M&A: Taking a Closer Look at the Adverse Effect Escape Clause

by: Prince of Wall Street

As more and more buyouts break the Material Adverse Clause [MAC], this is rightfully getting more and more attention. Back in 2001 when the tech bubble burst and many buyouts starting breaking, many sponsors pressured their bankers to invoke the MAC and kill deals that the sponsor no longer wanted to do (because the multiple didn’t make sense anymore, or the company was going to face recessionary headwinds etc.). Under this scheme, the sponsors used the promise of future investment banking business when the cycle turned to make the banks play the bad guys.

In more recent buyouts that are under pressure, the banks have started to make MAC arguments in committed financing negotiations with sponsors. This time the banks are using the MACs against the sponsors and not in the interest of the sponsors. While the Prince is not aware of a MAC being officially invoked in any recent busted buyouts, he certainly believes that banks are using MACs in contract negotiations as a threat and a bargaining chip.

Given the power that these clauses have to break up buyouts, absolve sponsors of paying breakup fees, and get banks off the hook from committed financings among other things, we should not be surprised that these clauses are, and will be, getting more attention.

A material adverse effects clause is a provision in M&A agreements that allows a party to walk away from a deal if a counterparty has suffered a so-called "MAE" as defined in the document. As reported in The Deal:

"The last nine or 10 months feel like one big MAE," said Faiza Saeed, a partner at the venerable M&A law firm, Cravath, Swaine & Moore LLP in New York. Pointing to one case where the interpretation of an MAE clause was central to a dispute, she noted that the one in the Finish Line Inc.-Genesco Inc. agreement was fairly standard in carving out a number of potential occurrences from the definition of MAE. "Definitions tend to be repeated from deal to deal without a lot of thought," said Saeed, who also noted that the complexity of MAE clauses often baffles clients as well as judges. "We’ve gone back and looked at these definitions and asked if anyone understands them."

Clearly the language of a MAC and an MAE needs to be carefully considered. For example, consider the MAC in the merger agreement for SLM Corp’s (NYSE:SLM) acquisition by J.C. Flowers. That agreement stated that Flowers could walk from the deal if SLM suffered a decline worse than that of other companies in its industry, but the agreement was ambiguous on a critical issue. Should the court compare SLM to the whole of financial services? Should it just compare it to student lenders? Clearly SLM is an example where the drafting of the MAC and MAE could have been done better and The Prince does not believe that this is an isolated incident.

Given the power that MACs hold, it is clear to the Prince that many attorneys will have to rethink how they draft such clauses and how they define an MAE in the future. Furthermore, sponsors, banks, and sellers would all be wise to approach the drafting and inclusion of MACs with a bit more caution and attention than they have granted in the past.