Diamond Foods Debacle May Crack Open a MAC A rare event occurred late on Wednesday in the deal world. Diamond Foods, the seller of Emerald snack nuts, announced it would restate its financial results for two years. It also placed its chief executive, Michael J. Mendes, and its chief financial officer, Steven M. Neil, on administrative leave. Throwing out executives is anything but rare these days, to be sure. But Diamond had previously agreed to acquire the Pringles brand from Procter & Gamble. So its restatement and executive changes likely constitute a real-life material adverse change, or MAC, giving P.&G. the right to terminate the acquisition, something P.&G. is now likely to do. And that almost never happens. A MAC is a clause placed in takeover agreements that allows a buyer to walk away if a material adverse change happens to the target company during the time a deal is announced and completed. Courts have interpreted MACs strictly, and a MAC is notoriously hard for a buyer to claim. During the financial crisis, courts repeatedly rejected attempts by buyers to walk away from deals by claiming a material adverse change. But the announcement that Diamond Foods will restate its earnings almost certainly meets the high threshold for a MAC. The earnings restatement is likely to be material. A $60 million momentum payment made in September 2011 will now be included in the company's 2011 fiscal results, which ended July 31. A similar $20 million momentum payment made in August 2010 will now be shifted from Diamond's 2011 financial results to 2010. Diamond earned only $50 million in 2011 and $26 million in 2010. One analyst and short-seller has estimated that Diamond's 2011 earnings would be reduced by this restatement to $1.14 a share from the previous number of $2.61 a share. And 2010 earnings would be similarly reduced. This is almost certainly a MAC. The courts have never said so, but the rule of thumb is that any accounting restatement that throws off earnings by 5 to 10 percent is material. In this case, earnings are likely to be reduced by more than 50 percent. And for those who like to cite cases, among the sparse MAC case law there is justification for such a large earnings drop being a MAC. For those who want to know more about MACs, including a list of those cases, read the case study I wrote in 2008 with Kristen Baiardi about the Accredited Home Lenders MAC dispute. The MAC clause in the Diamond/Pringles acquisition agreement is stricter than the typical MAC clause and requires a MAC to have an effect over more than two full fiscal years. But this is the case here. The payments will affect earnings in 2010, 2011 and 2012. Even if the accounting restatement were not a MAC, the Diamond/Pringles MAC clause has a second unusual feature. The parties have agreed that any change in the employment status of Diamond's senior management that is likely to result in a material adverse change on Diamond's future prospects is also deemed to be a MAC. While Diamond could argue that putting its management team on leave is not so bad, Pringles would have the better argument that the action has substantially harmed the company. If the clause was not meant to address this situation, what was it meant to do? The bottom line is that P.&G. appears to have very good grounds to walk away from this deal. As for Diamond, it is in a bad place. Its new acting chief executive is a director and its acting chief financial officer is from Alix Partners, a restructuring firm. Diamond will have to trudge through an accounting statement and the hiring of new executives. There is likely to be litigation brought by shareholders as well as possibly the Securities and Exchange Commission. Given all this, Diamond is unlikely to want to end up in another dispute with P.&G. over whether the terms of the MAC clause has been met. Expect Diamond to acquiesce quickly if P.&G. tries to terminate the deal. P.&G. could try to save the deal by renegotiating it. On Wednesday, the company was negative, but cautious, as a spokesman said the results of the inquiry were "very disappointing." But it is hard to see P.&G. renegotiating the deal. Diamond is paying for Pringles with stock, meaning that P.&G."s current shareholders are investing in Diamond (that is why P.&G. has a MAC clause here even though Diamond is technically not the target company, but the buyer). So P.&G. will most likely terminate the deal, and the only real question is whether it tries to make Diamond pay its expenses. Hopefully, P.&G. will have pity on Diamond and just walk away. It is no wonder that Diamond's share price has plummeted. The market hates uncertainty. The only winners are the short-sellers. Diamond's short interest as of January was 10.46 million shares, or about 48 percent of its outstanding float. People love to hate the shorts, but you have to give them ample credit in this case. Short-sellers first spotted the accounting problems at Diamond and highlighted them to the public. Diamond then clammed up for months, increasing the uncertainty and testing the resolve of the short interests.Those who stayed have been amply rewarded. A earlier version of this post misspelled the name of the packaged-goods company selling its Pringles brand. It is Procter & Gamble, not Proctor & Gamble.