Note on Material Adverse Change

B. Seth Bryant of Bryant Burgher Jaffe & Roberts LLP and Priscilla C. Hughes of Thomson Financial

The term Material Adverse Change (or "MAC" also sometimes called Material Adverse Effect or "MAE") describes an occurrence, event or condition that could or would likely cause a long-term and significant diminution in the earnings power or value of a business. The phrase is commonly used in venture investment or M&A transactions in connection with a closing condition whereby the investor/acquiror has the benefit of a 'walk' right if the target company experiences a serious adverse change between the date the contract is signed and the transaction closing date. The concept is also used in connection with standard representations and warranties.[1] Two decisions out of the Delaware Chancery Court, IBP, Inc. v. Tyson Foods, Inc.[2] and Frontier Oil Corporation v. Holly Corporation[3] , have examined MAC clauses and are instructive to lawyers and other venture or M&A professionals who, before these cases, often believed that adding the seemingly magic "MAC" words to a definitive agreement would provide an escape hatch from a deal that turned bad because of changes or events affecting the target business. While these cases shed light on court construction of MAC clauses in M&A contexts, for reasons stated below, it remains to be seen whether a court would apply the same standards in connection with investment transactions.

What Is A MAC?

Before moving to a discussion of the recent cases, it is useful to explore the standard definitions of the phrase MAC. The context of the deal matters a great deal as to the formulation used and affects how heavily negotiated the definition is. Nonetheless, typical MAC definitions are based on the following phraseology:

" Material Adverse Effect " or " Material Adverse Change " means any effect or change that [is][would be][would likely be][could be][4] materially adverse to the business, assets, condition (financial or otherwise), operating results, operations, [or business prospects][5] of Target and its Subsidiaries, taken as a whole, or to the ability of any party to consummate timely the transactions contemplated hereby.[6]

Often times, parties will agree that certain events or conditions that affect a business but that are not particular to it should not cause a MAC. Parties will agree on exceptions from the general MAC clause for changes in general economic conditions, industry specific downturns, war or acts of terrorism, changes in law, or changes resulting from the parties entering into the agreement to consummate the transaction. Unless the acquiror/investor has a strong position or has some specific reason why it believes that it is inappropriate to allow for all or any specific exception, these provisions are commonly included in the MAC definition.

Although it is rare, parties will sometimes attempt to quantify triggers for a MAC occurrence. In these situations, the definition may include concepts such as loss of some percentage or dollar value of sales, net profits, significant customers, etc. Quantifying MAC triggers is generally disfavored because both sides will probably see some advantage in being able to argue why some event or condition does or does not result in a MAC. There is another danger in identifying specific metrics in drafting the MAC definition. Courts tend to read specific language as exclusionary. Thus, if a specific item of potential change is specified (e.g., the loss of a major customer), a court may interpret that language as meaning that any event not specifically mentioned is not included in the clause. This is in line with a long-standing rule of construction that specific provisions trump general provisions. Accordingly, there is an understandable reluctance to include a list of specific triggering events.

Recent Court Interpretations Of MAC Clauses

The most notable recent decisions that have shed light on how courts construe MAC clauses are Tyson and Holly Corporation . Tyson, delivered in 2001 by Vice Chancellor Leo E. Strine, Jr. of the Delaware Chancery Court, provides a thorough analysis of what constitutes a "material adverse change". Tyson stands for the proposition that events giving rise to a MAC claim must be significantly more than a short term "hiccup" affecting a business. R ather, assuming a standard definition is used, a MAC is triggered by an event or condition that could affect the very survival of the enterprise. Holly was handed down in Spring of 2005. Holly stands for the proposition that in order to invoke a MAC "out" the event or condition must be of the magnitude described in Tyson and the party seeking to get out of the deal must show that a MAC has occurred or otherwise fits within the standard agreed by the parties, i.e. "would result in", "would likely result in a MAC", etc. Prior to these cases, there was very little law that analyzed MAC clauses.

