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Most agreements for the acquisition of a business condition the buyer’s obligation to complete the transaction on the absence of a material adverse change, or “MAC,” affecting the target company, either directly, through an express condition, or indirectly, through a “bring-down” of a representation and warranty as to the absence of a MAC (ie., a condition that the representation and warranty be true and correct at the closing date as if then made). The definitions of MAC vary; a buyer may seek to define it as: Any material adverse change in the business, operations, properties, prospects, assets or condition (financial or other) of the Company, or any event or circumstance that may result in such a material adverse change. Public company acquisition agreements may also use the concept of material adverse change to qualify some of the target’s representations and warranties (e.g., “the consummation of the Merger will not result in a breach or default of any contract to which the target is party, except for breaches or defaults that could not reasonably be expected to result in a material adverse change”) or to qualify the bring-down condition as to all representations and warranties (e.g., “the representations and warranties of the target set forth in this agreement shall be accurate in all respects as of the closing date as if made on the closing date; provided, however, that for purposes of determining the accuracy of the representations and warranties of the target set forth in this agreement, any inaccuracy that does not result in a Material Adverse Change shall be disregarded”). Despite the pervasive use of material adverse change provisions in acquisition agreements, their impact can be far from predictable, and a buyer’s decision to invoke a condition based on the claimed existence of a MAC may lead to litigation, as was the case with Verizon’s recent termination of its agreement to acquire NorthPoint Communications, Inc. The outcome of the resulting litigation will turn in large part on whether Verizon’s repudiation was permitted by their merger agreement’s MAC provision. In the current volatile economic climate, material adverse change provisions may be invoked more frequently, so that claims such as the NorthPoint litigation may not be uncommon in the next few years. SEARCHING FOR GUIDANCE Searching for guidance in case law on how to draft the optimal material adverse change provision and avoid litigation can be unsettling. Court decisions in this area are very fact- and language-specific, sometimes counterintuitive, making court rulings concerning any given MAC clause difficult to predict. The overriding message from an examination of the case law is that parties should not assume that a broad MAC provision will cover the full range of possible changes to a business that would render an acquisition unpalatable, because this broad stroke approach is not the outlook that most courts adopt in construing the clauses. General material adverse change language seems to leave more room for varied judicial approaches, leading to surprising outcomes in some cases. An event that is undeniably and significantly detrimental to a business will not necessarily trigger the “out” provided by a standard material adverse change provision. In Borders v. KRLB, Inc., [FOOTNOTE 1]the buyer had entered into an agreement to purchase a radio station. At the time the agreement was executed, the radio station had an Arbitron rating of 9.8. Arbitron ratings indicate the share of the listening market held by a radio station and are integral in determining the advertising rates that the station can charge. Shortly after the signing of the agreement, new Arbitron results were released, and the station’s Arbitron rating fell to 4.2. In other words, it had lost more than half its audience. The Court of Appeals of Texas concluded that the dramatic decline in the station’s Arbitron rating was not an event contemplated by the material adverse change provision in the agreement, which stated: Since November 3, 1983, there have not been any material adverse changes in the business, operations, properties and other assets of KRLB which would impair the operation of radio station KRLB-FM and KRLB-AM and since such date the business of KRLB has been conducted in the usual, regular and ordinary manner and shall continue, through and including the Closing Date, to be conducted in such manner, unless prior written approval for any variation there from shall have first been secured from Borders. Since said date, KRLB has not, except as indicated on Schedule 7 attached hereto and incorporated herein by this reference, directly or indirectly: . . . [the paragraph then went on to list various actions such as making loans to officers, directors, shareholders or employees exceeding a specified amount in the aggregate, subjecting the assets to any liens, etc.]