Elon Musk aims to be the second buyer in history to get out of a merger due to material adverse effects, but it won’t be easy.
Fresenius Kabi AG, a pharmaceutical company based in Germany, wanted out of a $4.3 billion deal to buy US-based drug manufacturer Akorn for $4.3 billion.
That’s no easy feat in Delaware courts, where sellers typically have the advantage. Fresenius, however, made the case that its target had suppressed information that would have “material adverse effect” (MAE) on the stock price. Whistleblowers revealed Akorn had submitted falsified data to the Food and Drug Administration, and Akorn’s stock price went into freefall. In 2018, the court ruled for Fresenius, making it the first buyer to successfully exit a merger due to an MAE.
Elon Musk hopes to be the second.
“Sellers aren’t particularly interested in giving an easy out for buyers having second thoughts,” notes Bryan Cummings, a senior financial sponsor banker with Cannacord Genuity. Those that get cold feet must usually fork over a ‘breakup fee’ of 1%-3% of the deal. An MAE allows buyers to exit without penalty.
As a result, of course, sell-side negotiators seek to limit them to the “truly extraordinary,” Cummings explains, so buyers “aren’t particularly incentivized to deploy the MAE catapult,” either.
Chancellor Kathaleen McCormick, currently chief judge on Delaware’s Court of Chancery, ordered Musk and Twitter to a trial to begin in mid-October, in order to hash out whether Musk, with a net worth hovering between $250 billion and $273 billion, can justifiably exit his $44 billion deal to buy Twitter, the social-media behemoth touting more than 220 million daily active users.
Too many of those users, Musk argues, are “fake accounts,” or so-called “bots.” That means Twitter is “likely to suffer a Company Material Adverse Effect,” his legal adviser wrote to Twitter’s chief legal officer. Spam accounts represent less than 5% of daily users, Twitter responded, and filed suit to ensure Musk makes the buy or shells out a breakup fee of $1 billion.
M&A pros and legal experts have since chimed in on this drama, an eye-opening retrospective on how to use MAE to nix a deal. “Musk has nothing here,” Julian Klymochko, CEO of Accelerate, tells Global Finance. “The bot issue is, quite frankly, disingenuous.”
In previous MAE cases, such as Akorn’s, the target company’s financials fell off a cliff. Twitter’s have held steady. “It’s basically impossible here to claim an MAE,” Klymochko says. “It’s somewhat laughable to look at how little they can come up with.”
Burden of Proof
While MAEs are generally used in connection with the time between signing and closing, giving the buyer an out if the business suddenly takes a downturn, it’s often less an issue of what can be claimed, and more an issue of what the courts might accept, Cummings says.
“The accepted view is that an MAE needs to be specific to a company, quantitatively significant—the material part—and durationally significant. Material doesn’t mean one-quarter of poor performance,” Cummings says. “If a target suffers a change in a reimbursement rate, that doesn’t necessarily qualify, since that risk is part and parcel for the industry.”
Such was the case in July 2021 when Bardy Diagnostics Inc. went to court with Hill-Rom. The Delaware Court of Chancery concluded that there had been no MAE within the meaning of the agreement between the two medical device companies. Therefore, Chicago-based Hill-Rom was on the hook for $375 million.
MAEs could also be external factors, such as a lawsuit, weather-related losses (an act of God) or something as simple as a key customer terminating a contract. And even then, “it’s a very high threshold,” says Don Ritucci, head of health-care M&A at investment bank Oppenheimer & Co.
In a $50-million health-care services deal Ritucci recently advised, one of the target’s customers wasn’t going to renew a contract. “Ultimately it was negotiated and the buyer did the deal but at a lower price,” Ritucci says. From a seller’s perspective, that’s a wise decision, he adds. Why? Because if a deal with your number one buyer gets canceled, the second- and third-choice buyers will smell “blood in the water,” and their offers will either be a lot smaller or disappear altogether. “Think of the BATNA, or the ‘best alternative to a negotiated agreement,’” Ritucci says. “Once you get hitched, you really have to try to see it through.”
