Canceling the Deal: Two Models of Material Adverse Change Clauses in Business Combination Agreements

Abstract

In any large corporate acquisition, there is a delay between the time the parties enter into a merger agreement (the signing) and the time the merger is effected and the purchase price paid (the closing). During this period, the business of one of the parties may deteriorate. When this happens to a target company in a cash deal or to either party in a stock deal, the counterparty may no longer want to consummate the transaction. Merger agreements typically protect counterparties against this risk through “material adverse change” (MAC) clauses, which permit the counterparty to cancel the deal if the party suffers a MAC between signing and closing.

Despite the complexity of typical MAC clauses, such clauses almost always rely on an undefined concept of materiality, and virtually all of the important reported cases arising from MAC clauses have required the court to decide whether a particular adverse change in a party’s business was “material” within the meaning the agreement. In attempting to give content to this term, courts have generally inquired whether the earnings capacity of the company has been substantially impaired. This inquiry, which I call the Earnings Potential Model, proceeds by comparing the actual or expected earnings of the company across various of its fiscal periods.

This article reviews all the important reported MAC cases and argues that the Earnings Potential Model has failed to provide courts with a judiciable standard by which to decide MAC cases. In particular, the model cannot explain (a) which fiscal periods of the company ought to be compared with which, and (b) what percent diminution in earnings between such periods is sufficient to cause a MAC.

The article then proposes an efficiency interpretation of materiality as used in MAC clauses: assuming the allocation of risk in MAC clauses is efficient, an adverse change is material if, but only if, it is sufficiently large to make the transaction unprofitable for the counterparty. Based on this interpretation, the article explains and defends a new model of MAC clauses, which I call the Continuing Profitability Model. Under this model, a court would apply a simplified discounted cash-flow analysis based on publicly-available data to determine whether, at the time the counterparty declared a MAC, the transaction was still profitable for it. If so, there was no MAC, and the counterparty should have to close the deal or be in breach. If not, then the party was MAC’d and the counterparty should be permitted to cancel the deal. The article concludes by applying the model to the facts in Hexion v. Huntsman, the most recent MAC case in the Delaware Court of Chancery, and argues that the court, misled by the Earnings Potential Model, was clearly mistaken in holding that Huntsman had not been MAC’d.

Keywords: MAC, MAE, Material Adverse Change, Material Adverse Effect

JEL Classification: G34, K00, K12, K22