Michael Hutchings.jpgTyler Hollenbeck.jpg

Michael Hutchings
(michael.hutchings@dlapiper.com) and
Tyler Hollenbeck (tyler.hollenbeck@dlapiper.com)



Although signing and closing of merger agreements occasionally occur simultaneously in mergers between private companies, most acquisition transactions, particularly those involving public companies, include a pre-closing period following execution of the merger agreement. During that period, certain conditions must be satisfied in order to consummate the merger.

In such transactions, one of the most powerful and heavily negotiated closing conditions is the requirement that the target’s representations and warranties be accurate as of a certain date or dates. In both private and public company acquisitions, this closing condition generally requires that the target’s representations be accurate both when made and when “brought down” to the date of closing.

This so-called bring-down condition plays a vital role in allocating risk between the parties during the pre-closing period. However, the extent to which this risk is placed solely on the target depends largely on the use of materiality qualifications in the bring-down condition. Subtle, semantic variations in the materiality qualifier can result in substantive shifts in risk allocation. It is important for companies considering acquisition transactions to thoroughly understand the common variants of such materiality qualifiers, as well as their frequency in comparable transactions.

How Accurate Must the Target’s Representations Be?

“In all material respects” vs. “Material Adverse Effect”

One of the most straightforward formulations of the bring-down clause, and that used as the baseline in the American Bar Association’s Model Merger Agreement, requires that the target’s representations and warranties be accurate “in all material respects” as of the closing date (this formulation of the bring-down condition is referred to herein as the AMR standard). Although the carveout for immaterial inaccuracies contained in the AMR standard does prevent the buyer from refusing to close the transaction as a result of a trivial breach of the target’s representations, this formulation does not entirely foreclose the buyer’s ability to walk away from the transaction as a result of a generally immaterial change in the target’s business. Because the AMR formulation tests the accuracy of the target’s representations on an individual basis, a material inaccuracy in a relatively immaterial representation may provide the buyer with an excuse to refuse to close.

In response to such concerns, the target may request that the accuracy of its representations be measured on an aggregate, rather than individual, basis.1 The most common formulation of this approach to materiality requires that the target’s representations be accurate “in all respects as of the closing date, expect for inaccuracies that could not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect” (MAE). The parties will then negotiate the definition in the merger agreement of an MAE, which generally covers “any change, event, condition or occurrence that is materially adverse to the target’s business, operations, properties, condition (financial or otherwise), assets, liabilities, operating results or cash flow,” with negotiated exclusions for certain macro economic, political and geographic conditions. While the MAE formulation of the bring-down condition does require that each of the target’s representations be individually accurate, the materiality threshold for any inaccuracies is tested at an aggregate level, thus excluding violations of relatively immaterial representations.

Carveouts for “double materiality” and fundamental representations

Under an aggregated measurement, such as the MAE formulation, the use of materiality qualifiers in the target’s representations themselves creates a “double materiality” risk for the buyer. Specifically, although each of the target’s representations may be individually accurate, as a result of the exclusion of immaterial inaccuracies pursuant to the terms of the representations themselves, such individually immaterial inaccuracies, when viewed as a whole, may be reasonably expected to have an MAE on the target. However, because the individual representations themselves are not technically inaccurate, the bring-down condition would be satisfied and the reasonable possibility of an MAE irrelevant.2

In order to remove such risk, the buyer may request inclusion in the bring-down condition of the following parenthetical: “For purposes of determining the accuracy of such representations, all “Material Adverse Effect” qualifications and other materiality qualifications contained in such representations shall be disregarded.” Under this formulation, the materiality of any inaccuracies in the target’s representations is considered only in determining whether such inaccuracies may reasonably be expected to result in an MAE for the target. However, the representation that no “Material Adverse Change” (MAC) to the target’s business has occurred since a particular date (usually the date of the last financial statements delivered to the buyer) is often excluded from such double materiality carve-out, because the representation itself would arguably become incoherent and unworkable were materiality disregarded entirely.

In addition to concerns regarding double materiality, certain of the target’s representations may be so fundamental to the transaction that the buyer will wish to maintain the ability to refuse to close in the event that such representations are inaccurate in any respect. Accordingly, the bring-down condition may expressly separate such representations from the others, requiring that they be accurate “in all respects” or “in all respects other than de minimus inaccuracies.” In particular, the target’s capitalization representation is often treated separately and distinctly because of the importance of the capitalization figures to allocating the consideration being offered in the merger. In addition, representations regarding the target’s authority to enter into the merger agreement (i.e. its receipt of the requisite board and stockholder approval), as well as the transaction’s compliance with state anti-takeover statutes, are often addressed separately and distinctly in the bring-down condition.

