There is no substitute for due diligence in corporate mergers. That's the message vice chancellor Leo E. Strine Jr. delivered to Tyson Foods Inc. in a June 15 ruling in the Delaware Chancery Court. The judge ruled that Tyson, the country's largest poultry producer, had breached the contract it signed on January 1 to acquire IBP, the country's largest meatpacker, for $3.2 billion in cash and stock. He also determined that, given the difficulties of calculating the damages to IBP shareholders, the best way to resolve the barnyard brawl was for Tyson to complete the merger. The company has since agreed to that remedy.
So much for getting off on the right hoof. Such shotgun mergers are exceedingly rare, but the judgment establishes an intriguing legal precedent regarding corporate control. It will likely affect the balance of power between buyers and sellers of companies prior to closing their deals, and it also may have an impact on the way potential partners draft their merger contracts.
Those contracts are particularly important given the uncertain M&A environment this year. According to Thomson Financial, there have been 187 busted deals in 2001 so far. There were 195 in the same period last year, but there were also 45 percent more mergers announced. If it's not antitrust regulators quashing deals like those between General Electric and Honeywell International or United Air Lines and US Airways, then plunging equity prices have done the trick — killing deals like the one between Ariba and Agile Software earlier this year. Add to that the unusual outcome to the Tyson-IBP case, and CFOs and legal strategists are advised to think more seriously about contingency planning and protecting themselves from bad mergers. Now more than ever, says Thomas Lys, professor of M&A at Northwestern University's Kellogg Graduate School of Management, "corporate executives had better concentrate on their due diligence before they enter deals."
At the heart of the Tyson-IBP ruling is the issue of what constitutes a material adverse change (MAC) in a business. Most merger contracts include a boilerplate clause stating that if a MAC occurs in the target company's business prior to the closing of the deal, the acquiring company has the right to either renegotiate or walk away. In most cases, the language of the MAC clause is tested in the negotiation phase, not in court. Says Garth Bray, a partner with Sullivan & Cromwell, "For every case that ends up in court, many more simply result in a renegotiation." And typically, he adds, negative developments that might give rise to a walkaway right result in a simple reduction of the purchase price.
For those cases in which a buyer wants to terminate a deal — as Tyson attempted to do with IBP in late March — and the seller sues for breach of contract, the buyer can face an uphill battle arguing that its MAC clause justifies a termination of the deal. "If companies use the MAC clause as an out [from a deal], they have to prove that a MAC has in fact occurred," says Bob Olanoff, CFO of Paragon Computer Professionals Inc., who in his previous job as CFO of Beechwood Data Systems helped negotiate the sale of the company to Cap Gemini.
Usually, the MAC clause is intended to protect buyers from a dramatic short-term deterioration in the target company's business. Such was the case with NorthPoint Communications Group Inc., a provider of digital subscriber line (DSL) service. Last August, Verizon Communications Inc. agreed to acquire a 55 percent stake in NorthPoint for $800 million. Shortly thereafter, the market for DSL providers collapsed, sending NorthPoint's stock into the tank and threatening the company's financial viability. Verizon terminated the deal, arguing that a MAC had occurred at NorthPoint, which has since declared bankruptcy and sold most of its assets to AT&T Corp. NorthPoint then sued Verizon for breach of contract in Superior Court of California.
In Tyson's case, the company argued that IBP had suffered MACs in two regards. First, like those of Tyson itself, IBP's operations have been hurt by the slowing U.S. economy: Both sales and earnings were down significantly in the first two quarters of this year. Second, Tyson claimed that IBP made false representations about the extent of accounting problems at its DFG Foods subsidiary, which produces hors d'oeuvres. Specifically, Tyson claimed that IBP executives failed to disclose that the Securities and Exchange Commission had launched an inquiry into the matter before IBP signed the deal with Tyson.
Judge Strine, however, ruled that neither matter qualified as a MAC. Tyson was well aware of the accounting problems at the IBP subsidiary before signing the deal, and it also could have reasonably expected that the economic slowdown would have a negative impact on IBP. While IBP may have experienced adverse developments since the signing of the merger agreement, they were developments that Tyson could and should have foreseen. In other words, Tyson failed in its due diligence, and the attempt to walk away from the deal was simply a case of buyer's remorse.
"If you allow people to walk away when they regret a contract they've signed, it damages commercial relationships," says Charles Elson, director of the Center for Corporate Governance at the University of Delaware. "Judge Strine upheld the solemnity of the contract."
Strine's ruling is likely to affect the M&A market in two ways. First, it shifts power toward the seller in merger transactions. Normally, buyers can extract concessions from sellers if adverse changes in the acquired company's business occur prior to closing. IBP president Richard Bond, for example, testified at trial that he entered into discussions with Tyson CEO John Tyson in March to lower the price on the deal, shortly before chairman of the board Donald Tyson — who, as family patriarch, is not quite ready to retire — reportedly pulled the plug on the merger.
Given that Strine bought neither of Tyson's MAC arguments, potential sellers in merger deals might be less accommodating to buyers' demands for price concessions in the future. Instead, they may stonewall, betting that the buyer won't want to risk a breach of contract lawsuit by terminating the deal. "Target companies might be emboldened not to renegotiate when a buyer alleges that a MAC has occurred," suggests Robert Spatt, a partner at Simpson Thacher & Bartlett.
From the buyers' perspective, the ruling may encourage them to more- specifically define the adverse changes that would give them the right to walk away from a deal. Whether it's a drop in revenue or profitability, a loss of customers or employees, or an adverse regulatory development, the more defined the MAC is, the more protection from potential litigation a buyer will have if it walks away from a deal. So, for example, had Tyson negotiated a condition into the merger contract with IBP regarding short-term sales or earnings performance at the business, it would have had a legitimate right to terminate the deal.
However, most MAC clauses lack specific details for a reason: to get deals done. The more explicit conditions an acquiring company puts on a deal, the less likely the seller is to agree to the merger. Busted deals — whatever the reason — can have disastrous consequences for target companies and their management teams. Just ask Michael Bonsignore, former CEO at Honeywell.
"When sellers sign a contract, they want a high degree of probability that the transaction will go forward," says Bray. "Any specific conditions you put into the MAC clause reduce the firmness of the transaction."
With a faltering economy and a more difficult business environment, however, avoiding a bad deal may be more valuable than completing a good one.
Andrew Osterland is a senior editor at CFO.
Large deals, involving at least one U.S. partner, that have fallen apart this year.
|Target/Acquirer||Deal Value ($millions)||Announced||Withdrawn|
|Northeast Utilities/Consolidated Edison||7,094.4||10/13/99||3/5/01|
|Dynex Capital/California Investment Fund||3,496.4||9/13/00||1/26/01|
|Portland GE/Sierra Pacific Resources||3,100.0||11/8/99||4/26/01|
|Barrett Resources/Shell Oil (Royal Dutch)||2,418.7||3/7/01||5/8/01|
|Pinnacle Entertainment/Harveys Casino Resorts||1,154.8||3/8/00||1/23/01|
|Empire District Electric/UtiliCorp United||794.6||5/11/99||1/2/01|
|Mohave Generating Station/AES||677.0||5/11/00||2/2/01|
|Adaptive Broadband/Western Multiplex||543.7||11/13/00||1/11/01|
Source: Thomson Financial