The collapse of the high-profile merger between Zee TV and Sony's Indian media assets have put the spotlight on “material adverse effect” (MAE) or “material adverse cause” (MAC) clause which is ubiquitously found in the transaction documents pertaining to mergers and acquisitions (M&A). If the newspaper reports are to be believed, Sony decided to pull the plug on the...
The collapse of the high-profile merger between Zee TV and Sony's Indian media assets have put the spotlight on “material adverse effect” (MAE) or “material adverse cause” (MAC) clause which is ubiquitously found in the transaction documents pertaining to mergers and acquisitions (M&A). If the newspaper reports are to be believed, Sony decided to pull the plug on the proposed merger because of certain events which could have a “material adverse effect” on the business of the merged entity.
What is MAE or MAC and why it is so critical.
In every large M&A transaction, lawyers and investment bankers typically pay special attention to the definition of MAE and the contours thereof which are carefully drafted and incorporated in definitive agreements.
In M&A transactions whether involving a change of control or not, numerous approvals (such as approval from the Competition Commission, approvals from sector specific regulators like the Reserve Bank of India or the Insurance Regulatory and Development Authority or the National Highways Authority of India) are required to be obtained by the acquirer/ selling shareholders/ target company prior to completion of the transfer of shares or implementation of merger (Closing).
The aforesaid requirement of approvals creates a window between execution date of the transaction documents and Closing (Interim Period) The Interim Period will typically depend upon the number of approvals required for the transaction and the nature of the regulators involved in the transaction. Having said the above, it is not un-common in a large M&A to have an Interim Period in the range of 6 (six) months – 1(one) year.
A MAE or MAC clause protects an acquirer by providing for a right to the acquirer to terminate a transaction prior to Closing, if during the Interim Period, due to any event or fact or occurrence or circumstances, there has been a material adverse impact on business or future business prospects or operations of the target company which deteriorates the value of the target company since the time of execution of the transaction documents. To put it simply, a MAE or MAC clause is a get out of jail card for an acquirer which can be used by the acquirer to terminate a bad deal in cases where there has been a material deterioration of the value of the target after execution of the transaction documents.
How is a MAE clause drafted.
A typical MAE clause includes a complicated base definition, followed by exceptions that shift various kinds of risks to the acquirer, some of which is further qualified in ways that shift disproportionate materializations of the relevant risks back to the target.[2] The business risks, i.e., risks arising to the business in the ordinary course are retained by the selling shareholders/ target and all other risks which are not in control of the parties are retained by the acquirer, unless there is a disproportionate effect of such risks on the business of the target when compared with other companies in the same industry or same geographical location.
The base definition will incorporate:(i) the underlying predicate event (“any event, fact, occurrence, circumstance, development or change that, either singly or in aggregate”); (ii) expectation metric (“has or would reasonably expected to have a material adverse effect on”); (iii) MAE object (“the company or its subsidiaries taken as a whole, or its (a) business; (b) financial condition; (c) results of operations; (d) assets; (e) properties; (f) liabilities etc.”).
The exceptions to the MAE which shifts the risk back to the acquirer will include:
(i) systematic risks (i.e. risks which are beyond the control of the parties) such as: (a) general changes in the economy or economic or business conditions; (b) general changes in financial, credit, debt, capital or securities market; (c) general changes in the industries or lines in which the company operates; (d) general changes in law or legal or regulatory conditions; (e) acts of war, terrorism, sabotage; (f) acts of god, pandemic etc.
(ii) indicator risks which evidence that MAE may have occurred rather than evidence of such a change such as: (a) drop in seller's stock price; (b) credit rating downgrade; and (c) failure to meet financial projection.
(iii) agreement risk, which includes all risk arising from the announcement of the transaction, such as mass resignation of employees.
A sophisticated MAE clause will have carve-outs from the systematic risks exceptions above based on the disproportionate effect of the events on the target company as compared to other companies or persons operating in the same industries and same geographical regions.
