Market-Based MAC and Termination Fee Clauses on the Rise, But Subject to Pitfalls

One way a buyer may protect itself is to negotiate a MAC clause that allows it to terminate a purchase agreement in the event pricing is significantly altered or financing is no longer available. Such a clause, if drafted carefully and with specificity, will allow a buyer to terminate an agreement without threat of significant recourse.

A buyer seeking to negotiate a MAC clause triggered by general market events, however, should be aware of potential pitfalls, including those raised by the Delaware Chancery Court in In re IBP, Inc. Shareholders Litigation (In re IBP, Inc.), 789 A.2d 14 (Del. Ch. 2001) and Frontier Oil v. Holly Corp., 2005 WL 1039027 (Del. Ch. April 29, 2005). As exemplified by those and other cases, the Delaware Chancery Court is loath to allow a buyer to use a MAC clause as an escape hatch in the event of mere buyer's remorse. But the cases also illustrate that the court will protect a buyer with specific, market-based concerns, so long as that buyer precisely identifies those concerns as potential MACs.

In IBP, the subject of the dispute was whether Tyson Foods, Inc., as buyer, properly terminated a merger agreement between itself and IBP. See, In re IBP, 789 A.2d at 51. The case is a clear example of buyer's remorse. Tyson had sought to acquire IBP to become the ”premier protein center-of-the-plate-provider' in the world' and also to prohibit a competitor from doing so. Id. at 31. Tyson, however, had second thoughts after a 'severe winter had hurt both beef and chicken supplies' and negatively impacted the financial performance of both Tyson and IBP. Id. at 47-48. As a result of that and other factors, Tyson sought to re-price the deal. Id. After failing to do so, Tyson sought to terminate the agreement, citing IBP's poor financial performance. Id. at 50-51. It is interesting to note that when Tyson initially provided notice of its reasons for terminating the agreement, it did not cite the occurrence of a material adverse effect.
Id. at 51.

In response to the attempted termination, IBP sought to specifically enforce the agreement. Id. Tyson Foods raised many arguments in its defense, including that IBP had suffered a material adverse effect based upon the decline in its performance over the last quarter of 2000 and the first quarter of 2001. Id. at 65. Under '5.10 of the agreement, a 'Material Adverse Effect' was defined 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 … ” Id. at 65. The agreement did not specifically exclude general events, such as declines in the overall economy or the relevant industry sector, or adverse weather or market conditions. See Id. at 65-66 ('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 is unqualified by such express exclusions.') (citation omitted). Tyson argued that the absence of such an exclusion impliedly included those general events as material adverse effects. Id. at 66.

The Delaware Chancery Court agreed that this MAC clause was 'far too general to preclude industry-wide or general factors from constituting a Material Adverse Effect,' but did not find that a material adverse effect occurred. See In re IBP, Inc., 789 A.2d at 66. Instead, it placed the burden on Tyson to show that the events cited 'had the required materiality of effect.' Id. The court employed a 'seller-friendly perspective' and explained that such a showing would be difficult for a number of reasons, including that the MAC was 'fraught with temporal ambiguity' and that Tyson would be viewed as 'as an acquirer who seeks to purchase the company as part of a long-term strategy.' Id. at 67-69. The court also interpreted New York law finding that 'to make a strong showing to invoice a Material Adverse Effect condition 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.' Id. at 68. Tyson could not make such a showing, and the court ultimately ordered specific performance. Id. at 82.

The lesson to be learned from IBP is that, while the Delaware Chancery Court will not prohibit enforcing a MAC clause on the basis of general factors, the factors cited must be specific enough to show the 'required materiality of effect.' Buyers paying heed to this decision will be careful to specifically list all potential adverse events and will consider citing specific events or thresholds as demonstrating sufficient magnitude.

A buyer seeking ultimate protection, however, should also be guided by the Delaware Chancery Court's decision in Frontier Oil v. Holly Corp. and attempt to allocate the burden of disproving the MAC clause upon the seller. In Frontier Oil, the court considered an action brought by Frontier Oil Corporation to enforce a merger agreement allegedly repudiated by Holly Corporation. Frontier Oil, 2005 WL 1039027, at *24. Holly alleged, among other things, that Frontier breached a representation that certain specified litigation would not have, and would not be reasonably expected to have, a material adverse effect. Id. at *26. As is typically the case, the court found the burden of proving the material adverse effect rested upon Holly and that Holly 'ought to have to make a strong showing to invoke a Material Adverse Effect exception to its obligation to close.' Id. at *34. While the court noted that the litigation at issue could be catastrophic, it also found that Holly did not meet its burden to demonstrate the likelihood of a catastrophe. Id. at *36. More importantly, however, the court noted that the '[t]he parties could have expressly allocated the burdens as a matter of contract, but they did not do so.' Id. at *34. Thus, if the parties had allocated the burden of proof to the seller, the outcome may well have been different.