Frontier Oil Corporation V. Holly Corporation

In Holly , Holly and Frontier entered into a merger agreement in March 2003. The agreement included a standard MAC clause.[7] Prior to the execution of the merger agreement, Frontier disclosed that it had become aware (through news reports) that it might be sued as one of many defendants in a toxic tort case that was being developed by famed activist Erin Brokavich . The "threatened" suit related to a property formally owned by a Frontier subsidiary. The subsidiary and other defendants were being accused of releasing air contaminants as part of drilling and on-site oil refining activities. Brokavich claimed that students attending a nearby high school had a disproportionately high incidence of cancer, which she alleged was attributable to those activities.

Holly's Board was very concerned about this "threatened litigation" and directed management to beef up the representations and warranties in the merger agreement regarding it . The Board also directed Holly's management to get more information about the seriousness of the claim.

Initially, Frontier assured Holly that the claim was not serious. Frontier indicated that the property had been owned by a Frontier subsidiary and therefore Frontier was shielded by "corporate separateness". Frontier's management further argued that Frontier's subsidiary had transferred the property at issue long before the threatened action and that any claim would likely be barred by applicable statutes of limitations. Frontier also said that if any suit commenced Frontier would be indemnified by other named defendants.

In April 2003, the Beverly Hills litigation commenced. In July 2003, Frontier turned over documents showing that, instead of being protected by another party's indemnification obligation, Frontier had a direct obligation to indemnify other defendants in the suit, including Chevron Corporation and the Beverly Hills Unified School District. T o Holly's great consternation and surprise, it found itself in a binding merger agreement with a partner who was facing potentially staggering toxic tort liability. Armed with this news, Holly's Board instructed management to renegotiate the deal. Significantly, Holly's Board did not instruct management to invoke the MAE clause to terminate the deal or to charge Frontier with breach of the representation regarding litigation, although the Board viewed either action as an option. At this stage, it appeared that Holly's Board genuinely wanted to see if there was a way to move forward with the deal.

After numerous attempts to renegotiate the deal proved unsuccessful, in late August 2003, Frontier's management decided that the parties were not making progress and that the impasse would end up hurting Frontier's stockholders. At that point, Frontier sued Holly for repudiation of the contract. The day after Frontier filed its suit, Holly sent Frontier a notice charging that Frontier breached its representation regarding threatened litigation and that Frontier had suffered a MAE because of the Beverly Hills litigation.

Ultimately, the Delaware Chancery Court found that (a) Holly did not repudiate the contract because (i) Holly's management seemed to still be actively engaged in the negotiation process, (ii) if it wanted to get out of the contract, Holly could have exercised its fiduciary out clause and paid a break-up fee, and [other reasons] and (b) Holly had not proved that Frontier had suffered a MAE.

In deciding the MAC issue, Vice Chancellor John W. Noble determined that Holly had to prove that Frontier suffered a MAC. This analysis centered on the question of whether, at the time of entering into the merger agreement, the Beverly Hills l itigation "would have or would reasonably be expected to have a Frontier MAC."

Vice Chancellor Noble acknowledged the seriousness of the threatened litigation but had difficulty with Holly's finding that a MAC had occurred. The Vice Chancellor indicated that the risks associated with the litigation included significant defense costs and the potentially large damage award if the plaintiffs were successful. The Vice Chancellor, however, was not moved by Holly's arguments that the threatened litigation "would reasonably be expected to have" a MAC because of the propensity of California juries to favor plaintiffs. The Vice Chancellor wrote that Holly failed to demonstrate that a MAC had occurred. Vice Chancellor Noble wrote

"Holly is correct that the Beverly Hills litigation could be catastrophic for Frontier. It is not possible to rule out judgments running into the hundreds of millions of dollars. Holly has not, however, demonstrated (or even seriously tried to demonstrate) the likelihood of the event . . . [Holly's claim] is more in the nature of random speculation. It is possible, in the right case, for a party in a position comparable to Holly's to come forward with factual and opinion testimony that would provide a court with the basis to make a reasonable and an informed judgment of the probability of an outcome on the merits. Holly simply has not provided that foundation."[8]

In essence, Holly's argument regarding the possible impact of the Beverly Hills litigation was misplaced. Holly's argument might have been appropriate if the MAC provision was phrased to say " could have a Frontier MAC". Given that the MAC provision was phrased to capture events that " would have a Frontier MAC", Holly needed to show that the Beverly Hills litigation met that higher standard. Vice Chancellor Noble said that Holly needed to prove the causal connection between the activities that Frontier was allegedly responsible for and the injuries to the plaintiffs to determine whether a Frontier MAC occurred without that connection, the possible "adverse effect" would be too remote.

