You are general counsel to a large healthcare products company that has agreed to acquire a medical devices company in a public merger for $25 billion in cash and stock. The business rationale for the acquisition is your company's desire to enter the market for heart rhythm devices - implanted defibrillators and pacemakers - a market segment in which the target is one of three leading producers. The merger agreement contains a clause allowing your company to terminate the agreement and not proceed with the acquisition if developments arise after the date of the agreement, but before the effective time of the merger, that would result in a "material adverse effect" ("MAE") on the target's business.
Your CEO informs you of the following recent developments regarding the target company: (i) some of the target's devices have failed to work as intended, and in some cases have even short-circuited after implantation, resulting in several deaths; (ii) approximately 100,000 of the devices have been the subject of safety notices or recalls; (iii) the Food and Drug Administration, Justice Department and Securities and Exchange Commission have each commenced investigations of the target; (iv) New York Attorney General Eliot Spitzer has commenced a lawsuit against the target, alleging fraud, and attorneys general in three other states, on behalf of their own states and more than thirty others, have commenced an investigation; and (v) more than 100 private civil actions have been commenced against the target. The target's stock price has dropped significantly. As news of these developments is prominently covered by the press, an M&A lawyer not involved in the deal is quoted as saying, "If there was ever a real-world example of a material adverse event, this may be it." Your CEO asks if the MAE clause can be invoked to excuse performance of the merger. What do you advise your CEO?
While some may agree with the foregoing lawyer's assessment of the real-life situation of Johnson & Johnson's proposed acquisition of Guidant described above, we will never know how a court would have ruled. Although Johnson & Johnson took the position that it was excused from performance by the MAE clause in its merger agreement, and Guidant brought suit in the Southern District of New York rejecting that view and seeking specific performance, the parties settled by reducing the price by $4 billion, or approximately 15% (subject to stockholder approval of the revised deal).
We do, however, have some recent guidance from the Delaware Chancery Court in the Frontier case, decided after trial in a memorandum decision earlier this year.1 This follows the Chancery Court's IBP decision, deciding similar issues in 2001.2 If, on the above facts, you would have told your CEO that your company could confidently deliver an MAE notice to the target, these Chancery Court decisions might give you pause.
In Frontier, petroleum refiners Frontier Oil Corporation and Holly Corporation negotiated a merger agreement pursuant to which Holly shareholders would receive cash and Frontier stock, with the result that Holly shareholders would own approximately 37% of post-merger Frontier. As the negotiations were proceeding, and before execution of the agreement, Holly learned that Erin Brockovich and her law firm were preparing to bring a toxic tort case against Beverly Hills High School, the Beverly Hills municipality and three oil companies, including a subsidiary of Frontier. The thrust of the claim was that oil drilling activities conducted over many years on the premises of the high school had resulted in significant health effects among the student population. The current drilling activities were conducted by a company that had acquired its rights from the Frontier subsidiary, a former operator on the site. Frontier argued that, for several reasons, this should not be of great concern to Holly. Principal among these reasons was the corporate veil, which, Frontier stressed, should confine liability to the subsidiary, and not result in liability for the parent company, i.e., Frontier. Holly continued to be concerned, and with Frontier pushing for a speedy resolution of the issue, the merger agreement's "litigation and liabilities" representation and "Material Adverse Effect" definition were modified as follows (additions are italicized; deletion is struck through):
Except as set forth on Schedule 4.8 of the Frontier Disclosure Letter, there are no actions, suits or proceedings pending against Frontier or any of its Subsidiaries or, to Frontier's knowledge, threatened against Frontier or any of its Subsidiaries, ... other than those that would not have or reasonably be expected to have, individually or in the aggregate, a ... Material Adverse Effect.
"Material Adverse Effect" with respect to Holly or Frontier shall mean a material adverse effect with respect to (A) the business, assets and liabilities (taken together), results of operations, material condition ( financial or otherwise) or prospects of a party and its Subsidiaries on a consolidated basis ....3
The "Schedule 4.8" added by the modification stated that the Beverly Hills potential litigation was agreed to be "threatened litigation" within the meaning of the rep, and that Holly's knowledge of it was not to be the basis of excluding it from the protections of the rep, should they be deemed otherwise to apply in accordance with the rep's terms. With the foregoing modifications, the merger agreement was signed.
Two developments followed: the Beverly Hills litigation was commenced, and Frontier was named as a defendant, on the basis of contractual indemnities that Frontier had earlier provided to its subsidiary, a fact not known at the time the merger agreement was signed. Thus, Frontier and Holly could no longer take any comfort in the pre-signing notion of "corporate separateness." Much negotiation followed in an attempt to keep the merger alive, but in the end the parties could not reach agreement. In the resulting litigation, the Chancery Court was asked to decide whether Frontier had breached its representation that the Beverly Hills litigation "would not have or reasonably be expected to have" an MAE so as to excuse Holly's performance of the merger on the grounds that the "true and correct at closing" condition had not been satisfied.4
In reaching its decision, the court emphasized the fact-specific nature of an MAE analysis, saying, "The notion of an MAE is imprecise and varies both with the context of the transaction and its parties and the words chosen by the parties."5 It then went on to cite the rule enunciated in the IBP decision:6
[A] buyer ought to have to make a strong showing to invoke a Material Adverse Effect exception to its obligation to close. Merger contracts are heavily negotiated and cover a large number of specific risks explicitly. As a result, even where a Material Adverse Effect condition is as broadly written as the one in the Merger Agreement, that provision is best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror.7
Next, the court ruled that the burden of proof rests on the party seeking to rely on the MAE to prove both that the event (here, the litigation) exists, and that it would have an MAE.8 In doing so, the court rejected Holly's argument that the burden was on Frontier to show that the Beverly Hills litigation would not reasonably be expected to have an MAE. The court also rejected Frontier's view that litigation can never constitute an MAE because by its nature litigation results are "inherently speculative."9 Having enunciated these principles, the court then applied them to the facts at bar.
