Failure of a 'basic assumption': the emerging standard for excuse under MAE provisions.

• Author: Somogie, Nathan
• Position: Material adverse effect

The onset of the current economic crisis has led many strategic and financial acquirers to reconsider the desirability of transactions to which they had previously agreed. Because many of these agreements contain substantial termination fees, buyers have increasingly sought to be excused from their contractual obligations by invoking Material Adverse Effect ("MAE") provisions. Reliance on MAE clauses as a basis for termination has historically been risky due to a lack of clarity in the case law regarding the standard for excuse under such provisions. A recent decision by the Delaware Chancery Court, Hexion v. Huntsman, the third in a series of prominent cases addressing the interpretation of MAE provisions, confirms that the standard is extremely high under Delaware law. However, because each of these cases found that no MAE had occurred, it remains unclear what circumstances, if any, will be sufficient to trigger judicial recognition of an MAE in Delaware. This Note suggests that the Delaware Chancery Court has applied a standard that analytically resembles the "basic assumption" test used to determine the existence of an excusing contingency under the doctrines of impracticability and frustration of purpose. This Note contends that such a standard is both unsurprising and desirable because the logical questions raised in disputes over MAE provisions closely parallel those addressed by default rules for excuse of performance. Given the broad language with which MAE clauses are typically drafted, this Note argues that courts should recognize that they are being asked to fill a gap in the merger agreement; as such, courts should apply the "basic assumption" test and follow the Delaware Chancery Court in setting a high standard for excuse under MAE provisions.

TABLE OF CONTENTS INTRODUCTION I. MAC PROVISIONS AND THE PROBLEM OF INTERPRETATION A. Structural Features of Typical MAC Provisions B. Difficulty in Interpreting "Materiality" in MAC Provisions C. Delaware Chancery Court's Approach to MAC Provisions 1. IBP, Inc. v. Tyson Foods, Inc 2. Frontier Oil Corp. v. Holly Corp 3. Hexion Specialty Chemicals, Inc. v. Huntsman Corp II. THE "BASIC ASSUMPTION" TEST A. Impracticability and Frustration of Purpose B. The "Basic Assumption" Test Should Apply to MAE Provisions Because Resolving Disputes Over Such Provisions Ultimately Involves "Gap Filling" C. Practical Aspects of Applying the "Basic Assumption" Test to MAE Provisions D. Objections to Applying the "Basic Assumption" Test to MAE Provisions III. THE EMERGING STANDARD FOR EXCUSE UNDER DELAWARE LAW CONCLUSION INTRODUCTION

Material Adverse Effect ("MAE") clauses, also known as Material Adverse Change ("MAC") clauses, (1) have become standard provisions in merger agreements. (2) These clauses operate in the interim period between the signing of an agreement and closing, and give one or both parties--usually the buyer--the right to terminate the contract upon the occurrence of certain events, such as a catastrophic change in the acquired company's financial condition. (3) The event must be "materially adverse" to trigger an MAE provision. What qualifies as "material" has been the subject of much debate. (4)

The meaning of these clauses has been litigated in several cases, but the case law is very fact specific, making outcomes difficult to predict. (5) The seminal case, IBP, Inc. v. Tyson Foods, Inc., (6) established an extremely high bar for excuse under MAE provisions, but did not provide a framework for determining what is "material" or which events qualify as adverse changes or effects. Because parties often do not define materiality or specify triggering events, (7) there is virtually always disagreement between the parties over whether obligations are excused. Thus, while courts and commentators seem to agree that the standard is very high, (8) no analytical framework has yet emerged to assist courts in determining when these clauses excuse performance and when their invocation by the party seeking to be excused itself constitutes a breach of the merger agreement.

The recent onset of an international economic crisis makes this a timely occasion for discussing the interpretation of MAE provisions. Inability to obtain financing on terms as advantageous as those available at signing, together with disappointing results in the target company's performance and unappealing market conditions generally, have prompted many buyers to look for ways to terminate their agreements--or to renegotiate for substantially reduced prices--without being held liable to the target company for damages. (9) MAE clauses have played a critical role in disputes over these failed merger agreements, representing a tantalizing opportunity for buyers, particularly private equity firms, to walk away from transactions that are no longer desirable. (10) Many of these disputes will be litigated, and courts will be faced with difficult interpretive questions in deciding whether the buyer should be excused from its contractual obligations without being required to pay damages.

