Private Equity Firms Continue to Utilize Material Adverse Effect Provisions as a Device to Force Sellers to Renegotiate Agreements

A Material Adverse Effect (“MAE”) is a provision that is included in a negotiated agreement to allocate risk between a buyer and seller during the period separating signing and closing. A pro-buyer MAE will provide the buyer with the ability to walk away from a transaction if there is a material adverse effect; whereas, a pro-target MAE will make closing of the deal fait accompli.

An example of the standard MAE is: “There shall not have occurred a Material Adverse Effect on the Company.” Consequently, the provision acts as a mechanism to protect the buyer from the occurrence of unknown events, which threaten the long-term health of the seller’s business. Sellers, however, will want to attenuate the provision’s applicability by requiring there to be certain carve-outs. For example, the seller may exclude from the definition of a MAE “Acts of God, earthquakes, hostilities, acts of sabotage or terrorism or military actions or any escalation or material worsening of any such hostilities, acts of sabotage or terrorism or military actions.”1 Otherwise buyers would be able to walk away from a deal under their own economic discretion.

Indeed, the chronological progression of MAE disputes have become all too predictable over the course of the past decade: (1) a buyer and seller reach a negotiated agreement that includes a MAE; (2) the buyer walks away from the agreement claiming that there has been a material adverse effect as a result of a change to the sellers business, assets, liabilities, operations, conditions or prospects; (3) the seller files suit asserting that the buyer improperly terminated the binding agreement; and (4) instead of progressing through trial, the buyer and seller renegotiate the purchase price (or some other remedy that is favorable to the buyer’s position), resulting in a settlement and dismissal of the lawsuit.

This is precisely what happened in In re Innkeepers USA Trust v. Cerberus Series Four Holdings2, which follows the recent trend of private equity firms using MAEs as an effective tool to force renegotiation and strike better deals for its stakeholders.3 Innkeepers filed suit against Cerberus and Chatham on August 29, 2011 for walking away from its $1.12 billion deal to purchase multiple hotels owned by Innkeepers. In Cerberus’ answer, it claimed there was a material adverse effect because of the “adverse changes in the debt and equity markets.” Nevertheless, the parties reached a settlement agreement on October 19, 2011, which resulted in a decrease of the purchase price by $180 million.

By settling the case, the judiciary– in this instance, the United States Bankruptcy Court for the Southern District of New York – is once again left unable to interpret another MAE provision. Such judicial interpretation is important for elucidating MAEs and clarifying when a buyer can successfully invoke a material adverse effect to walk away from a negotiated agreement. A small number of cases involving the interpretation and application of MAEs have been litigated from start to finish.4 To date, the Delaware courts have never found there to be a material adverse effect in the specific context of a merger agreement.

The question, therefore, is what is a MAE’s true purpose? This is a valid query since, in most cases, invoking a material adverse effect will be futile due to the fact that a court is highly unlikely to find that one has occurred. In a recent survey, Nixon Peabody identified that the use of MAEs in publically filed agreements consisting of asset purchases, stock purchases, and merger agreements, increased from 93% to 96% between June 1, 2010 and May 31, 2011.5

This undoubtedly demonstrates that, post the financial turbulence in 2007-2009, buyers, such as Cerberus and Chatham, are still negotiating for MAEs to use as leverage – in effect, arming themselves with a quasi-mulligan to renegotiate the agreement. Forcing a seller to litigate whether the buyer is entitled to invoke a material adverse effect is extraordinarily costly.

Consider the magnitude of the expense a seller would incur if it were to engage in full-scale discovery to prove the non-existence of a material adverse effect. There would be depositions of integral executives, which would contribute to a lack of productivity and presumably decrease the value of the firm; there would be a battle of highly expensive experts explaining, in their opinion, why or why not a material adverse effect occurred to the target; and there would be an unimaginable amount of documents produced in order to prove or disprove the claim. Therefore, in most cases, the economically prudent firm will simply renegotiate the purchase price to save the headache, expense, and, not to mention, expedite the efficient closing of the transaction so that new strategies can be effectively implemented.

Although Nixon Peabody reports that the current economic environment provides attractive sellers with a lot of leverage in the negotiation of MAEs (which is evidenced by the 23% increase in the use of definitional carve-outs), firms, such as Cerberus and Chatham, are still able to utilize MAEs as leverage to renegotiate deals. It is worthwhile to note that Inkeepers was in Chapter 11 during the negotiations; therefore, it certainly was in a weak position and not an attractive target. The actual MAE was heavily favored toward Cerberus. Nevertheless, the case demonstrates that MAEs continue to be of value to buyers.

A significant portion of the MAE puzzle remains to be filled-in by the courts. As a result, many questions persist: How much longer will targets endure this strategy? Are targets utterly defenseless? Are there any defensive measures that sellers can adopt to counter its inherent vulnerability? If one thing is for certain, however, firms such as Cerberus and Chatham are still negotiating for MAEs and reaping the economic benefits.

1 See, e.g., Weil Briefing: MAC/MAE Provisions.
2 In re Innkeepers USA Trust v. Cerberus Series Four Holdings, Case No. 11-02557.
3 Such as Bain Capital’s acquisition of Home Depot’s wholesale supply unit or KKR and Goldman Sachs termination of the transaction with Harman International and taking it private.
4 IBP, Inc. v. Tyson Foods, Inc. 789 A.2d 14, 54-55 (Del. Ch. 2001) (where the Delaware Chancery Court, applying New York law, stated that MAE clauses are to be construed narrowly against the party invoking the clause); Genesco v. Finish Line, Inc., No. 07-2137-II(III) (Tenn. Ch., Dec. 27, 2007) (where the Tennessee Court of Chancery found that the buyer failed to demonstrate the existence of a MAE because the genesis of the target’s financial deterioration was the result of general economic conditions, which was expressly carved-out); Hexion Specialty Chemical, Inc. v. Huntsman Corp., 965 A.2d 715, 738-739 (Del. Ch. 2008) (where the Delaware Chancery Court stated that the party claiming the material adverse effect bears a heavy burden of proof and emphasized that successfully demonstrating one has occurred is extremely difficult).
5 Nixon Peabody’s 10th Annual “Study of Current Negotiation Trends Involving Material Adverse Change Clauses in M&A Transactions”.