In any large corporate acquisition, there is an interim period between the time that the parties enter into a merger agreement and the time the transaction is effected and the purchase price paid. During this period, the business of the acquired company may deteriorate, thus raising the question of whether the counterparty must perform on the agreement and pay the purchase price. Merger agreements typically address this problem through "material adverse change" (MAC) clauses, which provide that a party may walk away from the transaction without penalty if the counterparty has suffered a MAC. Although the definition of MAC is usually very complex and intensely negotiated, when a company's business has deteriorated between the signing and closing of a deal, the parties will often disagree about whether the impairment amounts to a MAC within the meaning of the agreement. MAC clauses have thus given rise to more litigation than any other provision of merger agreements, and the amounts in controversy in such cases have often been spectacular. With the fate of transactions worth tens of billions of dollars turning on the proper interpretation of MAC clauses, the economic functioning of MAC clauses is therefore crucially important to the market for corporate control.
MAC clauses usually identify various kinds of risks to the company's business that may arise during the interim period and assign some of those risks to one party and some to the other. The economic theory of contract law suggests that such allocations will be efficient; for example, that risks will be assigned to cheaper cost avoiders or superior risk bearers. In order to investigate the efficient allocation of risk under MAC clauses, this Article reports the results of an empirical study of MAC clauses in 353 transactions involving public companies in the United States announced between July 1, 2007, and June 30, 2008, classifying such transactions by the form of consideration paid (i.e., cash, stock, or a mix of both).
On the basis of this study, this Article identifies four kinds of risks typically allocated in MAC clauses: (a) systematic risks, such as broad economic or market factors affecting firms generally; (b) indicator risks, which are risks that the company in question will not meet predetermined measures of its financial performance, such as internal projections or estimates by industry analysts; (c) agreement risks, such as attrition of employees or loss of customers arising from the announcement of the agreement; and (d) business risks, the kinds of risks that arise in the ordinary course of the company's operations, such as large environment liabilities for a petroleum company. The study shows that in both cash mergers, and stock-for-stock and cash-and-stock transactions, although business risks are allocated to the party itself, systematic risks and agreement risks are generally allocated to the contractual counterparty. Although indicator risks more often than not stay with the party itself, they are shifted to the counterparty in a significant minority of agreements.
The allocation of business risks to the party itself is readily explicable in terms of the party being either the cheaper cost avoider or superior risk bearer of such risks. The efficient allocation of systematic risks to counterparties, however, turns out to be very difficult to explain. In particular, in both stock-for-stock and cash-and-stock mergers, MAC clauses usually contain reciprocal provisions that shift systematic risks between the parties so that, during the interim period, parties often bear each other's systematic risks. Neither party can plausibly be thought to be the cheaper cost avoider or superior risk bearer with respect to such risks of the other party, especially when the risks of very large acquirers are shifted to relatively small targets. This risk-swapping phenomenon thus requires another explanation.
The solution lies in realizing that, when MAC clauses allocate systematic risks to the counterparty, the party is relieved not only of the systematic risk itself but also of an additional but related risk: namely, the risk that the counterparty will declare (either honestly or opportunistically) that the party has been MAC'd by the materialization of the risk. This additional risk is significant because it is much worse for a party to be declared MAC'd by its counterparty on the basis of a materializing risk than just to suffer the materialization of that risk. A public dispute about whether the company has been MAC'd exacerbates the disruption of its business that the pending transaction has already caused; imperils its relations with employees, customers, creditors, and others with whom it does business; publicly releases negative information about the company that otherwise would have remained confidential; exposes the company to disparagement by the counterparty; and, if the dispute is litigated, can even lead to a public certification by a court that the company is, in effect, damaged goods. All of these additional risks can be completely eliminated by shifting the underlying systematic risk to the counterparty. With the counterparty bearing the risk, it has no incentive to declare a MAC based on the materialization of the risk. The allocation of such risks in typical MAC clauses is thus efficient, not because the risks being shifted in such clauses can be borne more efficiently by the parties to whom they are shifted, but because, in the act of shifting them, different but related risks arising from the acquisition process itself are being eliminated. The shifting of agreement and indicator risks, though not entirely parallel, can be explained in related ways.
