The Court of Chancery of the State of Delaware (“Court”) has pronounced an important judgement in the case of Osram Sylvania Inc. v. Townsend Ventures, LLC (“Osram”) where the issue was whether failure to meet projected sales figures constitutes a Material Adverse Effect. The Court held the target company’s failure to meet sales forecasts to be a Material Adverse Effect (“MAE”) to the acquirers. In the following note, the terms material adverse effect and Material Adverse Change (“MAC”) have the same meaning and are used as alternate terms for each other.
Material Adverse Effect Clause
MAE clauses in contracts are used to specify a condition to the closing of a transaction or to qualify representations and warranties made by the parties to the contract . It is aimed at ensuring that a party can exit the transaction after an agreement has been signed and the transaction is closed.
Jeffrey Rothschild, Nick Azis, Patrice Corbiau, Dennis White and Abigail Reed of McDermott Will & Emery while discussing MAE describe it as follows “Merger and acquisition contracts typically feature a material adverse change or material adverse effect clause, under which a buyer may exit the deal or renegotiate terms if an unforeseen material adverse business or economic change affecting the target company occurs between executing the acquisition agreement and closing the transaction.” Generally a MAE clause must be drafted employing an objective criterion to establish MAE. The clause must also specify any exceptions to the clause expressly and specify a time frame within which MAE could take place.
Judicial position in Delaware till Osram
The Osram judgment is a paradigm shift in the Court’s position on MAE. The Court had earlier in IBP, Inc. v. Tyson Foods declared that MAE would occur only in case the target company’s long term earning power had changed. The Court while discussing the standard to establish if a MAE has indeed occurred, stated, “An adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months”.
It is also important to understand the Court’s position in Hexion Specialty Chems. Inc. v. Huntsman Corp, to understand the change in the Court’s position in Osram. In this case, Hexion Speciality Chemicals, Inc. (“Hexion”) had entered into an agreement to acquire Huntsman Corporation (“Huntsman”). Prior to the signing of the agreement, Huntsman had made projections of its financial position, which it was unable to meet after the signing of the agreement. The Court rejected Hexion’s contention that Huntsman’s failure to meet its financial projections amounted to a MAE. The Court further noted that it had never found MAE to have occurred in the context of a merger agreement.
Change in judicial position in Osram
In Osram, the plaintiff had entered into an agreement with the defendant to purchase some stock of Encelium Holdings, Inc. (“Encelium”) in October 2011 (“Agreement”). The plaintiff had agreed on the purchase price on the basis of the defendant’s representation of Encelium’s financial position. The defendants had forecast sales of USD 4 Million in the third quarter of 2011. However, Encelium’s sales in the third quarter were less than half of the projected amount. The defendant did not make any disclosure as to the sales falling short of its projections to the plaintiff.
The plaintiff contended that the defendant’s non-disclosure of facts amounted to a MAE. The plaintiff further alleged that the defendants had manipulated Encelium’s second quarter results to make Encelium look more profitable than it actually was. The Court found that financial manipulation prior to execution of the agreement could lead to a MAE. The Court also held the defendants failure to meet sales forecasts to be a MAE. The plaintiff had also raised a claim that the defendants misrepresentation based on financial manipulation amounted to fraud. The Court found the plaintiff’s plea met the standards for common law fraud. Kerry E. Berchem of Atkin Gump while discussing this states, “The court held that OSI had pled the elements of fraud with sufficient particularity to satisfy the heightened pleading standards applicable to common law fraud claims and OSI also pleaded a claim for negligent misrepresentation based on the sellers’ alleged manipulation and concealment of financial information before the closing. As to OSI’s equitable fraud claim, however, the court determined that OSI did not make the necessary allegations of any special relationship of trust or confidence between OSI and the sellers, and therefore granted sellers’ motion to dismiss as to OSI’s equitable fraud claim”. The plaintiff had also contended that the defendant had violated the implied covenant of good faith and fair dealing. However the Court held that defendant’s obligations were governed by the Agreement and found no contractual obligations under the Agreement to support the plaintiff’s claim.
In the light of the paradigm shift in the enforcement of MAE clauses in Delaware, it becomes important to analyze the implication of MAE on mergers and acquisitions in India.
Material Adverse Effect – Indian Context
In India, we are severely restricted with regards to literature on MAE clauses in acquisition contracts in the Indian context, mainly due to a glaring lack of case laws commenting on the same. While there has been reference to MAE clauses in an acquisition agreement by courts in passing, there have been no judgments as of yet which deals with the applicability or enforcement of the clause.
