Editor's note: This column was submitted by Stockpickr member Susanne Owen, also known as the Trading Nymph.Sallie Mae ( SLM), what went wrong? Well, you never brought me Flowers. As you've no doubt heard by now, SLM, better known as Sallie Mae, filed suit late Monday against a group of investors -- led by J.C. Flowers & Co. -- that had agreed to buy the student lender for $25 billion, but has since lowered its offer. In response to the lowered bid, Sallie Mae is seeking a declaration that the Flowers-led group "repudiated the merger agreement" and that no significant changes occurred to prompt the revised offer. Sallie Mae wants to terminate the merger agreement and collect $900 million in damages. First, my serious investor types, what is a MAC? It has pickles and cheese? No. The lawyer in the back of the class -- yes, it is a clause found in a contract that basically means if something unforeseen comes up that materially affects the original agreement, then all bets are off and everyone goes their separate ways. They are called MAC clauses (material adverse change), or MAE -- material adverse effect -- clauses. They really came into play, sadly, after the Sept. 11 terrorist attacks. So the April 15 agreement between Sallie Mae and the Flowers-led group -- which also includes Bank of America ( BAC) and JPMorgan Chase ( JPM) -- includes one of those clauses. The Flowers Group is indicating that it plans to rely on that clause to walk away from the deal. (If you want to read the clause, check out the April 8-K filing. The MAC clause is found in Section 11.0.1.)
As you are probably aware, on Sept. 27, George Bush signed into law the College Cost Reduction and Access Act. Now the Flowers Group is claiming that it, and a serious credit crunch, represents an MAE and the estimated combined impact of the legislation and credit crunch would reduce the student lender's core earnings net income by 14.4% in 2009 and by 20.1% in 2012. On the other side, Sallie Mae is claiming that the legislation is expected to result in a 2%reduction of its net income annually over the next five years. What will happen if these two end up in a courtroom over this? I know there is a strong chance that SLM may point to its Feb. 28, 2007, 10K, which starting on page 105 under "Recent Developments" discusses the possible passing of the Ted Kennedy Student Aid Reward Act of 2007 introduced on Feb. 13, 2007. The Flowers group may indicate that they were relying more on the Bush Budget proposal, which is also discussed there. Yet, on the issue of whether the legislation was fully expected prior to the deal, one would assume case law establishing the prior knowledge would automatically bar raising the MAE issue. However, that is wrong. At this time, there is no specific case law that finds that the existing knowledge of the underlying situation would bar the MAC/MAE argument. In a case of Frontier Oil v. Holly, Erin Brockovich was threatening to file a lawsuit against the seller. Both parties knew about this before they signed. After the agreement was made, she filed the suit asking for significant damages. The court was not concerned with the issue that the buyer had prior knowledge.
The court will be the judge (because both sides waived there right to a jury) that will have to make the call. So what will the judger be looking at? Well, the court will probably look at the landmark case IBP Inc. v. Tyson Foods Inc. (2001 WL 675330, Del. Ch. June 18, 2001), in which the court found it was the person who is trying to walk away who has the burden of the uncertainty faced with difficulty in interpreting a MAC clause. In that case, the court reasoned that merger agreements are heavily negotiated and cover many specific risks explicitly. Thus, a party invoking a MAC clause should expect to encounter the difficult task of overcoming a strong public policy in favor of closing a merger agreement. Yet, it would be a question of the facts, which means it will be a long process. Looking to similar cases, in Frontier Oil v. Holly, No. 20502, 2005 WL 1039027 (Del. Ch. April 29, 2005), addressing the dollar loss, the court recognized that a pending "Erin Brockovich" lawsuit posed serious risks in terms of defense costs, and that these would be "substantial." It also recognized that the Beverly Hills litigation "could be catastrophic," with judgments of "hundreds of millions of dollars." However, the court concluded that these substantial defense costs could be borne by the buyer. In English, this means that the Flowers-led group is going to have to do all the work to try and convince the judge that it is an MAE and show how this loss income is really going to substantially hurt them.
My take: The Flowers-led group may not be able to succeed in showing that an MAE occurred. But, the group can cause a lot of litigation costs for Sallie Mae. But the true takeaway is that the agreement should have had language in it defining the effects of the possible legislation in regards to the agreement. But what do I know -- I am just a Trading Nymph. If you want to see another example of a MAC clause, check out the Guitar Center ( GTRC) takeover by Bain Capital Partners, a Boston-based private equity group. You can find the terms of the MAC in the Guitar Center 8-K filed June 27 in Article 7.2.1.