In some respects, the Holly decision is troubling because it indicates that in order to prevail on its claim, Holly would have had to bring a mini-version of the Beverly Hills litigation. Query whether Holly or any acquirer/investor should be put in a position of proving the likelihood of success of a case involving a target and a third party. In making a reasonable determination as to the likelihood of success on the MAC claim, would an acquirer/investor have to perform discovery like a plaintiff regarding the matter (in a time frame between signing and closing a deal)? Would it also have to seek discovery like a defendant to try to determine whether there is an alternative explanation or defense regarding the matter? In either event, how much cooperation could a party like Holly expect from either side in discovering information since, in this strange position, an acquirer/investor is both potential friend and foe to each adverse party. Vice Chancellor Noble's statement that there must be some evidence in the record regarding opinion and factual testimony to support invocation of the MAC clause does not specifically indicate that extensive discovery is required, however, it clearly requires establishing that the event or occurrence "would reasonably likely have a Material Adverse Effect." With respect to threatened litigation, t he problem is how does one make the causal connection without the benefit of analysis informed by discoverable information?

IBP, Inc. V. Tyson Foods, Inc.

In Tyson Foods, Inc., the acquirer, Tyson, beat out a competitor, Smithfield Foods, in a bid for IBP. Tyson and IBP entered into a merger agreement in January 2001. The agreement included a broad MAC clause that omitted standard exclusions. Prior to execution of the merger agreement, IBP disclosed that it had uncovered accounting improprieties at one of its wholly-owned subsidiaries the magnitude of which it had not yet determined . The early view of the problems at the subsidiary was that they amounted to under $10 million at the time the agreement was signed that number increased to approximately $35 million .

Until the end of March 2001, Tyson touted the long term benefits of the deal and urged that the combination would greatly benefit shareholders of both companies. In early March 2001, however, IBP published financials that showed a significant drop in earnings (as compared to the same period in 2000). At the same time, the accounting problems associated with IBP's subsidiary grew to approximately $60 million .

At the end of March 2001, Tyson announced that, because of these developments, it had terminated the merger agreement claiming that IBP had suffered a MAC.

In an opinion widely heralded for its thoroughness and careful examination of an oft used and little understood phrase, Vice Chancellor Strine of the Delaware Chancery Court, analyzed the facts of Tyson and articulated a standard for determining whether a MAC has occurred. In delivering the Tyson opinion, Vice Chancellor Strine urged that MAC clauses should not be used to justify an acquiror's backing out of a transaction as a result of "buyer's regret" or the occurrence of some event or situation that is problematic but that does not threaten the overall health or viability of the business. Vice Chancellor Strine wrote that

"'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 acquirer from the occurrence of unknown events that subsequently threaten the overall earnings potential of the target in a durationally-significant manner ."[9] (emphasis added)

With respect to the accounting problems at IBP's subsidiary, Vice Chancellor Strine noted that as a factual matter, IBP had disclosed those difficulties prior to the execution of the merger agreement. Although the full extent of the problem was not then known, Tyson accepted the disclosures without requiring any cap on the liabilities . B y not putting any limitation on the liability associated with the subsidiary problems, Tyson accepted that the problems might have been valued at $10 million or $110 million. Because the subsidiary's problems had been disclosed and Tyson accepted the risks, Vice Chancellor Strine found that it was inappropriate for Tyson to later argue that the subsidiary's accounting improprieties resulted in a material adverse change from Tyson's understanding of IBP's business as disclosed at the time of the execution of the merger agreement.