TABLE OF CONTENTS INTRODUCTION I. FEATURES OF THE CORPORATE AND REGULATORY ENVIRONMENTS THAT AFFECT THE ALLOCATION OF DEAL RISK A. The Creation of Deal Risk: Non-Simultaneous Signing and Closing 1. Corporate and Securities Laws 2. Antitrust and Regulatory Regimes 3. Third-Party Consents B. Shareholder Votes as Mechanisms To Limit Deal Risk 1. Which Parties Vote 2. Interaction of Shareholder Votes and Regulatory Approvals C. The Effect of Revlon and Omnicare II. BUSINESS COMBINATION AGREEMENTS AND THE ALLOCATION OF DEAL RISK A. Interim Covenants and Moral Hazard B. MAC Representations and MAC Closing Conditions C. MAC Definitions in Public Company Merger Agreements III. THE EFFICIENCY OF MAC CONDITIONS A. Prior Theories of MAC Clauses 1. The Symmetry Theory 2. Gilson and Schwartz's Investment Theory a. The Investment Theory: Endogenous Risks b. The Investment Theory: Exogenous Risks B. The Efficient Allocation of Risk in MAC Conditions 1. Systematic Risks 2. Indicator Risks 3. Agreement Risks 4. Business Risks IV. DATA AND ANALYSIS ON MAC DEFINITIONS IN 353 RECENT AGREEMENTS V. CONCLUDING OBSERVATIONS TABLE 1. FREQUENCY OF MAC OBJECTS AND MAC EXCEPTIONS (WITH DISPROPORTIONALITY EXCLUSIONS) BY DEAL TYPE TABLE 2. COMPARISON OF MAC DEFINITIONS IN STOCK-FOR-STOCK AND CASH-AND-STOCK DEALS WITH MAC DEFINITIONS APPLICABLE TO TARGETS AND ACQUIRERS TABLE 3. COMPARISON OF MAC DEFINITIONS IN ALL STOCK-FOR-STOCK AND CASH-AND-STOCK DEALS TABLE 4. RELATION OF MAC EXCEPTIONS IN MAC DEFINITIONS IN STOCK-FOR-STOCK AND CASH-AND-STOCK DEALS: MAC EXCEPTIONS FOR TARGETS (VERTICAL) BY MAC EXCEPTIONS FOR ACQUIRER (HORIZONTAL) TABLE 5. RELATION OF MAC EXCEPTIONS IN MAC DEFINITIONS IN STOCK-FOR-STOCK AND CASH-AND-STOCK DEALS: MAC EXCEPTIONS FOR ACQUIRERS (VERTICAL) BY MAC EXCEPTIONS FOR TARGETS (HORIZONTAL) INTRODUCTION
In the acquisition of any large business, various corporate and regulatory reasons require that there be an interim period between the date on which the parties enter into a merger agreement (the signing) and the date on which the purchase price is paid and the ownership of the business is transferred (the closing). (1) Between signing and closing, the business or financial condition of the company being acquired may deteriorate. Merger agreements typically address this problem through complex and highly-negotiated "material adverse change" or "MAC" clauses, (2) which provide that, if a party has suffered a MAC within the meaning of the agreement, the counterparty can costlessly cancel the deal. Parties to merger agreements have often disagreed about whether one of them has suffered a MAC, and so MAC clauses have resulted in litigation in which tremendous sums of money, sometimes tens of billions of dollars, are at stake. (3)
Now, it is fundamental in the economic analysis of contract law that parties use contracts to shift risks to parties who can bear them most efficiently. (4) Hence, economic theory suggests that MAC clauses will distinguish various kinds of risk that can materialize between the signing and closing of a merger agreement--what mergers-and-acquisitions lawyers call deal risk--and assign each kind of deal risk to the contracting party that can bear it most efficiently, (5) that is, the cheaper cost avoider or the superior risk bearer for such risk. (8) The purpose of this Article is to describe the allocations of deal risk typically made in MAC clauses (7) in merger agreements involving public companies and to explain why such allocations are in fact efficient. To that end, the Article reports the results of a study of MAC clauses in 353 business combination agreements publicly filed in the EDGAR system of the Securities and Exchange Commission (SEC) between July 1, 2007, and June 30, 2008, classifying such agreements by the form of consideration paid (i.e., as cash deals, stock-for-stock deals, or cash-and-stock deals). (8)
I begin in Part I by describing the relevant features of the corporate and regulatory environments that affect the creation, mitigation, and allocation of deal risk. These features, which are beyond the control of particular companies entering into a merger agreement, define the bargaining space in which parties negotiate over the...