouth (2001).
  2. The term “Big MAC” is even used in deal parlance to describe the circumstance in which the typical closing condition (that each of the representations and warranties made by a seller shall be true as of the closing date) is modified such that no representation or warranty need be true as of the closing date if the failure of such representation or warranty to be true would not result in a material adverse change.
  3. See Joel I. Greenberg and A. Julia Haddad, The Material Adverse Change Clause; Careful Drafting Key, but Certain Concerns May Need to Be Addressed Elsewhere, N.Y.L.J., Vol. 225, No. 77 at s5 (col. 1) (April 23, 2001).
  4. Borders v. KRLB, Inc., 727 S.W.2d 357 (Tex. App. - Amarillo, 1987, writ refused). It should be noted, however, that in this case the material adverse change clause only referred to a material adverse change “which would impair the operation” of the radio stations. The court viewed the loss of ratings as having nothing to do with the stations operations because they had not changed at all—despite the tremendous loss associated with the ratings decline.
  5. Gordon v. Dolin, 105 Ill.App.3d 319 (1982).
  6. See generally, Kenneth A. Adams, Understanding Material Adverse Change Provisions, The M&A Lawyer, Vol. 10, No. 6 (2006); Carl L. Reisner, Gary J. Pagona and Joseph Rose, Material Adverse Clauses: Practice in an Uncertain World, The M&A Lawyer, Vol. 10, No. 4 (2006).
  7. See Ganino v. Citizens Util. Co., 228 F.3d 154, 162 (2d Cir. 2000).
  8. Interestingly, the concept of carve-outs from a standard material adverse change clause appears to have originated in the frenzy of Silicon Valley technology company acquisitions in the 1990s and then spread to other industries and other locations. Rod J. Howard, Deal Risk, Announcement Risk and Interim Changes—Allocating Risks in Recent Technology M&A Agreements, PLI Corporate Law and Practice Course Handbook Series No. B0-00OB, 1219 PLI/Corp 217 (Dec. 2000).
  9. See Dennis J. Block and Jonathan M. Hoff, Material Adverse Change Provisions in Merger Agreements, N.Y.L.J., Vol. 226, No. 38 at 5 (col.1) (Aug. 23, 2001).
  10. IBP, Inc. v. Tyson Foods, 789 A.2d 14 (Del. Ch. 2001).
  11. See Stephen I. Glover, The Impact of Tyson Foods on “MAC” Outs, The M&A Lawyer, Vol. 5, No. 6, at 1 (Nov.-Dec. 2001).
  12. See, e.g., Block & Hoffman, supra note 9; Sherri L. Toub, “Buyer’s Regret” No Longer: Drafting Effective MAC Clauses in a Post-IBP Environment, 24 Cardozo L. Rev. 849 (2003); Kari K. Hall, How Big is the MAC?: Material Adverse Change Clauses in Today’s Acquisition Environment, 71 U. Cin. L. Rev. 1061 (2003); and Kenneth A. Adams, A Legal-Usage Analysis of “Material Adverse Change” Provisions, 10 Fordham J. Corp. & Fin. L. 9 (2004).
  13. Tyson, supra note 10, at 68.
  14. See Glenn D. West and R. Jay Tabor, Sungard and Neiman Marcus LBO Transactions—Increased Liability Risk to Private Equity Sponsors?, Weil, Gotshal & Manges LLP Private Equity Alert (June 2005).
  15. See Frontier Oil Corp. v. Holly Corp., 2005 WL 1039027 (Del. Ch. April 29, 2005).