. The Court of Appeals of Texas construed this language to be: designed to prohibit KRLB management from raiding the corporation or seriously damaging its ability to function as a business entity, by incurring debt, selling assets, or taking money, i.e., impairing its operation. The paragraph contemplates deliberate adverse action by management. We cannot reasonably construe the paragraph to include an event over which management has little control. The Court’s analysis highlights the lack of predictability concerning the judicial construction of material adverse change provisions. Another court might have read the first sentence of the clause in Borders to encompass changes in the business of the radio station, whether or not caused by actions of management, especially since management is not even mentioned in the sentence that refers to material adverse changes. Under this reading, “material adverse changes in the business � of KRLB” could readily include a dramatic drop in ratings. A third court adopting the latter approach might still have concluded that the MAC clause was not triggered by the decline in ratings because the clause refers to “material adverse changes in the business � of KRLB which would impair the operation of radio station KRLB-FM and KRLB-AM �.” A disastrous drop in ratings might not technically “impair the operation” of a radio station. In reaching its decision that the radio station’s loss of over half its audience did not legitimate the buyer’s refusal to close the transaction, the Borderscourt emphasized that the agreement made no mention of Arbitron ratings and contained no representation that the radio station would maintain its audience share between the time of signing and closing. In Pine State Creamery Co. v. Land-O-Sun Dairies, Inc., [FOOTNOTE 2]the MAC clause stated that since “September 30, 1995, there shall not have occurred any material adverse change in the Business.” The U.S. District Court for the Eastern District of North Carolina stated that “this provision does not include within its scope the operating profits or losses of Pine State.” Again, one might have expected this clause to lend itself to a broader interpretation that would include operating losses as a material adverse change to a business. Esplanade Oil & Gas, Inc. v. Templeton Energy Income Corp. [FOOTNOTE 3]is another example of a case involving an event with significant economic impact on the value of an acquisition that was found not to trigger the material adverse change provision. Esplanade involved a letter agreement for the purchase of certain oil and gas properties. The letter agreement contained a condition precedent to closing that stated that “there shall occur no adverse material change to the Properties or Esplanade’s interest therein from the date of this letter to the Closing.” Within the same month that the letter agreement was signed, the price of oil on the spot market dropped from approximately $28.85 to $20.35 per barrel. The lower court had acknowledged that the MAC clause in the agreement was ambiguous, and held that it reasonably encompassed “a dramatic decline in the price of oil.” The 5th U.S. Circuit Court of Appeals reversed, pointing to the definition of “Properties” in the agreement, which was defined as: All of Seller’s right, title and interest in various oil and gas properties listed in Exhibit “A” including, but not limited to, Seller’s working interest and net revenue interest in the respective properties stated in Exhibit “A”, together with an identical right, title and interest in and to all leasehold estates, contracts, contract rights, materials, production facilities, salt water disposal systems, pipelines, gathering lines and other fixtures, equipment and personal or real property, easements, rights-of-way, and any and all other rights and privileges of Seller associated with the use, ownership and operation thereof . . . Based on this definition of Properties, the panel found that the “plain meaning” of the material adverse change provision in the agreement was “that no adverse material changes were to occur to Esplanade’s right, title and interest in the mineral leases and equipment listed in the letter agreement” — a significant decline in the value of the Properties was not covered. ENTIRE AGREEMENT RELEVANT Because courts do not construe material adverse change provisions in complete isolation from other language in an agreement, the drafting of a MAC clause should be approached with an awareness of how both inclusions in and omissions from other provisions in an agreement may influence the interpretation of the MAC clause. In Northern Heel Corp. v. Compo Industries, Inc., [FOOTNOTE 4]the purchase agreement included provisions stating that “there has been no change which materially and adversely affects [Northern Heel's] business, . . . financial condition or prospects” and that before closing, Northern Heel’s business and prospects “shall not have been materially adversely affected.” One of the issues raised by the buyer was that the daily production levels of the business had declined. Although the facts in the case did not support the buyer’s contention, the dicta of the 1st U.S. Circuit Court of Appeals suggested that even if the facts had shown that there were significant changes in daily production levels, the panel might not have changed its ruling that the buyer had not established a claim for misrepresentation, because the agreement did not