Enforcement of MAC: Judicial view in United States of America and India.
United States of America.
In the United States of America (USA), in the context of merger agreements, the courts have been reluctant to enforce a MAE clause and have placed a heavy burden on the acquirer to prove that there have been underlying MAE events (within the contours of the definition of MAE as set out in the relevant merger agreement) which entitles the acquirer to terminate the merger agreement.
The underlying principle that the courts have adopted has been that a MAE clause should not be used for termination of a transaction due to “buyer's remorse”, i.e., the buyer of an asset having second thoughts on proceeding with a transaction after execution of the transaction document.
The Delaware Court of Chancery first described the nature of 'material adverse effect' in IBP Shareholders Litigation v Tyson Foods[5] (IBP) as “the effect which should substantially threaten the overall earnings potential of the target in a durationally significant manner.”
Further, in Frontier Oil Corporation v Holly Corporation[6] (Frontier Oil) the court has held that when evaluating whether a particular issue would reasonably be expected to result in a MAE, the court must consider quantitative and qualitative effect of the event on the target company.
The principal expounded in IBP and Frontier Oil was extended further by the Delaware Court of Chancery in Hexion Speciality Chems, Inc. V Huntsman Corp[7] (Hexion) in the following words: “In the absence of evidence to the contrary, a corporate acquirer may be assumed to be purchasing the target as part of a long-term strategy. The important consideration therefore is whether there has been 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. A buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close. Many commentators have noted that Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement. This is not a coincidence. The ubiquitous material adverse effect clause should be seen as providing a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”
Therefore, the principles which emerged from the judgements of IBP, Frontier Oil and Hexion is that while determining whether an event should be considered as “material”, such event should be of such nature which qualitatively and quantitively is or are expected to adversely impact the target's business for a durationally significant manner.
Using this principle, the courts did not uphold the termination of the respective merger agreements in IBP, Frontier Oil and Hexion on the ground of MAE having occurred.
In Akron, Inc. V Fresenius Kabi AG[9] (Akron), however, the Court of Chancery of Delaware upheld the termination of the merger agreement on account of MAE in the context of breach of representations and warranties in the merger agreement on regulatory compliance by the target (Akron). In view of the court, the Akron's representations on regulatory compliance were untrue and the magnitude of the inaccuracies have caused a material adverse effect which is evidenced by the sharp collapse in the target's financial performance which could not be cured by the outside date in the merger agreement. In Akron, after examining the evidence presented before it, the court held that “The qualitative dimension of the MAE analysis strongly supports a finding that Akorn's regulatory problems would reasonably be expected to result in a Material Adverse Effect. There is overwhelming evidence of widespread regulatory violations and pervasive compliance problems at Akorn. These problems existed at signing and got worse, rather than better, during the period between signing and when Fresenius served its termination notice. Akorn does not dispute that it has problems, only their extent and seriousness.”
Thus, in Akron, the twin tests of an event being considered “material”, i.e., the event being of such nature that it will or is expected to cause: (a) “quantitively and qualitatively” adverse effect on the business of the target (Akron); and (b) the adverse effect will be “durationally significant”, were satisfied.
India
Given that Indian corporate law jurisprudence is developing, we do not yet have any judgement which are in public domain on MAE pertaining to M&A transactions. However, in the context of public takeovers, to protect the interest of the public shareholders, the Securities and Exchange Board of India (SEBI) and the Securities Appellate Tribunal (SAT) in past have opposed any pull out from the public offer by the acquirer, on account of the transaction becoming economically un-viable due to adverse changes in the business or financial condition of the target.
