Given the increased likelihood of problems while negotiating mergers or acquisitions in the current economic climate, parties to a deal can negotiate for several terms, which may help allocate the risk of a failed deal.
Three ways that buyers and sellers may allocate risks include walk-away rights, break up fees and material adverse effect clauses.
Walk-away rights
The best option is to negotiate for a right to walk away from the deal if certain conditions are met. When tightly drafted, these provisions are rarely disputed. Typical walk-away rights include financing outs, insolvency outs, and performance outs, among others.
Financing outs permit the buyer to walk away if it is unable to secure financing for the transaction. Buyer-friendly clauses usually designate certain lenders and a range of acceptable terms. Seller-friendly clauses require the buyer to look for financing on many different terms and from many different sources. Even if an agreement sets forth a pre-negotiated walk-away right, a buyer is still required to make a good faith effort to obtain financing. A performance out allows a buyer to walk away from a transaction if the target’s financial results do not meet the projections provided during the course of due diligence, and an insolvency out allows the buyer to walk away if the target or the combined company in a merger would be insolvent after the transaction.
When negotiating any of these walk-away rights, the parties should ensure that the provisions are as clear as possible to avoid disputes if the right is triggered.
Break up fees
Parties may also allocate the risk of a failed deal by negotiating a breakup fee (or reverse breakup fee). A breakup fee is typically paid to a buyer to deter other buyers from bidding on the target, whereas a reverse breakup fee is typically paid to a seller where a buyer enforces, in good faith, a pre-negotiated walk away right. Breakup fees are intended to represent the loss the other party will sustain due to the failed deal, while simultaneously capping those losses at a reasonable level. They are typically a pre-negotiated percentage of the purchase price. If a court determines that the agreement is terminated in bad faith, the court may allow the non-terminating party to recoup damages in excess of the breakup fee.
When drafting, parties should note that breakup fees are conceptually inconsistent with specific performance clauses, which allow a non-breaching party to force a breaching party to fulfill its obligations instead of recovering damages. When used together in a contract, these conflicting provisions can make the contract ambiguous. Accordingly, if the parties intend to include both, the agreement must be specific about the situations in which each clause applies.
Material adverse effect
A material adverse effect clause allows a party to walk away from a deal if the other experiences an event that is materially adverse to its business or financial condition. According to recent Delaware case law, which may have implications nationwide, buyers invoking this clause must prove that the adverse event substantially threatens the overall earnings potential of the target in a durationally-significant manner. Accordingly, short-term events alone are unlikely to trigger this clause, especially if the associated risk has been allocated in the agreement. Additionally, buyers are not permitted to ignore signs of trouble before signing and later use this information to invoke this clause. Therefore, sellers should disclose during the negotiations any circumstances which may have a material adverse effect.
Buyers will have the burden of proving that a material adverse effect has taken place. Proving this is very difficult, partly because courts interpret the term “materially adverse” narrowly. Therefore, buyers should be as specific as possible when drafting and negotiating this clause, and if possible, should define “materially adverse” using metrics that are important to the seller’s business. For example, if a buyer knows that a 25-percent drop in a seller’s earnings will make the acquisition unattractive, the buyer should include such language in the clause. Additionally, if certain lines of business are important, the buyer should include specific language making a dip in those lines of business a materially adverse event. When negotiating this type of clause, sellers will typically push for large carveouts such as exceptions for economic downturns and instability in the financial markets. Accordingly, buyers should make sure these carveouts are narrowly tailored.
Conclusion
When negotiating an acquisition agreement in the current economic climate, parties should view these risk allocation provisions as tools to help clearly delineate how the parties may walk away from a failed deal and which party will bear any economic loss associated with abandoning a deal that later becomes unattractive.
