DEAL BREAKERS
Buyers are giving themselves more outs by expanding material adverse change clauses
By Tim Reason

Mergers and acquisitions may be coming back in style, but contracts signed in the past 12 months suggest it is very much a buyer's market. Among the common features of M&A contracts is a material adverse change (MAC) clause, which gives the buyer the right to pull out of the deal or renegotiate the terms if there's a major change in buyer or seller fortunes before the deal closes. These days, MACs are, well, big.

A recent survey by New York-based law firm Nixon Peabody of deals worth US$10 million or more shows that broader and more-subjective MAC clauses are finding their way into contracts. Meanwhile, exceptions to MAC clauses, which usually benefit the seller, are shrinking.

Nixon Peabody's Richard Langan says that 19 percent of deals between July 2002 and July 2003 defined an adverse change in the target company's "prospects" as a type of MAC. That's almost a fivefold increase for the same period the prior year. There's nothing particularly new about the prospects' language - Langan says such clauses were in use when he started practicing law 23 years ago. But in the seller's market of recent years, buyers typically didn't include such broad language, for fear that it might cause sellers to balk. It also seemed safe to assume that a dramatic change in a company's prospects would, in fact, be an MAC. "A lot of lawyers felt comfortable that courts would probably implicitly include 'prospects' in the MAC," says Langan, "particularly when the basis for the pricing of the transaction was forecast results."

That comfort level has clearly declined. "Buyers are wary," notes Patrick G. Quick, a partner at the Milwaukee office of Foley & Lardner, and the end of the boom means they are even less likely to consider past financial results. "The CFO is buying a business based on how he or she thinks it will perform in the future," says Quick. "Sellers are reluctant to make promises - if they felt confident about the future, they'd keep the business. So there's a tension there."

Adding to that tension, notes Langan, is the loss of pooling treatment for mergers, which puts a buyer at risk of significant impairment charges if the target company's prospects take a turn for the worse.

Of course, Quick adds, an MAC clause covers only the period between signing and closing the deal. Unless a buyer also requires earnouts or some other post-close guarantees, he says, "there is still no recourse after closing based on prospects." Nonetheless, buyers like the protection, and in today's M&A market, they're usually in a position to demand it. "

Caveat Emptor

Rent-A-Center, a Texas-based rent-to-own business, included an extensive MAC clause - complete with prospects language and with no significant exceptions - in its agreement to buy 295 underperforming stores late last year from competitor Rent-Way.

"It is fair to say we had the upper hand," says Rent-A-Center CFO Robert D Davis. Rent-Way is still recovering from a US$60 million accounting fraud in 2000 (the CFO, controller, and a senior vice president all pleaded guilty to criminal charges in July). Although the Pennsylvania-based appliance-rental firm is second in size only to Rent-A-Center, it had little liquidity available for reinvestment or expansion and needed the US$100.4 million sale to pay down debt. "At the end of the day, they were more desperate for capital than we were to purchase stores," says Davis.

But that advantage was a double-edged sword. Davis wanted to make sure that buying almost a third of his competitor's 1,000 stores wouldn't drive Rent-Way out of business, a concern partially reflected in the extensive MAC clause. "We didn't want to cause Rent-Way to become insolvent and have its creditors come after us," he recalls. For additional protection, Davis demanded independent opinions to confirm Rent-Way's solvency and attest that the deal was fair.

The MAC clause also reflected Davis's concern about the time it would take to close the deal, the size of which triggered the regulatory provisions of the Hart-Scott-Rodino Act and required approval from the Federal Trade Commission. That meant about a three-month wait in a business where the average appliance-rental contract lasts four to six months. As a result, the contract included a number of performance clauses backed up by the MAC clause. "We wanted to make sure the stores maintained an acceptable level of performance in terms of the number of contracts on rent," says Davis. In addition, Rent-A-Center negotiated 90-day and 18-month holdbacks totaling US$10 million. The company has since paid the first US$5 million. "They did a good job holding up their end of the bargain," says Davis.

Know Your Prenup

As Rent-A-Center's experience demonstrates, lawyers may draw up the beginning boilerplate, but finance concerns ultimately determine the shape of an MAC clause. "As the battle lines are drawn during negotiations, CFOs step in and define what the appropriate MAC definition should be, with the advice of counsel," explains Langan.