In 2020, the pandemic was cited by dealmakers as a potential MAE. But that April, when Covid-19 infections and deaths were devastating the UK, London-based insurance broker Aon notably excluded the pandemic as a potential MAE trigger in its $30-billion all-stock deal for Willis Towers Watson—ultimately the biggest M&A deal that year and the largest ever in the insurance industry. If the agreement had fallen through, Aon would have had to pay $1 billion to Willis Towers.
An MAE can serve as negotiating leverage, too. That same year, Simon Property Group wanted to leave Taubman Centers at the altar. Taubman sued, and the deal went through—just before the trial was about to start—at an 18% reduced price. Settling for a reduced price is the likeliest scenario, Klymochko says. Musk may also be able to convince a judge that Twitter simply didn’t provide him with adequate information as promised. That would make the spam account issue moot.
Musk could also negotiate a deal where he cancels his shares in lieu of the large financial penalty, although that’s highly unlikely, Klymochko adds. “Currently, Elon Musk owns 9.5% of Twitter shares outstanding, or 73 million shares. These shares have a takeout value of $4 billion at $54.20 per share, or nearly $3 billion at current market value,” Klymochko says. “If Musk is not going to buy Twitter outright, then he would want to part ways with the company. An amicable way would be for him to give up his shares for no consideration, which would be a $3 billion-$4 billion penalty—depending on how it’s calculated.” As a result, each remaining share would consist of a larger portion of the company.
The Surprise Factor
MAEs are also tied to new events and circumstances that were either previously unknown or unexpected. If Musk is looking to paint Twitter as fraudulent based on the number of bots and spam accounts, that’s a tough hill to climb.
“Musk couldn’t get comfortable with the number of real accounts [versus] bot accounts, but I don’t see how that’s a ‘material adverse event’ because it would have been a condition that already existed, not some new ‘event’ that occurred and caused a deterioration in the business after he signed his deal or completed his diligence,” says James Caruso, chief financial officer of J. Knipper and Company.
Caruso is right. After all, Musk has been an active Twitter user since 2009. Today, he has more than 102 million followers, who have grown used to his penchant for memes, trolling and lewd commentary. Musk also mentioned bots when the deal was first announced in April. He pledged to make Twitter “better than ever by enhancing the product with new features, making the algorithms open source to increase trust, defeating the spam bots, and authenticating all humans.”
Musk also has some fuel in the form of a whistleblower complaint, recently filed with regulators. Twitter’s former head of security, Peiter Zatko, who was let go in January, alleges the company misled regulators and its own board of directors about certain security practices and spam controls.
Moreover, Musk can afford the best in legal advice. The entrepreneur has tapped Skadden Arps Slate Meagher & Flom, a top M&A law firm, and Los Angeles-based Quinn Emanuel Urquhart & Sullivan as legal counsel. Whether they can effectively wield what Cummings calls the “‘but’ cannon,” remains to be seen. “Think of the MAE as the ‘but…’ cannon: I planned to buy this company, ‘but’ this business is no longer what I signed up for,” Cummings says. “I really want to consummate the transaction, ‘but’ the seller was totally fraudulent in its representations and I can’t be expected to close.”
Except, firing one shot does not bring the walls of the castle crashing down, he adds: “Exactly the opposite. A world where MAE disputes strike down deals frequently is a world in which M&A—an uncertain business in the best of circumstances—becomes a roulette game.”
Twitter has legal heavyweights in its corner, too. Wachtell Lipton Rosen & Katz and Simpson Thacher & Bartlett are both advising the San Francisco–based company to make sure the Musk deal stays intact or otherwise pays off. Twitter has even sought counsel from Wilson Sonsini, where partner William Chandler III is a former chancellor of the Delaware Chancery Court.
“Merger contracts are meticulously negotiated and agreed, and a free-for-all clause throws all that to the wind, creates a market uncertainty that would mute deal activity and over time discourage deals that would benefit shareholders,” Cummings comments. “Delaware knows that, which is why, in both language and practice, proving the MAE is an extremely high bar to meet.”