More on Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc.

Robert Miller —  14 September 2007

Steven Davidoff responded to my blog here last week regarding Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. and made the excellent point that just how bad for Merrill the representation I quoted really was depends in part on the limitations on indemnification that were included in the purchase agreement. For example, if the representations survived for only a short period and were subject to a large deductible and low cap, Merrill’s liability under the representation would be sharply limited. Unfortunately, the second circuit opinion says nothing about the indemnification provisions, and so I don’t know how much Merrill’s lawyers were able to take back with the left hand what they had given away with the right.

Steven also mentioned a representation that as counsel on the buy-side he generally tried to get and that is in some ways similar to the one I so criticized Merrill’s lawyers for giving on the sell-side. The representation Steven mentioned provides as follows:Â

There does not now exist any event, condition, or other matter, or any series of events, conditions, or other matters, individually or in the aggregate, adversely affecting Seller’s assets, business, prospects, financial condition, or results of its operations, that has not been specifically disclosed to Buyer in writing by Seller on or prior to the date of this Agreement.Â

As seller’s counsel, I would be willing to give this representation only if a few key changes were made. First and most important, it would have to be qualified by some materiality threshold. Every day any number of things “adversely affect” the company—far too many to be listed on a disclosure schedule—and so this representation would be false when made unless qualified as to materiality. In my view, the correct qualification here would be qualification to a “MAC”—a “material adverse change” on the company (defined with all the usual carve-outs, etc.). If the buyer’s counsel argued for a lower level of materiality—say anything “materially adversely affecting” the company—I would push back very hard. I think the seller ought not be in the position of having to determine for the buyer what is “material” to the value of the business from the buyer’s point of view.

This brings me to the second change I would think necessary: the MAC in the qualification should be a MAC on the company as a whole (including its “business” and “financial condition”), not on the company’s “assets” and certainly not on its “prospects.” “Assets” is wrong because something can adversely affect the company’s assets and not make the company itself worse off (e.g., a fully-insured asset is destroyed in an act of God). “Prospects” is wrong because no rational seller guarantees the future results of the business.Â

Third, the representation should be qualified as to time, meaning that it should pertain only to the period beginning on the date of the most recent audited financial statements of the company. Anything prior to the date should be covered in those financial statements.

With these three changes, the representation would sayÂ

Since the date of the Seller Financial Statements, there has not occurred any Material Adverse Effect on the Seller, its business or financial condition, except as has been specifically disclosed to Buyer in writing.Â

Thus modified, the representation is, I believe, customary. A representation substantially identical to it appears, for example, in the KKR-First Data merger agreement (the merger proxy for the deal, with the agreement appended, is available here):Â

Section 4.7 Absence of Material Adverse Change. Since December 31, 2006, … there has not been any Material Adverse Change or any Effect that would, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on the Company.

Representations like this, I think, are significantly different from the representation Merrill gave in the Allegheny deal. For one thing, the representation above does not amount to representing that all statements in the diligence materials were true. To prove a breach of the representation above, the buyer would have to show (a) there was a fact that amounts to a MAC on the company, and (b) the seller didn’t disclose that fact in diligence. It would be a question of a MAC-level omission from diligence, not a question of a false statement in the diligence materials. From a litigation point of view, the issue would probably come down to the seller combing the diligence materials and arguing that some obscure statement in the materials really did disclose the fact in question. From an economic point of view, the representation above creates an incentive for the seller to disclose more information rather than less in diligence, and that sounds efficient to me.

Although the representation in Merrill-Allegheny makes Merrill liable for omissions from diligence and so creates a similar incentive, it also creates an exactly opposite incentive as well. For, under the Merrill-Allegheny representation, the buyer can comb the diligence materials for an arguably-false statement and then argue that the falsity of the statement breaches the representation. Hence, the representation creates an incentive for the seller to disclose less information rather than more. To this extent, it’s very likely inefficient.

There’s another difference too. Nothing in the representation above requires the seller to make normative judgments about whether the information delivered is “appropriate” to value the company. The only judgment that the seller has to make is whether a fact amounts to a MAC on the company. It would seem possible that the seller could disclose all negative information about the company while still not disclosing some information needed to “appropriately” value the company. Imagine, for example, that inventory turnover rates are very important in the business being sold, and so valuation methodologies for this kind of business usually make use of such information. Under the Merrill Lynch representation, I think the seller would have to disclose inventory turnover information, even if there was nothing “bad” in the information (e.g., even if the turnover rates were average for the industry) and even if the buyer never asked for it. Under the representation above, as long as the turnover rates were not unusually bad, I don’t think the failure to disclose information about them would amount to a breach.

So although I didn’t want to harsh all over Merrill’s lawyers, I still think they gave a representation that was unreasonably unfavorable for their client. Steven and I both recall seeing counsel, even from elite firms, make serious mistakes similar to this—missing double materiality qualifications and so on. Steven suggested that the explanation may lie in the negotiation process being private (hence most mistakes don’t lead to public embarrassment), in an unthinking adherence to the firm’s form agreements (hence once a mistake is incorporated into the form, it gets repeated), or in over-reliance on network effects (other lawyers know what they are doing and so the associates will learn from them).

I’m inclined to think the problem is simply one of agency costs. Clients don’t read business combination agreements, and they certainly don’t read the representations—much less do they understand what can reasonably be given in representations and what cannot. Hence, when lawyers make a serious mistake, it’s often the lawyers themselves who are advising the client as to how serious the mistake was and how it ought be handled. The clients are ill-equipped to make an independent judgment. The lawyers can thus cover up the mistake at the client’s expense.

Unless, of course, some tiresome law professors want to blog about them.Â