One such dispute, involving a merger agreement between two large chemical companies, was the subject of a recent decision by the Delaware Chancery Court in Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (11) The decision confirms that the standard for excuse under MAE provisions in Delaware is extremely high, (12) but leaves open the question of what circumstances may be sufficient to support the finding of an MAE under Delaware law. To be sure, Huntsman is yet another unsympathetic tale of buyer's remorse, but it seems likely that other buyers seeking to have their contractual obligations discharged may present factually more compelling cases. (13) In such cases, Huntsman offers little additional guidance relative to the analysis provided in the landmark IBP decision.

But further guidance can be found elsewhere. This Note explores the parallels between MAE clauses and default rules for excuse under the familiar contract doctrines of impracticability and frustration of purpose. In many cases, courts have failed to recognize that they are being asked to resolve the same questions as those addressed by default rules governing excuse of performance. These default rules are eminently relevant to disagreements over the interpretation of MAE provisions in light of the broad and ambiguous language with which such clauses are typically drafted. The doctrines of impracticability and frustration, as articulated in the Second Restatement of Contracts (14) and the Uniform Commercial Code, (15) provide a flexible analytical framework for determining whether a promisor's contractual obligations are excused by the existence of some unknown condition or the occurrence of some unexpected event. The standard under the modern formulation of these doctrines, known as the "basic assumption" test, holds parties to their agreements absent the failure of a "basic assumption on which the contract was made." (16) The "basic assumption" test synthesizes centuries of case law struggling with the concept of excuse, (17) and offers courts a powerful and preferable alternative to praying for the "wisdom of Solomon." (18)

This Note argues that courts should apply the "basic assumption" test in resolving disputes over MAE provisions because the logical questions raised in interpreting such provisions closely resemble those addressed by default rules governing excuse of performance. As currently drafted, most MAE provisions are effectively superfluous because they are not specific enough to override the default rules. Because the typical MAE provision fails to adequately state the parties' intentions regarding the allocation of risk in the interim period between signing and closing, courts should recognize that--in a large majority of cases--they are being asked to fill a gap in the parties' agreement rather than enforce an existing term of that agreement. The sensibility of applying the "basic assumption" test to resolve disputes over MAE provisions is supported by the decisions of the Delaware Chancery Court, which are consistent with outcomes we would expect under the default rules.

Part I provides a brief overview of MAE provisions and describes the difficulties courts have encountered in resolving disputes over such provisions, focusing on three prominent decisions by the Delaware Chancery Court. Part II lays out the "basic assumption" test under the doctrines of impracticability and frustration of purpose, and argues that this standard should be used to determine whether the buyer's obligation to close is discharged under an MAE provision. Part III returns to the decisions of the Delaware Chancery Court and explores how the court has allocated the risk of adverse changes between the parties, concluding that the refusal to excuse the buyer's obligation to close in each case is consistent with an application of the "basic assumption" test.

1. MAE PROVISIONS AND THE PROBLEM OF INTERPRETATION

   This Part provides an overview of MAE provisions and discusses the interpretive difficulties these clauses present. Section I.A briefly outlines the structural features of the typical MAE provision, focusing on the elements of the provision that tend to be the most heavily negotiated. Section I.B lays out the problems faced by courts in interpreting MAE provisions, and highlights the lack of consensus regarding the standard for "materiality." Section I.C illustrates the prevailing judicial approach to MAE provisions by discussing three prominent cases decided by the Delaware Chancery Court.

   1. Structural Features of Typical MAE Provisions

      A Material Adverse Effect ("MAE") provision is a contractual mechanism by which the parties to a merger agreement allocate "interim risk"--the risk of undesirable conditions or events during the interim period between signing and closing. (19) "Material Adverse Effect" is usually a defined term that is used...