The court recognized that the litigation posed serious risks in terms of defense costs and that these would be "substantial."10 It also recognized that the Beverly Hills litigation "could be catastrophic," with judgments of "hundreds of millions of dollars."11 However, the court concluded that these substantial defense costs could be borne by Frontier. As to the potentially "catastrophic" damages award, the court concluded that "Holly has not met its burden of proving by a preponderance of the evidence that the Beverly Hills Litigation, because of the risk of adverse results, because of the costs of defense, or because of both considerations taken together, does have, would have, or would reasonably be expected to have a[n] ... MAE."12 The court ruled this way even though it recognized that to address this concern, Holly would need to put itself in the position of substantiating plaintiff's claim, and in so doing would assist plaintiff and provide arguments for other plaintiffs against defendants in the petroleum business generally.13 Having concluded that Holly had failed to meet its burden by a preponderance of the evidence, the court rejected Holly's MAE claim.14
The lessons for the practitioner would seem to be clear: the burden of showing an MAE is substantial and highly fact-dependent. The MAE, in the case of a strategic buyer in particular, must be shown to be "durationally-significant."
In view of this, an effort should be made in drafting to reduce the burden. Fundamentally, drafting should attempt to address specific known concerns, rather than seeking to rely on a general MAE clause as attempted in Frontier. The court might have placed less of a burden on Holly had the Beverly Hills litigation arisen as an issue after the merger agreement had been signed. With the issue arising before the agreement was signed, it could have been addressed with greater specificity. The threatened litigation could have been addressed by allowing an out, or perhaps a mandatory price adjustment, in the event of certain specified, objective occurrences with respect to the threatened litigation - for example, if the threatened litigation became an actual one, or if Frontier, rather than its subsidiary alone, were to be named in the suit. Also, perhaps the result would have been different if the merger agreement had stated that there would be an MAE if the litigation had been commenced and "assuming it were to be decided adversely, would result in a Material Adverse Effect." While this suffers somewhat from the problem (noted in footnote 3) of defining a "Material Adverse Effect" by reference to a "material adverse effect," it would remove from the party seeking to invoke the MAE the burden, suffered by Holly, of being required to prove the likelihood that the litigation would be decided adversely. More generally, since the Frontier court noted that "could" presents a lower (although not easily quantified) burden than "would," acquirors should push for that formulation.15
In the end, it will likely be difficult to predict with confidence a favorable result when seeking to invoke an MAE in court. The courts might well favor a certain degree of uncertainty; it would serve a policy of encouraging the parties to renegotiate their price, with the ultimate decision being made by the stockholders, who must vote to approve the deal.
In view of the foregoing, my advice to your CEO would be, notwithstanding all these adverse effects, they may very well not constitute an MAE for purposes of excusing performance under the merger agreement. The most recent developments in the Johnson & Johnson/Guidant story might support this view, based on the way a purchaser with a "long-term strategy," in the words of the IBP court, might see the developments: on December 5, Boston Scientific offered to acquire Guidant for the original Johnson & Johnson price of $25 billion.
1 Frontier Oil v. Holly, No. 20502, 2005 WL 1039027 (Del. Ch. April 29, 2005).
2 In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001).
3 Frontier at 4. No doubt echoing the thoughts of many M&A practitioners, the court noted, "It would be neither original nor perceptive to observe that defining a 'Material Adverse Effect' as a 'material adverse effect' is not especially helpful." Frontier at 33.
4 The court noted that the issue at bar might have been decided differently had the parties chosen, instead of an MAE standard with regard to litigation, a materiality standard. These dicta would stand for the proposition that litigation could be "material," even if it did not rise to a higher level by creating an MAE. The court explained, "In the context of the merger agreement, the concept of 'Material Adverse Effect' and 'material' are analytically distinct, even though their application may be influenced by the same factors ... . A fact is generally thought to be 'material' if it is 'a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.'" Frontier at 38, citing: TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449; 96 S. Ct. 2126; 48 L. Ed. 2d 757 (1976).
5 Frontier at 34. The importance of the nature of the parties in an MAE analysis is well articulated in the IBP decision: "To a short-term speculator the failure of a company to meet analysts' projected earnings for a quarter could be highly material. Such a failure is less important to an acquiror who seeks to purchase the company as part of a long-term strategy." IBP at 67.
6 The IBP court was applying New York law, but the Frontier court "[saw] no reason why the law of Delaware should prescribe a different perspective." Frontier at 34.
7 Frontier at 34; citing IBP at 68.
8 Frontier at 34.
9 Frontier at 35.
10 Frontier at 35.
11 Frontier at 36.
12 Frontier at 37.
13 Frontier at 35, note 221.
14 Frontier at 37.
15 Frontier at 33, note 209.
Sandy K. Feldman is a member of the Corporate Department at Torys LLP in New York, representing clients in mergers and acquisitions, joint ventures and other business relationships and related financings. For further information about Torys LLP, please see www.torys.com.