The Three Big Words at the Center of the Twitter Saga

Few M&A transactions have captured the public’s attention to quite the same degree as the ongoing saga surrounding Elon Musk’s bid to take Twitter private. What began as a simmering hostile takeover, evolved into a negotiated transaction that was then terminated by Musk and landed in the Delaware Court of Chancery for what looked like would be a protracted legal battle.

In the latest twist, Musk has now reversed course once again and stated that he would honor his original deal to purchase the social media company at the previously agreed amount of $44 billion on the condition that Twitter drops its lawsuit. Twitter, for its part, has indicated that it had received Musk’s letter and reiterated the company’s intention to close the deal.

It is anticipated that Twitter will seek to add conditions to any agreement that would make it increasingly difficult for Musk to change his mind again.

A careful analysis of the legal issues presented in the looming litigation reveals why it is unsurprising that, with Twitter failing to blink in the face of Musk’s legal threats, he has now come back to the table in an attempt to close the transaction.

Musk took the position in his Securities and Exchange Commission filings that he was legally entitled to terminate the transaction because certain alleged misrepresentations Twitter made as part of the acquisition agreement constituted a “material adverse effect.” In short, Musk’s claim rested on the notion that on account of Twitter’s malfeasance, it would be inequitable to require him to buy a business that, he claimed, was worth considerably less than what was contemplated when the agreement was signed.

While Musk’s argument might sound good on paper, prudent legal commentators were quick to point out that he faced a steep, uphill climb in having his claim validated in court. As we will see, instances of a Delaware Court finding that a “material adverse effect” has occurred are few and far between, so a ruling that one has occurred in this case would have been atypical.

Background

On April 25, 2022, Twitter Inc. and Musk (individually and through a corporation formed by him) entered into an Agreement and Plan of Merger providing for Musk’s acquisition of 100% of Twitter’s stock for a purchase price of $44 billion.

On July 8, Elon Musk terminated the Agreement and Plan of Merger, and Twitter immediately filed suit, asking the Delaware Court to enforce the terms of the original deal.

At stake in the lawsuit was the ownership of the social media conglomerate and the adjudication of whether Musk was required to pay a $1 billion reverse breakup fee to Twitter. Pursuant to the terms of the Agreement and Plan of Merger, Musk would be liable for the termination fee if the conditions to his obligations to close were satisfied and he nevertheless failed to close. Musk argued that he was justified in terminating the agreement because, among other reasons, Twitter misrepresented the number of its “false and spam accounts” in its SEC disclosures. Given that approximately 90% of its revenue comes from advertising, Musk’s team argued that the number of Twitter’s monetizable daily active users is a critical component of its future business prospects, and the misrepresentation of this figure allowed him to walk away under the terms of the Agreement and Plan of Merger because it constituted a “material adverse effect.” Indeed, Section 7.2(c) of the Agreement and Plan of Merger states that Musk’s obligation to close the transaction is conditioned on the stipulation that “no…Material Adverse Effect shall have occurred and be continuing” prior to the closing of the transaction.

What is a Material Adverse Effect?

A “Material Adverse Effect” is a legal term of art typically used in acquisition agreements as a standard materiality threshold to measure the negative impact of a particular event on the target business. This concept is sometimes used as a qualifier on a seller’s representations and warranties. For example, if a seller is asked to make a representation that it has disclosed all of its liabilities to the buyer, the seller may attempt to qualify its representation by representing that it has disclosed all liabilities “except for liabilities that would not have a Material Adverse Effect”. This gives the seller the comfort that it will not be found to have misrepresented its liabilities unless the liability it failed to disclose is something really bad. More often, it is utilized as a closing condition, thus allowing a buyer to terminate a transaction without penalty if the target business has suffered a Material Adverse Effect between the signing and closing of the transaction.

The Agreement and Plan of Merger contains a typical definition of Material Adverse Effect that operatively defines the term as “any change, event, effect or circumstance which, individually or in the aggregate, has resulted in or would reasonably be expected to result in a material adverse effect on the business, financial condition or results of operations of [Twitter].”

The Agreement and Plan of Merger also contains standard exceptions which provide that a Material Adverse Effect does not include materially adverse changes, events, effects or circumstances that result from general economic or political conditions, conditions that impact Twitter’s industry as a whole or force majeure events or other acts of god such as wars, terror attacks, natural disasters and the like.

What Constitutes a Material Adverse Effect?

