Billionaire Elon Musk completed his highly publicised acquisition of Twitter last month, ending a near eight-month sale process. The total purchase price payable to Twitter’s shareholders from the acquisition exceeded US$44 billion/AUD$68 billion.
One of the more intriguing aspects of this transaction (of which there were many) was Musk’s attempts to pull out of the transaction in May and June after the definitive merger agreements were entered into on April 25 (Merger Agreements). Musk asserted that, amongst other things, Twitter had made misleading representations over the number of automated accounts on Twitter that were not connected to a legitimate (and human) user (referred to as “bot” accounts). At one point, Musk suggested that the number of bot accounts made up at least 20% of all users on Twitter, and indicated that the number could be as high as 90%. Musk’s alleged discovery of the bot accounts in May was after the Merger Agreements had been signed, and in July, Musk sought to back out of the deal over the misleading representations, prompting litigation from Twitter seeking to enforce the deal, and a subsequent counterclaim from Musk.
Ultimately, Musk agreed to acquire Twitter, avoiding a trial scheduled for October 17 2022 in the Delaware Court of Chancery, and the transaction completed on the terms of the Merger Agreements on October 27 2022.
Private M&A in Australia – Material Adverse Change
A buyer could feel justified in seeking to walk away from a transaction after a sale agreement has been signed, either due to an alleged misrepresentation or because circumstances change. While Twitter was a US public company, and Musk’s acquisition was governed by Delaware law, in the context of Australian private M&A transactions, a key protection for buyers often contained in sale agreements is the “Material Adverse Change” (or MAC) clause.
In a private M&A sale agreement, there is often a timing gap between signing the sale agreement and completing the transaction, usually for the parties to satisfy various conditions precedent. While the gap is not often six months (as was the case during Musk’s Twitter acquisition), it can be enough time for an adverse change or deterioration in the target business or its future prospects to occur. A buyer may conclude that it ought not to be bound to complete the transaction, as it is not getting what it bargained for.
Accordingly, a buyer will often seek to include a Material Adverse Change clause in the sale agreement, such that the buyer can terminate the sale agreement before completion in certain circumstances.
Material Adverse Change clauses tend to be expressed in qualitative terms, such as a change that has material and adverse effect on the financial condition, operations or prospects of the target business, or in quantitative terms, such as a change based on a drop in revenue, earnings or other financial thresholds (or a combination of the two).
Analysing the Material Adverse Change clause
Material Adverse Change clauses will be interpreted in accordance with contract law, including by having regard to the entirety of the contract, and where possible giving the clause its natural meaning in accordance with the expectations of the parties at the time of entering the sale agreement. The burden will fall on the buyer to prove that a Material Adverse Change has occurred.
Material Adverse Change clauses have rarely been interpreted by Australian courts, and have mostly been considered by US courts. While US decisions are not binding on Australian courts, the approach of US courts to MAC clauses will carry weight here, at least for general, qualitative Material Adverse Change clauses.
The principles established in the US cases of Hexion1, IBP2 and Akorn3, and the Canadian case of Fairstone4 can be summarised as follows:
- US jurisprudence defines Material Adverse Change as “the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner”.
- A buyer faces a heavy burden when it attempts to invoke a Material Adverse Change clause in order to avoid its obligation to complete.
- A “short-term hiccup in earnings” may not suffice as a Material Adverse Change. The Material Adverse Change should be material when viewed from the longer-term perspective of a reasonable buyer. In the IBP case, the Court held that a 64% drop in quarterly earnings did not constitute a Material Adverse Change as shortly after the 64% drop, IBP began to perform more in line with its profitable yearly results. The durational significance of the effect5, will generally be measured in years rather than months.
- In the absence of evidence to the contrary, the buyer may be assumed to be purchasing the target as part of a long term strategy.
- Generally, a qualitative Material Adverse Change will require the occurrence of an unknown event. In Fairstone, the Court found that, notwithstanding that the COVID-19 pandemic was the subject of regular newspaper reports at the date that the relevant purchase agreement was signed, the effect of the pandemic on the seller’s business was not known and the effect of the COVID-19 pandemic on the seller’s business constituted a Material Adverse Change.
However, each situation will depend on the specific wording of the relevant clause, and the few Australian cases in recent times turn on the particular clause in issue.
A buyer should seek to set out precisely what constitutes a “Material Adverse Change”, in order to avoid ambiguity. A buyer may face difficulties enforcing a qualitative Material Adverse Changes that is drafted too generally, as the question of whether a material and adverse change has occurred is in many cases inherently uncertain.
Sellers will often seek to include carve-outs to the Material Adverse Change clause in order to limit its scope. These carve outs can include changes in general business conditions, the industry or markets in which the target operates and changes in law. The carve-outs can also include force majeure type events beyond the target’s control. In Fairstone, the seller successfully established that the COVID-19 pandemic had a general impact on the Canadian consumer finance industry, and relied on a carve-out which excluded changes in the markets or industry as constituting a Material Adverse Change (which would otherwise have been established on the facts of that case).
A buyer may concede certain carve-outs on the basis that the relevant event that is carved out does not disproportionately effect the target.
Just as the scope of a Material Adverse Change clause is often the subject of detailed negotiations, the carve-outs can also receive much focus in the parties seeking to reach agreement on the clause.
For both sellers and buyers, being involved in a public dispute over a Material Adverse Change clause can have negative reputational effects, quite aside from the cost and distraction of litigation. Buyers should seek to strengthen their position – even if their aim is to threaten to walk away in order to renegotiate a transaction – and mitigate the risk of uncertainty, by including specific quantitative thresholds, to determine objectively whether a Material Adverse Change has occurred. Sellers, if they must agree a Material Adverse Change clause, may be more sanguine about the risk of a public dispute if a Material Adverse Change that is broadly drafted, and less certain in its application, gives them grounds to argue that a Material Adverse Change has not occurred. Sellers should also ensure that a Material Adverse Change clause does not turn on a buyer’s opinion; seek appropriate carve-outs that limit Material Adverse Change events to those that are specific to the target business; and finally attempt to avoid the Material Adverse Change being based on potential future impacts.
1 Re Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del. Ch. 2008) at 738.
2 Re IBP, Inc. S’holders Litig., 2001 Del. Ch. LEXIS 81, 789 A.2d 14 (2001).
3 Akorn v Fresenius – memorandum opinion – pages 129 to 130 –https://courts.delaware.gov/Opinions/Download.aspx?id=279250.
4 Fairstone Financial Holdings Inc. v. Duo Bank of Canada, 2020 ONSC 7397
5 Re Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del. Ch. 2008) at 738.