With respect to IBP's weak earnings, Vice Chancellor Strine noted that IBP's earnings had historically been volatile and that its recent performance was consistent with historic ranges.

Vice Chancellor Strine's opinion clearly recognizes that in the context of business combinations shareholders of target companies will be seriously hurt if merger partners are allowed to back out of deals because of occurrences that are bad, but more or less routine in the life a public companies. Avoiding this potential harm justified the extraordinary order of specific performance that compelled Tyson to complete the deal. The message delivered by Vice Chancellor strike to acquirors is, "once you sign the deal, in order to invoke a MAC walk right, the target must suffer a "enterprise threatening" event."

Are Investment Transactions Different?

As noted above, both Holly and Frontier were delivered in the context of M&A transactions, it is worth noting that in the investment context which is more relevant for venture investors, the term "material" has developed its own meaning. In investment transactions, information is deemed to be "material" if its disclosure would affect the investment decision of a reasonable investor exercising prudent judgment. When coupled with the full concept of MAC, in the investment context, it is conceivable that a court could take the view that a MAC clause means an adverse event or condition that would affect the investment decision of a reasonable investor . Given the differences in the types of transactions, a strong argument could be made that a different treatment is justified. B usiness combinations are highly disruptive events resulting in integrated businesses, requiring careful planning and business restructuring. M&A transactions are entered into as a long term play. M&A is marriage. On the other hand, investments are made for a variety of objectives. Any hint of a glitch in reaching those objectives will send most investors "heading for the hills". In venture investment deals, not wanting the risk of being forced to fund after the occurrence of some bad news is one reason why simultaneous "sign and close" deals are preferred. However, in milestone deals where funding is staggered or made incrementally after targets are reached, the MAC closing condition becomes more important.

[Although this line of reasoning is conceivable, whether a court would adopt it is doubtful given existing precedent (at least in New York). [For example, in [Bear Stearns v. Jardine Holdings, a 1990 New York State court decision, Jardine and Bear Stearns entered into an agreement in the summer of 1987 to purchase 20 percent of Bear Stearns for $400 million.[10] The agreement was executed prior to October 19, 1987, and contained a MAC provision, which Jardine sought to invoke following the crash. The issue before the New York Supreme Court arose on Jardine's motion for summary judgment. Jardine claimed that the MAC provision should have given it an "out" . The judge denied the motion for summary judgment. The decision is fact-specific, and it can be argued that the case can be explained by the judge's sense that the extended and conflicting testimony about the different understandings of the parties presented a jury issue. Nonetheless, if the October 19, 1987, crash did not produce a MAC in the affairs of an investment banking house, one wonders what circumstances would qualify to allow the purchaser an "out" as a matter of law.

[If parties to an agreement had a common understanding that the MAC definition is based on the concept of "materiality" emanating from the securities laws, that understanding should be spelled out. One way to do this would be to define "material" as it is found in securities law cases. The parties would be borrowing the extensive judicial gloss on the phrase arising out of the landmark cases like SEC v. Texas Gulf Sulphur Co.[11] If the clause is drafted to incorporate the Texas Gulf Sulphur test it will be difficult for a court to disregard the wealth of precedent which suggests that just about any adverse event of any significance whatsoever will occasion a walk right.


In conclusion, recent cases like Tyson Foods and Holly Corporation demonstrate that courts (a) deem "MAC events" as major adverse, "bet the farm" type of events that are not to be lightly found, and (b) will compel a party seeking to assert a "MAC out" to prove the standard agreed to in the definitive documents. These decisions made in the context of M&A transactions would certainly be influential in connection with any investment transaction controversy relating to a "MAC out." If parties in investment transactions intend for a MAC clause to have a different meaning than the standard adopted in Tyson and used in Holly, the parties should make that clear by adding language to make that clear in the MAC definition. Referring to specific court interpretations is a strong way to achieve that objective.