The Supreme Court of India in Nirma Industries and anr. v. Securities Exchange Board of India, despite allegations of fraud due to the company’s financial manipulation, did not find it as sufficient grounds for the investor to exit the transaction. Similarly, in Subhiksha Trading Services v. (G) the Madras High Court held financial misrepresentations by a transferee company to be insufficient grounds to withdraw consent to a scheme of amalgamation. It must be noted that while the courts in both these cases did discuss MAE in spirit, they refused to allow the acquirers to walk away from their respective transactions due to consideration of different statutory provisions. In spite of the fact that both these judgments were on issues other than material adverse effect, and in neither case was a such a clause or enforcement of such a clause urged by the petitioners, the courts in both cases, through their ancillary observations, held that such acts of misrepresentation. Fraud or suppression of facts still did not amount to material adverse effect as these could have been known to the petitioners if they had applied greater diligence. Therefore the Indian courts have not recognized MAC to be a basis for a party to walk out of a transaction.
A significant feature of any agreement is the representations and warranties by the parties to each other. While certain information provided by the sellers may be verified and relied upon in view of the filings made by the company at various public offices, reliance is required to be placed on the representations made by the parties where no such verification is possible. Hence, in the event a material adverse change occurs, the buyer has a vested right to terminate the agreement. This naturally makes the drafting of the material adverse clause extremely significant from the point of view of the counsel of both the acquirer and the seller.
Drafting MAE clauses
It is necessary for a MAE clause to be defined in a manner that eliminates any ambiguity as to the meaning of the term material itself. The term ‘material’ must be defined in a manner in which it clearly denotes that such change affects the decision of the parties. The exact manner in which material must be defined would depend on the context of the agreement.
It is possible for both parties to be subject to provisions containing a materiality standard. In such case, it would be necessary to clearly define materiality. The parties to an agreement may choose to limit the qualifications for a change to ensure that the transaction is closed without delay. In case of a MAE that can occur in the closing conditions of a transaction, in such case it is important to ensure that the MAE clause is an incorporated condition and not as a separate representation.
The difference between having the MAE clause as an additional condition or as representation would be in its enforcement. In case the MAE clause is a representation, its breach would grant the party against whom such MAE has taken place, a cause of action for damages or claims. However, if the MAE clause is a part of the conditions precedent to closing, a breach would allow the party against whom the breach has been committed to void the contract.
The standard of proof for a change to have MAE on the agreement is high, and the burden of proof would fall on the buyer. Although the buyer can try to shift the burden to the seller by explicitly stating so in the agreement, it is better for the buyer to identify objective criteria or metrics (such as financial or operational targets) and include them in the agreement, rather than relying on the standard formulation of an MAE condition to terminate a deal. On the other hand, it is possible for the seller to insert carve-outs in the MAE clause so that specific changes (such as changes in the economic or financial policies or laws of the country)which result in changes in projections etc. of the financial status of the seller company are not counted as an MAE.
It is to be kept in mind that the seller will not generally accept a very wide definition of an MAE. However, the buyer may try to negotiate so as to include changes in the ‘prospects’ of the company and may provide exceptions to the carve-outs proposed by the buyer so as to exclude any disproportionate effects on the target even with consideration for the carve-outs. Similarly, the buyer too cannot be expected to agree to a wide range of carve-outs and the seller may need to specify the same.
The change in approach of the Courts in Delaware seems understandable in the volatile economic situation witnessed globally and specifically the elements of financial manipulation found in the Osram case. With India fast emerging as a major economy, it is not inconceivable that in the near future several private equity and acquisition transactions could be affected in valuation by complex manipulations especially where such valuations are entirely based on earning projections.
It may be pertinent to note for the Indian judiciary that such changing times may require application of greater weightage on Material Adverse Effect clauses in acquisition contracts, in order to better protect the future acquirers from avoidable losses and debacles. From a drafting point of view, it would be desirable to clearly set out the terms of a MAE clause and its carve outs. Clearer MAE clauses with detailed position on what would constitute material adverse effect or an exhaustive list of clearly defined carve-outs with a broader primary definition could go a long way in protecting future acquirers.
Clearly defined MAE clauses across acquisition agreements would also set the stage for greater enforcement of such clauses by courts in India.
See, http://www.akingump.com/en/experience/practices/corporate/ag-deal-diary/black-friday-needs-to-start-really-early-risk-of-material.html; https://blogs.law.harvard.edu/corpgov/2013/12/08/delaware-court-missed-sales-forecasts-could-be-material-adverse-effect/
 Kenneth A. Adam, A Manual of Style for Contract Drafting, Second Edition, American Bar Association, Pg 162
Andrew M. Herman and Bernardo L. Piereck, Revisiting the MAC Clause in Transaction:What Can Counsel Learn from the Credit Crisis?, Business Law Today, 2 August 2010
789 A.2d 14 (Del. Ch. 2001)
965 A.2d 715 (Del. Ch. 2008)
CIVIL APPEAL NO. 6082 of 2008
C.Ps. No. 239 and 240 of 2008
Kenneth A. Adam, A Manual of Style for Contract Drafting, Second Edition, American Bar Association, Pg 152
Id. Pg 154
Id, Pg 157
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