contain any references to daily production levels: “Had the parties deemed average daily production important (‘material’ to the deal), surely an appropriate reference would have been included.” This suggests that the absence of a representation in an agreement may indicate to a court that the subject matter was not important enough to the parties for it to be encompassed by a general material adverse change provision. However, the inclusion of a representation concerning a particular topic may also be interpreted as limiting the scope of a material adverse change provision. In Gordon v. Dolin, [FOOTNOTE 5]the buyer sought rescission of the purchase agreement, arguing, among other things, that the material adverse change provision in the purchase agreement had been breached based on the reduction in business from one of the seller’s key customers during the warranty period. The purchase agreement contained a MAC clause which stated that between Sept. 30, 1978, and the date of closing, there had not been: (a) any material and adverse change in the financial condition, properties, assets, liabilities, or business of Seller . . . (h) any other event or condition materially and adversely affecting the properties and assets of the business of Seller. The agreement also contained the following clause: No Reduction in Business or Loss of Customers. Seller shall not have received actual notice from any customer prior to the Closing Date that, prior to, on, or after the Closing Date, such customer will or intends to (a) discontinue to purchase from Seller any of the products manufactured and sold by Seller to such customer or (b) reduce the annual amount of such products to be purchased from Seller from the annual amount purchased by such customer from Seller prior to the Closing Date and Seller . . . shall deliver a certificate to Buyer to that effect at Closing. Because the seller had not received actual notice from its customer of a reduction in business as required by the language of this clause, the issue was whether it was in addition to, or in limitation of, the material adverse change provision in the agreement. The Appellate Court of Illinois concluded that the “No Reduction in Business or Loss of Customers” clause limited the scope of the MAC clause so that the latter would not be triggered by the seller’s loss of customers or a reduction in business. The court cited the principle that where an agreement contains both general and specific provisions relating to the same subject, the specific provision will control. TARGETS’ STRATEGY Notwithstanding the inherent uncertainty of the MAC clause, target companies typically seek to limit its scope and to increase further the uncertainty that buyers face when seeking to invoke it. One focus of a target’s efforts will be to delete any reference in the MAC definition to “prospects” or other forward-looking concepts (e.g., “or any event or circumstance that may result in such a material adverse change”). The significance of this sort of language is demonstrated by Pacheco v. Cambridge Technology Partners (Massachusetts), Inc., [FOOTNOTE 6]which involved a stock-for-stock merger between Cambridge Technology Partners (Massachusetts), Inc. and Excell Data Corporation. Cambridge’s recognized revenue growth rate had declined from 49 percent for the first two months of the third quarter of fiscal year 1997 to 32 percent for the first two months of the third quarter of fiscal year 1998 (the warranty period under the material adverse change provision in the merger agreement). The merger agreement contained a MAC clause which stated that “since June 30, 1998, there has not been any material adverse change in the Business Condition of Cambridge.” The term “Business Condition” was defined as follows: As used in this Agreement, “Business Condition” with respect to any entity means the business, financial condition, results of operations, assets or prospects (as defined below) . . . The term “prospects” was defined as follows: Prospects means events, conditions, facts or developments that are known to Excell and that in the reasonable course of events are expected to have an effect on future operations of the business as presently conducted by Excell . . . Based on this definition of “prospects,” the U.S. District Court for the District of Massachusetts concluded that financial prospects were encompassed by the material adverse change provision only as the provision applied to Excell, not to Cambridge. The MAC clause as it applied to Cambridge covered only Cambridge’s current operations, not its prospects. The court characterized the decline in Cambridge’s recognized revenue growth rate as bearing only on the prospective ability of Cambridge to meet third quarter expectations, and therefore relating only to forward-looking prospects, not the business, financial condition, results of operations or assets of Cambridge: “the intraquarterly information that Pacheco views as evidencing a material adverse change in Cambridge’s current business condition instead must be conceived of as information relating only to Cambridge’s ability to meet end-of-quarter expectations, ie., its ‘prospects.’” The court held that