In Nirma Industries Ltd. and Anr. V SEBI[10] the Supreme Court upheld the order of the SAT wherein SAT had refused to allow the acquirer (Nirma Industries) to withdraw the open offer after public announcement on account of discovery of facts after the public announcement of open offer which made the acquisition economically unviable. The Supreme Court applied strict interpretation and ejusdem generis rule of interpretation to Regulation 27 of the erstwhile SEBI (Substantial Acquisition and Takeovers) Regulations 1997 (1997 SAST Regulations) and held that any withdrawal of open offer after public announcement must be within the contours of Regulation 27 of the 1997 SAST Regulations[11]. The Supreme Court's decision was based on the principle that a key objective of the 1997 SAST Regulations was to protect the interest of the shareholders and to ensure that the takeover process does not operate in a clandestine manner without protecting the interest of the shareholders.[12] Applying the ejusdem generis rule, the Supreme Court held that “such other circumstances as determined by SEBI” stated in clause (d) should be restricted to the realm of impossibility as envisaged in clause (b) and clause (c) of Regulation 27, and therefore, the discretion provided to SEBI in clause (d) does not include circumstances where it has become economically unviable for the acquirer to complete the open offer.
The decision of Nirma Industries was also followed by the Supreme Court in SEBI v M/s. Akshya infrastructure Pvt. Ltd. [13] (Akshya Infrastructure) where it was held that an acquirer cannot be permitted to withdraw an open offer because “it has now become impossible to give effect to the public offer”.
It may be noted that the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (2011 SAST Regulations) which has replaced the 1997 SAST Regulations permit withdrawal of open offer after public announcement only in the following circumstances: (a) statutory approvals required for the open offer or for the acquisition have been refused; (b) the acquirer, being a natural person has died; (c) a condition stipulated in the agreement for the acquisition attracting the open offer not being met for reasons outside the reasonable control of the acquirer, and such agreement being rescinded; and (d) such circumstances as in the opinion of SEBI, merits withdrawal.[15] Although under Regulation 23(1)(d), discretion has been provided to SEBI to allow withdrawal of open offer, however, relying on the decisions of the Supreme Court in Nirma Industries and Akshya Infrastructure, it is logical to presume that the discretion provided to SEBI under Regulation 23(1)(d) will not include circumstances where an acquirer intends to revoke the open offer due to the acquisition becoming economically un-viable due to certain events having occurred after public announcement of open offer.
Given the reluctance of the courts to enforce a MAE clause and the heavy burden being placed on the acquirer to prove that the events or circumstances in question cause a material adverse effect on the business or financial condition of the target, it is now becoming increasingly popular to define the qualitative and quantitative thresholds and the time- period for continuance of adverse effect within the definition of MAE. Having well defined qualitive, qualitative and time thresholds somewhat lessens the burden of the acquirer and gives teeth to the termination right of the acquirer due to MAE.
However, in case of acquisition of shares of listed companies, the aforesaid approach of having well defined qualitive, qualitative and time thresholds within the definition of MAE may not work as SEBI may continue to rely on the principles set out in Nirma Industries and Akshya Infrastructure to deny approval for revocation of open offer on account of the transaction becoming economically un-viable due to certain events.
The author is a corporate counsel and views are personal.
[1] https://www.indiatoday.in/business/story/sony-zee-merger-deal-called-off-reason-2495894-2024-01-31#, accessed on 23 April, 2024.
[2] A New Theory of Material Adverse Effect by Rober T. Miller, The Business Lawyer; Vol 7, Summer 2021.
[3] ibid
[4] Akron, Inc. v Fresenius Kabi AG (Court of Chancery of Delaware) (C.A. No. 2018-0300-JTL)
[5] 789 A.2D 14, 2001 Del Ch. Lexis 81
[6] Frontier Oil, 2005 Del. Ch. Lexis 57, 2005 WL 1039027
[7] 965 A 2d 715, 2008 Del Ch. Lexis 134
[8] In IBP the court held that a drop of 64% in quarterly earnings did not constitute a material adverse effect as large quarterly decline in performance was primarily due to widely known circles in the meat industry, exacerbated by harsh winter that also affected the buyer. After the bad quarter and onset of spring, IBP began to perform more in line with its past year results.
