No Exit

Divorcing for irreconcilable differences may be legal in most states, but it won't get you out of a merger. Just consider the 2006 court battle between marketing-services firm Valassis Communications Inc. and direct-mail firm ADVO Inc.

Designed to create a co-op mail giant, the $1.3 billion deal was signed in July but fell apart a month later when updated financial statements showed quarterly operating income at ADVO running 30 percent below what Valassis management expected. In response, Valassis filed suit in Delaware Chancery Court seeking to be released from the agreement. ADVO management, Valassis charged, had "materially misrepresented the financial health of the company and failed to reveal internal-control deficiencies," triggering the contract's material adverse change (MAC) clause.

The legal briefs contained juicy charges of fraud and cover-up and countercharges of buyer's remorse. But nine days after the trial started, Vice Chancellor Leo E. Strine Jr. closed his courtroom to confer with both parties.

What transpired there has never been made public, but it is widely assumed that Strine reminded them of his 2001 decision involving Tyson Foods's attempt to get out of a merger with IBP Inc. on the basis of a change in quarterly performance (see "Steak and Eggs," August 2001). In what was then and remains the definitive ruling on MAC clauses, Strine required Tyson to complete the merger at the agreed-upon price.

Two days later, Valassis management announced that a deal they had only recently said would cause the company serious financial harm was going ahead. And while Judge Strine never got to rule because of the settlement, his earlier warning to buyers still rings true: after due diligence is done there are few exits to a merger. As Lou Kling, a partner with Skadden, Arps, Slate, Meagher & Flom, told an audience at Harvard Law School last year, for a MAC clause to apply, a problem must be "a hundred times worse than what the client actually thinks it has to be." In most instances, the client underestimates "by multiples how bad that effect has to be to get a court to say it was a material adverse effect."

Specific Triggers
The Valassis/ADVO case is unusual because it actually went to trial. Despite being standard fare in any M&A deal, MAC clauses are rarely invoked and even more rarely litigated. "In a couple of decades of investment banking, I have never been in a position where one of these was invoked," says Jeffery Bistrong, managing director and head of the technology group at M&A advisory firm Harris Williams & Co.

But the rarity of their exercise only underscores the gravity of the situation they address: a collapsing deal with potentially enormous repercussions for both parties. "This is one of the most important clauses in the contract because both sides get hurt if the deal blows up, but usually the seller gets hurt much more," says H. Rodgin Cohen, chairman of law firm Sullivan & Cromwell in New York.

For that reason, sellers are particularly anxious to grab every advantage they can. This is borne out by a recent Nixon Peabody study that found the seller's market of the past several years has further tilted MAC clauses in their favor. "It comes and goes, depending on whether you have a buyer's market or a seller's market," says Martha M. Anderson, a partner in the law firm's mergers-and-acquisitions practice. And the reality, says Darrell W. Crate, CFO of Affiliated Managers Group in Pride's Crossing, Massachusetts, is that "we are in a time where it is a frothy credit market, and sellers have more power than buyers."

To protect that advantage, sellers have increasingly wrapped themselves in "exceptions" — outlying events that the parties agree will not be considered a MAC for purposes of the contract. According to Nixon Peabody, both the number and type of exceptions in MAC clauses were significantly higher in the year ending in June 2006 than in the preceding 12 months. Among the more common were acts of war or terrorism, changes in laws or regulations, and the impact that the announcement of the deal itself has on the seller's business. For instance, in one pending deal, the effort of a consortium led by the Royal Bank of Scotland to purchase ABN AMRO carries a clause specifically excluding any material adverse change suffered by ABN AMRO as a result of the breakup of its previous agreement to sell its subsidiary, LaSalle Bank, to Bank of America.

Sellers have also been helped by the courts, which have made it clear that there is an increasing burden on buyers to enumerate exactly what will be considered material adverse changes. In 2005, for example, Holly Corp.'s effort to invoke the MAC clause was denied by the Delaware Chancery Court because the company didn't specifically enumerate that a specific event (in this case, initiation of a "toxic tort" case against target Frontier Oil by famed consumer activist Erin Brockovich) would constitute an adverse change in the target's status. (Holly was allowed to escape the merger, but on grounds unrelated to the MAC.)

In another case, a Massachusetts court rejected a shareholder lawsuit in 2000 challenging Excell Data Corp.'s acquisition of Cambridge Technology Partners. Excell shareholders claimed that Cambridge management had falsely claimed it was on track to meet analysts' expectations in an upcoming earnings report, despite knowing it would fail to do so. The judge ruled, however, that Cambridge had not triggered the MAC clause, because "[b]y the parties' express agreement, Cambridge's warranties only covered the accuracy of representations about its current operations, not its future prospects."

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