While Material Adverse Effect provisions can often be the subject of much negotiation in the context of acquisition agreements, in practice, these provisions have not typically provided much protection for buyers who seek to use them to either enforce or terminate a transaction.

This reality began to set in with a pair of decisions in 2007-2008: the decision of the Tennessee Chancery Court in Genesco v. Finish Line and the Delaware Court of Chancery’s ruling in Hexion Specialty Chemicals v. Huntsman. In each of these cases, the buyers’ claim that the occurrence of a Material Adverse Effect allowed them to terminate an acquisition agreement was rejected despite evidence of clear downturns in the businesses being acquired. In Genesco, the Court found that Genesco had indeed suffered a Material Adverse Effect but that it was due to broader economic conditions and not disproportionate to its peers in the industry. In Hexion, the Court ruled that despite clear indications that the target business had declined, the invocation of a Material Adverse Effect requires a finding that the harm to the subject business be a “significantly durational” adverse event that is “expected to persist in the future.” Indeed, the Court in Hexion was sure to point out that “Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement.”

In fact, it was not until the Delaware Court of Chancery’s 2018 decision in Akorn v. Fresenius Kabi that a Delaware court has ever allowed a buyer to terminate an acquisition agreement on the grounds that a Material Adverse Effect had occurred. The Court in Akorn found that that the target company had experienced five straight quarters of decline that showed “no sign of abating” and could not be attributed to industry decline or other exceptions in the merger agreement. The Court also found “overwhelming evidence of widespread regulatory violations and pervasive compliance problems at Akorn” that would necessitate approximately $900 million in remediation. This figure represented approximately 21 percent of the equity value of the target and the court noted that a 20 percent loss in value “would reasonably be expected to result in [a Material Adverse Effect]”.

While the Akorn case finally broke the seal as the first Delaware Court of Chancery decision to permit a party to terminate an agreement based on the existence of a Material Adverse Effect, the facts and circumstances needed to declare a Material Adverse Effect remain extreme, as only a serious downturn in the business with long-term ramifications will qualify. This fact was confirmed by the Delaware Court of Chancery’s subsequent 2019 decision in Channel Medsystems, Inc. v. Boston Scientific Corp., where the Court found that the buyer had failed to prove a Material Adverse Effect notwithstanding seller’s material misrepresentations in the merger agreement because the buyer failed to show that the misrepresentations had a lasting effect on the target’s business.

Did Twitter Suffer a Material Adverse Effect?

The relevant case law demonstrates that proving the existence of a Material Adverse Effect remains a high bar to clear. Indeed, despite several cases involving buyers who entered into M&A transactions prior to the onset of COVID-19, not a single one successfully persuaded a court that it had met the burden for proving a Material Adverse Effect because of the pandemic or its financial consequences.

Accordingly, Twitter’s alleged inflation of the number of its monetizable daily active users would be, by itself, unlikely to convince a court that a Material Adverse Effect occurred unless Musk could have demonstrated that it was likely to have a significant long-term impact on Twitter’s earnings. Moreover, the fact that Musk waived his right to conduct due diligence on the target as part of the Agreement and Plan of Merger further weakened his case.

While Twitter’s share price, as of the writing of this article, has dropped by nearly 10% off the $54.20-per-share deal price in the Agreement and Plan of Merger, cause and effect is hard to prove, especially since the U.S. stock market, as a whole, has experienced a decline during the same period. Moreover, the controversies surrounding Musk himself may have also contributed to the decline in Twitter’s share price. A recent Wall Street Journal headline even went so far as to jest that “Elon Musk Is Twitter’s Material Adverse Effect.”

A recent publication by the Washington Post of a whistleblower report to Congress, the SEC, FTC, and DOJ looked for a moment like it may have been Musk’s saving grace. Filed by Peiter “Mudge” Zatko, Twitter’s former chief security officer, the report alleges that, among other things, Twitter is in violation of its obligations under data privacy, unfair trade practice, and consumer protection laws and regulations and that its platform was built in significant part on the misappropriation of third-party intellectual property. However, given Musk’s recent announcement of his intent to close the deal, his legal team likely advised him that even these revelations would not be sufficient to constitute a “material adverse effect”.

Given the twists and turns this transaction has already provided, it would be unwise to assume that this story is done. However, if Musk finds a way to wiggle his way out of this deal, it will unlikely be due to the finding that a “material adverse effect” occurred.

Reprinted with permission from the October 14, 2022, issue of the New York Law Journal^©, ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.