In Frontier Oil, a litigation against the target (Frontier Oil) was not held to be a MAE as it did not sufficiently impact the results of the target (Frontier Oil) nor was it proved that the cost of defense would be so high that it could not be absorbed by the acquirer (Holly Corporation).
Similarly, in Hexion, not meeting forecast earnings and a downward trend in EBITDA of 19% for a similar quarter of the previous year was not held to be a good enough reason for MAE having occurred. The court noted that the target was usually down on a quarter over quarter basis in each of third and fourth quarters of a year. Further, comparing the trailing -twelve-months EBIDTA for second quarter 2007 to second quarter 2008, the 2008 quarter results was only down 6% from 2007.
[9] Supra at fn 2.
[10] 2013 (8) SCC 20
[11] Regulation 27 of the 1997 SAST Regulations provided that a public offer once made can be withdrawn due to the following reasons: (a) the statutory approvals required have been refused; (b) the sole acquirer being a natural person, has died; and (c) such circumstances as in the opinion of SEBI merits withdrawal.
[12] See, Nirma Industries at paragraph 40 “A conspectus of the aforesaid Regulations would show that the scheme of the Takeover Code is – (a) to ensure that the target company is aware of the substantial acquisition ; (b) to ensure that in the process of the substantial acquisition or takeover, the security market is not distorted or manipulated and (c) to ensure that the small investors are given an option to exit, that is, they are offered a choice to either offload their shares at a price as determined in accordance with the takeover code or to continue as shareholders under the new dispensation. In other words, the takeover code is meant to ensure fair and equal treatment of all shareholders in relation to substantial acquisition of shares and takeovers and that the process does not take place in a clandestine manner without protecting the interest of the shareholders. It is keeping in view the aforesaid aims and objects of the takeover code that we shall have to interpret Regulations 27(1).”
[13] 2014(11) SCC 112
[14] See, Akshya Infrastructure at paragraph 31 “We are also not impressed by the submission of Mr. Nariman that it has now become economically impossible to give effect to the public offer. This very submission has been rejected in Nirma Industries Ltd. (supra). We reiterate our opinion in Nirma Industries Ltd. (supra) that under Clause 27(1)(b)(c) and (d), a Public Offer, once made, can only be permitted to be withdrawn in circumstances which make it virtually impossible to perform the Public Offer. In fact, the very purpose for deleting Regulation 27(1)(a) was to remove any misapprehension that an offer once made can be withdrawn if it becomes economically not viable. We are of the considered opinion that the distinction sought to be made by Mr. Nariman between a voluntary public offer and a triggered public offer is wholly misconceived. Accepting such a submission would defeat the very purpose for which the Takeover Code has been enacted.”
[15] Regulation 23(1) of the 2011 SAST Regulations:
“23.(1) An open offer for acquiring shares once made shall not be withdrawn except under any of the following circumstances,—
(a) statutory approvals required for the open offer or for effecting the acquisitions attracting the obligation to make an open offer under these regulations having been finally refused, subject to such requirements for approval having been specifically disclosed in the detailed public statement and the letter of offer;
(b) the acquirer, being a natural person, has died;
(c) any condition stipulated in the agreement for acquisition attracting the obligation to make the open offer is not met for reasons outside the reasonable control of the acquirer, and such agreement is rescinded, subject to such conditions having been specifically disclosed in the detailed public statement and the letter of offer; or
Provided that an acquirer shall not withdraw an open offer pursuant to a public announcement made under clause (g) of sub-regulation (2) of regulation 13, even if the proposed acquisition through the preferential issue is not successful.
(d) such circumstances as in the opinion of the Board, merit withdrawal.
Explanation.— For the purposes of clause (d) of sub-regulation (1), the Board shall pass a reasoned order permitting withdrawal, and such order shall be hosted by the Board on its official website.”