B. Seth Bryant, Esq. Managing Partner, Bryant Burgher Jaffe & Roberts LLP,

B. Seth Bryant is the founder and Managing Partner of Bryant Burgher Jaffe & Roberts LLP. Mr. Bryant represents a diverse group of clients, including Fortune 500 companies, middle market and early stage companies, private equity funds and real estate developers in a range of transactional matters. Mr. Bryant has significant experience in private placements of equity and debt securities and mergers & acquisitions transactions. Mr. Bryant also represents clients in structuring joint ventures, investment fund formations and on MWBE matters.

Priscilla Hughes, General Counsel, Thomson Financial,

Priscilla Hughes currently serves as General Counsel for Thomson Financial. Priscilla has overall responsibility for the legal affairs of Thomson Financial.

Previously Hughes was a partner in the New York office of Morrison & Foerster LLP and co-head of the firm's M&A practice. Priscilla's practice focused on complex mergers and acquisitions, and federal securities regulation. Hughes also has substantial experience in public offerings, debt and equity financings, restructurings, and regulatory compliance matters.

[1] As a representation or warranty, the phrase can sometimes serve as a positive representation as to the absence of undisclosed problems, and in other instances as a "catch all" exception to characterize certain undisclosed or unaddressed matters as insignificant, i.e., not arising to the severity of a MAC. In this context, the phrase is used to support factual representations in the following manner "except as disclosed on Schedule X, the Target has no violations of law, except as such would not constitute a Material Adverse Effect."

[2] 789 A.2d 14 (Del. Ch. June 15, 2001)

[3] 2005 WL 1039027 (Del. Ch. April 29, 2005)

[4] Here the words "is", "would", "would likely" and "could" represent different ranges of certainty whether the event or condition is a MAC. These verbs should be thought through carefully. Investor s or acquiror s seek more latitude to characterize an event or condition as a MAC and given the choice should seek phraseology that allows for that . Targets, on the other hand, seek to limit situations that could be deemed a MAC and therefore should seek a formulation based on the idea that the Target has actually suffered a MAC . Most often times, parties use a formulation that is in the middle of the two extremes, such as "an event or condition that is or would likely result in a material adverse change ..."

[5] Use of the term "prospects" is often negotiated, but seldom of real concern. "Prospects" is a nebulous concept that describes future performance or results. One could argue that including "prospects" does not add anything meaningful because "prospects" depend on the business, assets, condition, operating results etc. of a target. Parties will often use it as a bargaining chip recognizing that its value is limited because (i) it is nebulous enough as a concept that a court would likely find it to be too indefinite to give it effect, and (ii) it probably does not add much that it is not covered by the existing litany of affected areas, i.e., is "prospects" different than "condition (financial or otherwise)" or "business"?

[6] Mergers, Acquisitions, and Buyouts, Ginsberg and Levin, Volume 4, Sec. 2203, July 2005.

[7] The parties agreed to the following definition: "Material Adverse Effect" with respect to Holly or Frontier shall mean a material adverse effect with respect to (a) the business, assets and liabilities (taken together), results of operations, condition (financial or otherwise) or prospects of a party and its Subsidiaries on a consolidated basis or (b) the ability of the party to consummate the transactions contemplated by this Agreement or fulfill the conditions to closing set forth in Article 6, except to the extent (in the case of either clause (a) or clause (b) above) that such adverse effect results from:

  • general economic, regulatory or political conditions or changes therein in the United States or the other countries in which such party operates;
  • financial or securities market fluctuations or conditions;
  • changes in, or events or conditions affecting, the petroleum refining industry generally;
  • the announcement or pendency of the Mergers or compliance with the terms and conditions of Section 5.1 hereof; or

  • stockholder class action or other litigation arising from allegations of a breach of fiduciary duty relating to this Agreement. "Holly Material Adverse Effect" and "Frontier Material Adverse Effect" mean a Material Adverse Effect with respect to Holly and Frontier, respectively.

[8] Holly Corporation, 2005 Del. Ch. Lexis at *36.

[9] Tyson Foods, Inc. at p.31.

[10] Bear Stearns Co. v. Jardine Strategical Holdings, reported in N.Y.L.J. June 13, 1990, at 22

[11] Bear Stearns Co. v. Jardine Strategical Holdings, reported in N.Y.L.J. June 13, 1990, at 22