Termination Fee Clauses

In the recent case of United Rentals, Inc. v. RAM Holdings, Inc. and RAM Acquisition Corp., 937 A.2d 810 (Del.Ch. 2007), the Delaware Chancery Court considered the termination fee clause in the failed purchase of United Rentals, Inc., ('URI') by RAM Holdings, Inc. and RAM Acquisition Corp, entities created by Cerberus Partners, L.P. for the purpose of acquiring URI (together, RAM). On July 22, 2007, URI and RAM entered into an Agreement and Plan of Merger ('Merger Agreement') pursuant to which RAM agreed to purchase all of the common shares of URI for $34.50 in cash for a total purchase price of approximately $7 billion. Id. at 815. Under the terms of the Merger Agreement, RAM Acquisition Corp. was to be merged into URI, which would be the surviving corporation. Id.

The Merger Agreement was not a model of clarity. It included a 'specific performance' clause which permitted URI to 'seek an injunction or injunctions to prevent breaches of this Agreement by [RAM] and to enforce specifically the terms and provisions of this Agreement ' ' Id. The Merger Agreement also included a provision that permitted payment of a termination fee upon termination of the Merger Agreement. Id. at 816. This provision stated:

In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [RAM or Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [RAM] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [URI] seek equitable relief or seek to recover any money damages in excess of such amount from [RAM or Cerberus]. Id. at 817 n.12.

On Nov. 14, 2007, RAM notified URI that it would not consummate the merger on the terms set forth in the Merger Agreement. Id. at 827. In a letter from RAM to URI, RAM offered to either: 1) explore entering into a transaction with URI on 'revised terms' or 2) pay the $100 million termination fee. Id. It has been reported that URI announced that RAM had told its advisers that it was not willing to force their financing sources to meet their commitments, but that Cerberus had confirmed to URI that there had been no material adverse change at URI that could be the basis for terminating the deal. The purchase price was advantageous to URI (URI's stock price dropped in excess of 30% over the four weeks following RAM's termination of the deal) and URI sought to enforce the specific performance clause of the Merger Agreement. Id.

After two days of trial, William B. Chandler III, the Chancellor of the Delaware Chancery Court, ruled that RAM could not be forced to consummate the merger on the basis of the specific performance clause in the Merger Agreement. Id. at 844. The Chancellor found that the terms of the Merger Agreement were susceptible to more than one interpretation. Id. at 831. In particular, the specific performance provision and the termination fee provision were in conflict. Id. Further, the Chancellor ruled that each party's interpretation was reasonable and that URI was unable to prove a common understanding of the specific performance clause.

The Chancellor then invoked the 'forthright negotiator principle.' This principle provides that 'in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract's meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.' Id. at 836. Citing the multiple drafts of the Merger Agreement and the course of its negotiation of the Merger Agreement, Chancellor Chandler determined that URI should have known that RAM's understanding of the Merger Agreement was that RAM could walk away from the deal if it paid a $100 million termination fee and URI did not expressly state that its interpretation of the contract differed. Id. at 838. URI determined not to challenge the ruling, and sought to have RAM pay the termination fee.

There are several additional lessons to be learned from this case. First, clear and consistent drafting would have prevented Chancellor Chandler from looking into the course of negotiations. If the Chancellor could have determined the intent of the parties from the Merger Agreement itself, he would have ruled on that basis. However, the negotiations cited in the decision suggest that perhaps there was no agreement on this issue that could have been clearly memorialized. Sometimes certain parts of documents are left unclear for tactical advantage in the negotiation process. It is important to realize that other factors may be examined if the document is not clear. Second, it appears from the opinion that URI's lawyers did not pay enough attention to RAM's lawyers' statements that they believed that they had the right to refuse to consummate the transaction without consequences any more costly than payment of the $100 million termination fee. Had URI disputed RAM's statement of its interpretation of the Merger Agreement, the Chancellor may have ruled differently. Then again, had the issue been brought to a head, the parties may never have agreed on the meaning of the termination fee provision and the Merger Agreement may not have been executed.

G. Thomas Stromberg is a partner and Justin Rawlins is an associate in the Corporate Group at Winston & Strawn LLP.

Financial markets are unsettled. A result of the U.S. housing crisis has been a disruption in the general credit markets and increased scrutiny of transactions using higher risk debt financing, including leveraged buyout deals. Much of the disruption in the credit markets became evident during September 2007, and many equity sponsors and financing sources that had issued commitments prior to that time reconsidered their commitments later in the year. In many cases the cost of the financing was significantly more expensive, and in some cases the financing was no longer available. This situation has caused various equity sponsors and financing sources to re-examine their obligations to consummate a distressed commitment and their ability to back out of a deal.