Recent Trends in Drafting the Bring-Down Condition

Given the important risk-allocation role played by the bring-down condition and the subtlety of the distinctions between the foregoing formulations, parties negotiating merger agreements often look to market trends in the use of these formulations. Accordingly, the ABA’s M&A Market Trends Subcommittee of the Committee on Negotiated Acquisitions undertakes an annual survey of deal terms in mergers between strategic buyers and public company targets. This survey includes a detailed analysis of the bring-down condition. Recent iterations of this study reveal an important crystallization in approach to the bring-down condition in public company mergers: a strong majority of such acquisitions from 2004 through 2008 utilized some variant of the aggregated MAE formulation, with the percentage increasing from approximately 83 percent in 2005-2006 to approximately 90 percent in 2007-2008.3 In addition, an overwhelming majority of such transactions during the same period included a double materiality carveout, with such percentage increasing from 77 percent in 2004 to 96 percent in 2008.4 In 2008, approximately 85 percent of acquisition transactions between public companies included the MAE formulation of the bring-down condition with a carveout for double materiality.

Given the crisis that shook the US financial system in late 2008, one may expect that this trend toward the more target-favorable MAE formulation would have slowed, if not receded, in the fourth quarter of 2008, as buyers gained significant leverage in the turbulent capital markets. Moreover, recent case law has reinforced the Delaware courts’ narrow interpretation of MAE clauses, thus further solidifying the target-friendly nature of this formulation. Building on its decision in IBP, Inc. v. Tyson Foods, Inc., the court’s September 2008 opinion in Hexion Specialty Chemicals, Inc. et al v. Huntsman Corp. reaffirmed the proposition that “a buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close.” In fact, the court went on to note that “Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement.”

While these changes in market power and case law may partially explain the increasing prevalence of the buyer-favorable double-materiality carveout, data from the fourth quarter of 2008 reveals no significant shift in approach to the bring-down condition in public company m ergers vis-à-vis 2007 or the first three quarters of 2008. This entrenchment, even in the face of unprecedented market upheaval and target-friendly case law, suggests that the MAE formulation has gained strong acceptance among buyers and sellers in public company acquisitions, particularly when coupled with carveouts for double materiality and fundamental representations, notwithstanding the absence of any “correct” approach. As with any contractual provision, however, strong buyer leverage, as a result of general macroeconomic or deal-specific factors, may trump market practice in any particular transaction. In addition, buyer leverage and the market’s internalization of the Hexion Specialty Chemicals decision may lead to increasingly detailed and broad definitions of an MAE, as buyers look to exert their negotiating power to contractually reject the Delaware courts’ narrow interpretation of MAE conditions.

Accordingly, the 2009 iteration of the ABA’s survey may well reveal a change in the trend observed through 2008. Regardless of the outcome of the ABA’s next survey, however, the uncertain economic climate virtually ensures that the bring-down condition will continue to draw significant attention when acquisition transactions are negotiated in the near future.

1 Public company targets are sometimes able to successfully argue that the importance of speed and confidentiality in a particular negotiation prevents them from engaging their entire organization in the confirmation of the target’s representations and the preparation of its disclosure schedule at the time of signing. Accordingly, the target would argue, the buyer should not be entitled to walk away from the transaction solely as a result of an inaccuracy at the time of signing, as long as that inaccuracy is cured prior to closing. Despite such arguments, recent studies by the ABA’s M&A Market Trends Subcommittee of the Committee on Negotiated Acquisitions reveal that from 2004-2008 approximately 80 percent of mergers between strategic buyers and public company targets contained closing conditions that tested the accuracy of the target’s representations as of both the date of signing and the date of closing.
2 Although the risk of double materiality exists whenever materiality qualifiers are included in both the bring-down condition and the target’s representations, the risk is less acute when the target’s representations are measured on an individual rather than an aggregate basis. When accuracy is tested on an individual basis, there is no risk of multiple individually immaterial inaccuracies being material in the aggregate. Instead, the double materiality risk in this context relates more to interpretive ambiguity with respect to double qualification. Nevertheless, the double materiality carveout noted above may be included in merger agreements where each of the target’s representations must individually be materially accurate. Alternatively, the bring-down condition may be formulated to require that the target’s representations be accurate “in all respects if qualified by materiality and in all material respects if not so qualified.”
3 ABA’s M&A Market Trends Subcommittee of the Committee on Negotiated Acquisitions, http://www.abanet.org/dch/committee.cfm?com=CL560003.

4 Id. This latter trend suggests that as the MAE formulation gradually crystallized as the prevailing standard, buyers and their counsel became increasingly aware of the acute double materiality risk and insisted on appropriate carveouts in most such transactions.