Deal Breakers

Buyers are giving themselves more outs by expanding material adverse change clauses.

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 LLP of deals worth $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 a 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, a 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 Plano, 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 Inc.

“It is fair to say we had the upper hand,” says Rent-A-Center CFO Robert D. Davis. Rent-Way is still re-covering from a $60 million accounting fraud in 2000 (the CFO, controller, and a senior vice president all pleaded guilty to criminal charges in July). Although the Erie, 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 $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.

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