Two types of contract clauses are commonly cited when a buyer or financing source desires not to make good on its commitment. These clauses are material adverse change ('MAC') clauses and termination fee clauses. Several recent cases show that good draftsmanship and a clear understanding of their intended effect are essential in heading off disputes when implementing these provisions.

MAC Clauses

One way a buyer may protect itself is to negotiate a MAC clause that allows it to terminate a purchase agreement in the event pricing is significantly altered or financing is no longer available. Such a clause, if drafted carefully and with specificity, will allow a buyer to terminate an agreement without threat of significant recourse.

A buyer seeking to negotiate a MAC clause triggered by general market events, however, should be aware of potential pitfalls, including those raised by the Delaware Chancery Court in In re IBP, Inc. Shareholders Litigation (In re IBP, Inc.), 789 A.2d 14 (Del. Ch. 2001) and Frontier Oil v. Holly Corp., 2005 WL 1039027 (Del. Ch. April 29, 2005). As exemplified by those and other cases, the Delaware Chancery Court is loath to allow a buyer to use a MAC clause as an escape hatch in the event of mere buyer's remorse. But the cases also illustrate that the court will protect a buyer with specific, market-based concerns, so long as that buyer precisely identifies those concerns as potential MACs.

In IBP, the subject of the dispute was whether Tyson Foods, Inc., as buyer, properly terminated a merger agreement between itself and IBP. See, In re IBP, 789 A.2d at 51. The case is a clear example of buyer's remorse. Tyson had sought to acquire IBP to become the ”premier protein center-of-the-plate-provider' in the world' and also to prohibit a competitor from doing so. Id. at 31. Tyson, however, had second thoughts after a 'severe winter had hurt both beef and chicken supplies' and negatively impacted the financial performance of both Tyson and IBP. Id. at 47-48. As a result of that and other factors, Tyson sought to re-price the deal. Id. After failing to do so, Tyson sought to terminate the agreement, citing IBP's poor financial performance. Id. at 50-51. It is interesting to note that when Tyson initially provided notice of its reasons for terminating the agreement, it did not cite the occurrence of a material adverse effect.
Id. at 51.

In response to the attempted termination, IBP sought to specifically enforce the agreement. Id. Tyson Foods raised many arguments in its defense, including that IBP had suffered a material adverse effect based upon the decline in its performance over the last quarter of 2000 and the first quarter of 2001. Id. at 65. Under '5.10 of the agreement, a 'Material Adverse Effect' was defined 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 … ” Id. at 65. The agreement did not specifically exclude general events, such as declines in the overall economy or the relevant industry sector, or adverse weather or market conditions. See Id. at 65-66 ('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 is unqualified by such express exclusions.') (citation omitted). Tyson argued that the absence of such an exclusion impliedly included those general events as material adverse effects. Id. at 66.

The Delaware Chancery Court agreed that this MAC clause was 'far too general to preclude industry-wide or general factors from constituting a Material Adverse Effect,' but did not find that a material adverse effect occurred. See In re IBP, Inc., 789 A.2d at 66. Instead, it placed the burden on Tyson to show that the events cited 'had the required materiality of effect.' Id. The court employed a 'seller-friendly perspective' and explained that such a showing would be difficult for a number of reasons, including that the MAC was 'fraught with temporal ambiguity' and that Tyson would be viewed as 'as an acquirer who seeks to purchase the company as part of a long-term strategy.' Id. at 67-69. The court also interpreted New York law finding that 'to make a strong showing to invoice a Material Adverse Effect condition 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.' Id. at 68. Tyson could not make such a showing, and the court ultimately ordered specific performance. Id. at 82.

The lesson to be learned from IBP is that, while the Delaware Chancery Court will not prohibit enforcing a MAC clause on the basis of general factors, the factors cited must be specific enough to show the 'required materiality of effect.' Buyers paying heed to this decision will be careful to specifically list all potential adverse events and will consider citing specific events or thresholds as demonstrating sufficient magnitude.

A buyer seeking ultimate protection, however, should also be guided by the Delaware Chancery Court's decision in Frontier Oil v. Holly Corp. and attempt to allocate the burden of disproving the MAC clause upon the seller. In Frontier Oil, the court considered an action brought by Frontier Oil Corporation to enforce a merger agreement allegedly repudiated by Holly Corporation. Frontier Oil, 2005 WL 1039027, at *24. Holly alleged, among other things, that Frontier breached a representation that certain specified litigation would not have, and would not be reasonably expected to have, a material adverse effect. Id. at *26. As is typically the case, the court found the burden of proving the material adverse effect rested upon Holly and that Holly 'ought to have to make a strong showing to invoke a Material Adverse Effect exception to its obligation to close.' Id. at *34. While the court noted that the litigation at issue could be catastrophic, it also found that Holly did not meet its burden to demonstrate the likelihood of a catastrophe. Id. at *36. More importantly, however, the court noted that the '[t]he parties could have expressly allocated the burdens as a matter of contract, but they did not do so.' Id. at *34. Thus, if the parties had allocated the burden of proof to the seller, the outcome may well have been different.

