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Cardozo Law Review

Abstract

In any large corporate acquisition, there is a delay between the time the parties enter into a merger agreement and the time the transaction is effected and the purchase price is paid. One effect of this delay is that the business or financial condition of one of the parties may deteriorate before the deal closes. When this happens to the target in a cash deal or to either party in a stock deal, the counterparty may conclude that the transaction is no longer attractive. Merger agreements typically protect counterparties against such contingencies through material adverse change (MAC) clauses. Under the typical MAC clause, if a party has suffered a MAC before the deal closes, the counterparty may costlessly cancel the deal and walk away.

MAC clauses are very complex and are highly negotiated. They typically distinguish various kinds of risks to the party's business and assign some risks to the party, others to the counterparty, often with exceptions and exceptions to exceptions. When a counterparty declares a MAC and attempts to cancel a pending transaction, the fate of the deal hangs in the balance, and so when parties to a merger agreement litigate whether one of them has been MAC'd, the stakes are usually enormous, often tens of billions of dollars.

In such litigations, the key issue has usually been whether an admittedly adverse change in a party's business is of sufficient magnitude to be a MAC - i.e., whether the adverse change is material. Despite their complexity and prolixity, typical MAC clauses do not define materiality. To decide such cases, therefore, courts have had to turn to their own devices.

Led by the Delaware Court of Chancery, courts have decided MAC cases by estimating the present and future earnings of the affected company in order to determine whether such earnings have declined relative to historical standards. This method of interpreting MAC clauses is here called the Earnings Potential Model. As the case law developed, courts have improved the Earnings Potential Model by invoking financial theory, generally accepted accounting principles (GAAP), and the disclosure standards of the federal securities laws in order to make the inquiry mandated by the model increasingly precise. For example, courts have taken to measuring a company's earnings by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and have identified relevant fiscal periods to compare using the disclosure requirements of Regulations S-X and S-K.

Nevertheless, the Earnings Potential Model fails at two critical points. First, the model does not specify which fiscal periods of the party should be compared with which. In practice, courts have made any number of comparisons that have seemed relevant, but they have never articulated a rational explanation of which comparisons are important and why. Second, although the model allows the court to calculate with great precision the percent diminution in a party's earnings across any two fiscal periods, the model is completely silent as to what level of diminution is necessary to cause a MAC. Having calculated the percent diminutions as between various pairs of fiscal periods, courts have then simply announced - without the slightest explanation and apparently on the basis of nothing more than judicial intuition - that the party was or was not MAC'd. In the end, therefore, the Earnings Potential Model yields no principled answers in MAC litigations.

To develop a more satisfactory method of resolving MAC disputes, this Article first identifies the efficiency rationales for assigning the risk of material adverse changes in a party's business to the party itself and the risk of immaterial adverse changes to the counterparty. With respect to risks arising in its own business, the party is, for readily apparent reasons, almost always the cheaper cost avoider or superior risk bearer, and so such risks are efficiently allocated to the party itself. For exactly the same reasons, however, the party would also be the cheaper cost avoider or superior risk bearer of immaterial risks to its business, and so the assignment of such risks to the counterparty requires a special, overriding explanation.

In fact, risks of immaterial adverse changes to the party's business are assigned to the counterparty because, if they were assigned to the party, the counterparty could declare a MAC and credibly threaten to cancel the deal whenever the party's business was adversely affected, no matter how slightly. In such circumstances, the counterparty would have tremendous leverage over the party and could generally renegotiate the purchase price downwards. Since the adverse change was immaterial, however, the transaction would very likely still have been profitable for the counterparty at the original price. When, in such circumstances, the counterparty threatens to cancel the deal and seeks to renegotiate the price, it is simply attempting to transfer value from the party to itself; its behavior, in other words, is pure rentseeking. Such inefficient behavior can be completely forestalled, however, if the risk of immaterial adverse changes is allocated to the counterparty in the MAC clause. When such risks are thus allocated, the counterparty cannot credibly threaten to cancel the deal because of trivial changes in the party's business.

Understanding the rationales for allocating material risks to parties and immaterial risks to counterparties allows us to locate the efficient border between material and immaterial adverse changes. That border lies at the point at which the efficiency rationale for allocating immaterial risks to the counterparty is outweighed by the efficiency rationale for allocating material risks to the party. That is, in the argument that allocating immaterial risks to the counterparty was efficient, it was essential that, when such risks materialize, the transaction would still be profitable for the counterparty; hence, the efficient border between materiality and immateriality lies at the point at which the transaction ceases to be profitable for the counterparty. Therefore, a risk is material if, but only if, its materialization makes the transaction unprofitable for the counterparty. This insight allows us to create a new model to resolve MAC disputes - the Continuing Profitability Model.

In applying the Continuing Profitability Model, we employ a discounted cash-flow model to value the party's equity. Applying the model requires that we obtain estimates of the party's future EBITDA, an appropriate enterprise value to future EBTIDA ratio, and an estimate of the party's weighted average cost of capital (WACC), as well as information about the party's net debt. If on the date that the counterparty declares a MAC, the value of the party's equity as determined by the model is greater than the purchase price, then the deal is still profitable for the counterparty, and the party has not been MAC'd. If the value of the party's equity is less than the purchase price, then the deal is no longer profitable for the counterparty, and the party has been MAC'd. In the latter case but not the former, the counterparty should be permitted to cancel the deal.

Although implementing the Continuing Profitability Model in practice may at first appear daunting, it turns out to be no more difficult or uncertain in real cases than applying the Earnings Potential Model. In that model, courts are already relying on data, usually derived from published estimates by industry analysts, of the party's expected future EBITDA. Such estimates are uncertain, to be sure, but since the Earnings Potential Model cannot be implemented without some data about the future EBITDA of the company, courts have had little choice but to rely on such data. Implementing the Continuing Profitability Model, however, requires only that courts accept some more data also readily ascertainable from publicly available sources - most importantly, estimates of enterprise value/forward-EBITDA multiples and WACCs for companies operating in the same industry as the party. If the estimates of analysts are good enough to measure future EBITDA in the Earnings Potential Model, then they are good enough to measure enterprise value/forward-EBITDA multiples and WACCs in the Continuing Profitability Model as well. By accepting such data, courts can have in the Continuing Profitability Model an economically rational, fully principled, and reasonably practical tool of judicial decision-making sufficient to settle MAC disputes.

To demonstrate how the Continuing Profitability Model would work in practice, I conclude by applying it to the facts in Hexion v. Huntsman, the most recent MAC case in the Delaware Court of Chancery, and I argue that the court, relying on the Earnings Potential Model, was clearly wrong in holding that Huntsman had not been MAC'd.

Disciplines

Banking and Finance Law | Law | Law and Society | Securities Law

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