there was no breach of the merger agreement’s material adverse change provision as it applied to Cambridge. It would not be inconceivable to characterize an intraquarter decline in a company’s recognized revenue growth rate as reflecting a change in the company’s current business condition. Perhaps the Pachecocourt’s decision would have been different had the word “prospects” not appeared in the material adverse change provision with reference to the other party in the transaction, so that the words “business, financial condition, results of operations” could have been read more broadly. However, another decision, Goodman Manufacturing Co. L.P. v. Raytheon Co., [FOOTNOTE 7]confirms a judicial reluctance to read “prospects” or other forward-looking concepts into a MAC definition that does not explicitly contain them. It has also become common for public company targets to seek to include “carve-outs” in material adverse change definitions in an effort to infuse the MAC provision with even more ambiguity. An extreme — some might say absurd — example of carve-outs from a MAC definition can be found in the agreement and plan of reorganization dated as of March 12, 2000, by and among i2 Technologies, Inc., Hoya Merger Corp., and Aspect Development, Inc.: “Company Material Adverse Effect” means any change, effect, event, occurrence, state of facts or development that is materially adverse to the business, financial condition or results of operations of Company and its Subsidiaries, taking Company and its Subsidiaries together as a whole; provided, however, that none of the following shall be deemed in themselves, either alone or in combination, to constitute, and none of the following shall be taken into account in determining whether there has been or will be, a Company Material Adverse Effect: (a) any change in the market price or trading volume of Company’s stock after the date hereof; (b) any failure by Company to meet internal projections or forecasts or published revenue or earnings predictions for any period ending (or for which revenues or earnings are released) on or after the date of this Agreement; (c) any adverse change, effect, event, occurrence, state of facts or development to the extent attributable to the announcement or pendency of the Merger (including any cancellations of or delays in customer orders, any reduction in sales, any disruption in supplier, distributor, partner or similar relationships or any loss of employees); (d) any adverse change, effect, event, occurrence, state of facts or development attributable to conditions affecting the industries in which Company participates, the U.S. economy as a whole or foreign economies in any locations where Company or any of its Subsidiaries has material operations or sales; (e) any adverse change, effect, event, occurrence, state of facts or development attributable or relating to (i) out-of-pocket fees and expenses (including legal, accounting, investment banking and other fees and expenses) incurred in connection with the transactions contemplated by this Agreement, or (ii) the payment of any amounts due to, or the provision of any other benefits (including benefits relating to acceleration of stock options) to, any officers or employees under employment contracts, noncompetition agreements, employee benefit plans, severance arrangements or other arrangements in existence as of the date of this Agreement; (f) any adverse change, effect, event, occurrence, state of facts or development resulting from or relating to compliance with the terms of, or the taking of any action required by, this Agreement; (g) any adverse change, effect, event, occurrence, state of facts or development arising from or relating to any change in accounting requirements or principles or any change in applicable laws, rules or regulations or the interpretation thereof; or (h) any adverse change, effect, event, occurrence, state of facts or development arising from or relating to actions required to be taken under applicable laws, rules, regulations, contracts or agreements. (see Figure 1). It would take a brave buyer indeed to invoke a MAC termination right under an agreement incorporating the i2 definition, absent a truly catastrophic external event. [FOOTNOTE 8]But even a more limited set of carve-outs, such as those contained in clauses (c) and (d) of the i2 definition, some form of which are often found in public company acquisition agreements, can add uncertainty to a buyer’s determination to refuse to close based on the existence of a MAC. Allegheny Energy, Inc. v. DQE, Inc. [FOOTNOTE 9]involved a stock-for-stock merger pursuant to which DQE, Inc. was to become a wholly-owned subsidiary of Allegheny Energy, Inc. DQE terminated the merger agreement, arguing that Allegheny was not in compliance with its material adverse change representation due to the effect of the application of the Pennsylvania Electricity Generation Customer Choice and Competition Act on Allegheny. The Act was directly addressed in a carve-out to the definition of “Material Adverse Effect” in the merger agreement. The MAC clause stated: Since the Audit Date . . . there has not been (i) any change in the financial