Termination Fee Clauses

In the recent case of United Rentals, Inc. v. RAM Holdings, Inc. and RAM Acquisition Corp. , 937 A.2d 810 (Del.Ch. 2007), the Delaware Chancery Court considered the termination fee clause in the failed purchase of United Rentals, Inc., ('URI') by RAM Holdings, Inc. and RAM Acquisition Corp, entities created by Cerberus Partners, L.P. for the purpose of acquiring URI (together, RAM). On July 22, 2007, URI and RAM entered into an Agreement and Plan of Merger ('Merger Agreement') pursuant to which RAM agreed to purchase all of the common shares of URI for $34.50 in cash for a total purchase price of approximately $7 billion. Id. at 815. Under the terms of the Merger Agreement, RAM Acquisition Corp. was to be merged into URI, which would be the surviving corporation. Id.

The Merger Agreement was not a model of clarity. It included a 'specific performance' clause which permitted URI to 'seek an injunction or injunctions to prevent breaches of this Agreement by [RAM] and to enforce specifically the terms and provisions of this Agreement ' ' Id. The Merger Agreement also included a provision that permitted payment of a termination fee upon termination of the Merger Agreement. Id. at 816. This provision stated:

In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [RAM or Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [RAM] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [URI] seek equitable relief or seek to recover any money damages in excess of such amount from [RAM or Cerberus]. Id. at 817 n.12.

On Nov. 14, 2007, RAM notified URI that it would not consummate the merger on the terms set forth in the Merger Agreement. Id. at 827. In a letter from RAM to URI, RAM offered to either: 1) explore entering into a transaction with URI on 'revised terms' or 2) pay the $100 million termination fee. Id. It has been reported that URI announced that RAM had told its advisers that it was not willing to force their financing sources to meet their commitments, but that Cerberus had confirmed to URI that there had been no material adverse change at URI that could be the basis for terminating the deal. The purchase price was advantageous to URI (URI's stock price dropped in excess of 30% over the four weeks following RAM's termination of the deal) and URI sought to enforce the specific performance clause of the Merger Agreement. Id.

After two days of trial, William B. Chandler III, the Chancellor of the Delaware Chancery Court, ruled that RAM could not be forced to consummate the merger on the basis of the specific performance clause in the Merger Agreement. Id. at 844. The Chancellor found that the terms of the Merger Agreement were susceptible to more than one interpretation. Id. at 831. In particular, the specific performance provision and the termination fee provision were in conflict. Id. Further, the Chancellor ruled that each party's interpretation was reasonable and that URI was unable to prove a common understanding of the specific performance clause.

The Chancellor then invoked the 'forthright negotiator principle.' This principle provides that 'in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract's meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.' Id. at 836. Citing the multiple drafts of the Merger Agreement and the course of its negotiation of the Merger Agreement, Chancellor Chandler determined that URI should have known that RAM's understanding of the Merger Agreement was that RAM could walk away from the deal if it paid a $100 million termination fee and URI did not expressly state that its interpretation of the contract differed. Id. at 838. URI determined not to challenge the ruling, and sought to have RAM pay the termination fee.

There are several additional lessons to be learned from this case. First, clear and consistent drafting would have prevented Chancellor Chandler from looking into the course of negotiations. If the Chancellor could have determined the intent of the parties from the Merger Agreement itself, he would have ruled on that basis. However, the negotiations cited in the decision suggest that perhaps there was no agreement on this issue that could have been clearly memorialized. Sometimes certain parts of documents are left unclear for tactical advantage in the negotiation process. It is important to realize that other factors may be examined if the document is not clear. Second, it appears from the opinion that URI's lawyers did not pay enough attention to RAM's lawyers' statements that they believed that they had the right to refuse to consummate the transaction without consequences any more costly than payment of the $100 million termination fee. Had URI disputed RAM's statement of its interpretation of the Merger Agreement, the Chancellor may have ruled differently. Then again, had the issue been brought to a head, the parties may never have agreed on the meaning of the termination fee provision and the Merger Agreement may not have been executed.

G. Thomas Stromberg is a partner and Justin Rawlins is an associate in the Corporate Group at Winston & Strawn LLP.