When it comes to friendly mergers, that's not an enviable role. MAC clauses are somewhat like prenuptial agreements: they offer financial protection, but can put a damper on the romance. "This is a subject people don't like to talk about," explains Foley & Lardner's Quick, who says the task often falls to the CFO. "The CEO is more the vision guy," he says. "The CFO obviously has to be led by the CEO's vision, but also has to deal with the numbers and rationale that he presented to the board and the banks."

At the same time, MACs are one of the fuzzier areas of contract law, and no substitute for financial due diligence. It is rare, for example, for an MAC to actually be used as a deal breaker. Perhaps the most infamous exception was in November 2001, when Dynegy backed out of buying a clearly imploding Enron. For deal makers, however, the more instructive example came earlier that year, when chicken distributor Tyson Foods tried to pull out of a deal to acquire beef-and-pork distributor IBP, only to be forced to proceed by the Delaware Chancery Court. The court ruled that Tyson was suffering from "buyer's remorse", and that it either knew about or had implicitly accepted the risk of IBP's financial and regulatory difficulties that Tyson later cited as MACs.

Indeed, an MAC clause is the epitome of a legal catch-22: load it up with specifics, and a judge is likely to rule that anything not specified doesn't count. "You can lose the forest for the trees," comments Langan.

However, if the MAC clause casts too wide a net, it can be triggered by some unforeseen event that management doesn't even consider a deal breaker. That's a potential problem, says Langan, because "if the board decides to waive the MAC, there can be some question as to the propriety of the board's exercise of fiduciary duty."

Big MAC or Little MAC?

When MAC clauses actually are invoked, the result is almost always a renegotiation of the deal price. "You don't want to pull out of a deal - that's such a hassle," says Tony Vasconcellos, senior vice president and CFO of Regent Communications in Kentucky. "If you want to fight somebody on an MAC in court, it's going to drag out for a long time and legal fees will kill you. Both sides are better off negotiating."

Vasconcellos has plenty of experience drafting (and occasionally invoking) MAC clauses from both sides of the bargaining table - Regent owns 76 radio stations, all purchased during a series of multistation acquisitions and divestitures in the past five years. "There isn't a seller out there who's excited about giving you that [MAC] language," he says. Still, Vasconcellos considers drafting an MAC clause to be a fairly straightforward risk-assessment exercise. "You craft an MAC that will protect you against [key] risks - and then some - so you have something to negotiate with."

In an industry where Federal Communications Commission approval of an acquisition can take up to six months or more, an MAC clause can be "absolutely critical," says Vasconcellos. "There are instances where we insist on very strong language." As part of any deal, Regent typically insists that the target company continue to spend its planned budget - promoting the radio station, conducting music research, and paying its talent. That provides a fairly strong guarantee that performance won't slide before the deal closes, he says. "Then, if they're spending their budget, we consider what the risks are beyond that [that should be included in an MAC clause]."

In some cases, Regent has been able to take advantage of a unique feature of the broadcast industry known as a local marketing agreement (LMA), which allows the acquirer to take control of day-to-day operations while waiting for the deal to close. "In those situations," says Vasconcellos, "the buyer is at least partly responsible for any deterioration in operations."

Regent began running Brill Media less than three weeks after signing a US$62 million acquisition contract in August 2002. Although the contract included a detailed MAC clause, complete with the prospects phrase, Vasconcellos says the language wasn't as strong as it would have been without an LMA. "It was nice to have [the MAC clause], but we were protected in the sense that we were taking over the operations."

Indeed, MAC clauses are just part of a larger array of protections. Vasconcellos always insists on one- or two-year holdbacks totaling 6 to 10 percent of the purchase price. Ultimately, he says, MAC clauses may be worth more as indications of good faith than as legal safeguards. "If sellers were really concerned about tripping the MAC, they wouldn't let you put it in the contract," he says. "So it's almost an additional level of due diligence if the seller is willing to agree to the MAC."

Tim Reason is a senior writer at CFO. CFO, CFO Asia's sister publication.