condition, properties, business or results of operations of it and its Subsidiaries or any development or combination of developments affecting it of which its management has knowledge that, individually or in the aggregate, is reasonably likely to have a Material Adverse Effect on it. “Material Adverse Effect” was defined as follows: “Material Adverse Effect” means with respect to any Person, a material adverse effect on the financial condition, properties, operations, business or results of operations of such Person and its Subsidiaries taken as a whole; provided, however, that any such effect resulting from . . . the application of the Pennsylvania Restructuring Legislation . . . which affects both [DQE] and its Subsidiaries, taken as a whole, and [Allegheny] and its Subsidiaries, taken as a whole, shall only be considered when determining if a Material Adverse Effect has occurred to the extent that such effect on one such party exceeds such effect on the other party. [emphasis added]. The U.S. District Court for the Western District of Pennsylvania acknowledged that “reasonable minds could differ” as to the meaning of the Material Adverse Effect provision. Allegheny argued that the “which affects both” language in the carve-out referred to the restructuring order made by the Pennsylvania Public Utility Commission that would be applicable to both DQE and Allegheny if the merger went through, not to the stand-alone orders made with respect to each entity individually. The court disagreed, and interpreted the language more broadly to refer to the fact that the legislation would affect both parties, and to include the effect of the stand-alone orders. The court interpreted the carve-out clause to mean that since the effect of Allegheny’s stand-alone order on Allegheny was greater than the effect of DQE’s stand alone order on DQE, and such greater effect was materially adverse, Allegheny had suffered a Material Adverse Effect. SO HOW TO PROCEED? The case law in the area of material adverse change provisions highlights the lack of predictability concerning judicial interpretations in this arena, and underscores the importance of careful drafting tailored to the specific concerns of the parties and the specific transaction involved. Parties cannot rely on courts to read their concerns into a general MAC clause. A well-designed material adverse change provision may decrease both the likelihood of litigation and the likelihood that if there is litigation, it will be resolved in surprising ways. Still, even with a carefully crafted provision, the parties cannot be too confident. Rather than depending entirely on the MAC clause to carry the burden of addressing all significant contingencies, parties may choose to take specific known concerns out of the purview of the MAC and address them in a separate closing condition. This is the approach taken by Warner-Lambert Company in its merger agreement with American Home Products, [FOOTNOTE 10]in which the issue of dexfenfluramine or fenfluramine diet drug litigation was addressed in a separate closing condition and largely excluded from the MAC definition. The advantage to employing a closing condition to address particularly important subjects is that the closing condition can be drafted precisely and concretely without being subject to the inherent ambiguities in meaning in a MAC definition. However, the more general MAC condition remains important to deal with contingencies that the parties cannot anticipate, and buyers and targets can be expected to focus considerable attention on the drafting of a MAC definition and to continue their respective efforts to decrease and increase the uncertainty inherent in a MAC termination right. Joel I. Greenberg is a partner of Kaye Scholer LLPand co-chair of its corporate and finance department, where A. Julia Haddad is an associate. Mr. Greenberg and the firm represented Celestica, Inc., the buyer in the agreement referred to in footnote 8 to this article. ::::FOOTNOTES:::: FN1727 S.W.2d 357 (Tex. Civ. App. 1987). FN21997 U.S. Dist. LEXIS 22035 (E.D.N.C. 1997). FN3889 F.2d 621 (5th Cir. 1989). FN4851 F.2d 456 (1st Cir. 1988). FN5105 Ill. App. 3d 319 (1982). FN685 F. Supp. 2d 69 (D. Mass. 2000). FN71999 U.S. Dist. LEXIS 13418 (S.D.N.Y. 1999). FN8An even more limited MAC definition can be found in the agreement and plan of merger by and among Celestica Inc., Celestica Asia Inc. and International Manufacturing Services, Inc. dated as of Nov. 1, 1998: “For all purposes of this Agreement, ‘Material Adverse Change’ or ‘Material Adverse Effect’ means, when used in connection with the Company or Parent, as the case may be, any change or effect, as the case may be, caused by an act of God (or other supernatural body mutually acceptable to the parties) (including such events as fire, earthquake and typhoon) which has a catastrophic effect on the Company or Parent, as the case may be, and their respective subsidiaries taken as a whole.” FN974 F. Supp. 2d 482 (W.D. Pa.. 1999). FN10Agreement and Plan of Merger, dated as of Nov. 3, 1999, among American Home Products Corporation, Wolverine Sub Corp., and WarnerLambert Company.

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