Legal Briefs

The legal imbroglio stemming from J.C. Flowers & Co.’s broken take-private of student lender Sallie Mae reminds deal-makers of the importance of material adverse change (MAC) clauses in their contracts.

It also has attorneys rethinking ways to draft MACs, which is language that allows a party to back out of a deal if a deal-altering event takes place between a transaction’s signing and closing. Negotiators should not only make MAC language more specific but also make MACs a more essential component of contract deliberations, according to an unpublished paper by attorneys Cathy L. Reese, Brian Rostocki and Kyle Wagner Compton of law firm Fish & Richardson PC and Joseph W. Bartlett of Sonnenschein Nath & Rosenthal.

For a long time now, buyers and sellers have inserted standard MAC language into contracts, and the boilerplate is incredibly broad. In fact, as Reese et al. point out, any mention of specific triggers—like a meltdown in the economy or weakening performance by the target company—is usually included to demonstrate what would not constitute a MAC.

Buyers typically like vaguely worded MACs because if a contract lists, say, 10 MAC-inducing events, inevitably an eleventh would actually occur; because it wasn’t in the contract, the eleventh event isn’t “part of the bargain,” the attorneys point out. Still, the burden usually falls on buyers to show that MACs are indeed unforeseen and deal-altering, since it’s almost always buyers that are seeking to escape bad deals. They’re therefore caught in something of a bind, since the Delaware Chancery Court tends to side with the seller in interpreting broadly worded language.

What Reese et al. propose is that buyers and sellers negotiate specific MAC triggers upfront and that they focus on which side has the burden of proving that a MAC has occurred. The attorneys reasoning is this: Buyers are usually well aware of what the downside risks of a target company are. In the case of Sallie Mae, J.C. Flowers knew that pending federal legislation could crimp Sallie Mae’s earnings potential. The buyout firm ultimately cited the law Congress passed as the MAC-triggering event, arguing that it would indeed eat into Sallie Mae’s profits. Although the case never made it far enough, Reese et al. imply that the Delaware Chancery Court, given its rulings in previous cases, likely wouldn’t have sided with the LBO shop. J.C. Flowers’s justification would have been, as the attorneys put it, “buyer’s remorse cloaked in hindsight justification.”

As a remedy for potential similar cases, Reese et al. suggest that buyers include in the contract those specific things that are “anticipated but uncertain” contingencies at the time of signing—such as pending legislation. At the same time, buyers should force sellers to assume the burden of proving that those events aren’t MAC triggers.

Obviously, this would force sellers to assume greater responsibility, and they could reasonably ask for some other contract piece in return. At the same time, sellers might like to know the exact contingencies that could constitute a MAC. That kind of assurance, especially given the busted deals and ensuing litigation in 2007, might be worth quite a bit, according to the attorneys.