Material Adverse Effect Clauses
In the course of business, things often deviate from plans: earnings might fall short, business relationships dissolve, regulatory approvals stall, lawsuits arise, and unforeseen disasters occur. These are the uncertainties of the business landscape. But what happens when such events occur between signing and closing an M&A deal? Sellers typically argue that the deal should proceed at the agreed-upon price despite these occurrences. Conversely, buyers contend that they shouldn't shoulder the risk of adverse developments, especially because sellers maintain control of the target's operations during this gap period.
Usually, a compromise is reached where some of the risk is shifted to the seller. This is facilitated through indemnification and termination provisions in primary transaction agreements, with one crucial aspect being the concept of Material Adverse Effect (MAE), also referred to as Material Adverse Change (MAC).
In this post on The M&A Lawyer Blog, I will:
introduce the concept of Material Adverse Effect and explain its principal functions,
present pro-buyer and pro-seller versions of MAE definitions and explain how, and why, they differ, including with respect to forward-looking language and common qualifications, and
describe key cases that provide important context for the preparation of MAE clauses.
Functions of Material Adverse Effect Clauses
The Material Adverse Effect (MAE) plays a dual role in a transaction agreement. First, it acts as a qualifier, setting a relatively high standard for certain seller representations, warranties, and commitments. It establishes a threshold for disclosure or compliance related to risks associated with changes in the target company's business. For instance, a representation might state that all target liabilities have been disclosed, "except for liabilities that would not result in a Material Adverse Effect." Therefore, the inclusion of MAE renders certain adverse events irrelevant and not actionable under the agreement. It's important to note that in this context, the incorporation of the MAE concept benefits the seller by reducing disclosure obligations and the risk of breach.
The Material Adverse Effect (MAE) has a second role in determining the conditions necessary for the buyer to finalize the deal or waive certain requirements. Essentially, an MAE must not have occurred during the gap period; otherwise, the buyer may opt to terminate the acquisition agreement, often referred to as a MAC out. Almost 95% of M&A deals include a MAC out provision. Unlike its use in representations, warranties, and commitments, this application of the MAE concept benefits the buyer by allowing them the option to step away from a deal when the expected value has changed.
However, in both scenarios, the seller aims to minimize the chance of an MAE by limiting which events and circumstances satisfy the definition, whereas the buyer seeks to broaden the scope to achieve the opposite effect.
Material Adverse Effect Definition
Virtually all acquisition agreements include a formal definition of Material Adverse Effect in the Definitions section. Here’s a pro-buyer example, intended to cast a wide net:
A "Material Adverse Effect" refers to any event, change, circumstance, or other matter that has or could reasonably be anticipated to have, either on its own or in combination with other events, changes, circumstances, effects, or matters, with or without notice or the passage of time, a significant negative impact on: (a) the overall business, assets, liabilities, properties, condition (financial or otherwise), operating results, operations, or prospects of the Acquired Companies, considered as a whole; or (b) the ability of the Company or the Seller to fulfill their obligations under this Agreement or to promptly complete the transactions outlined in this Agreement.
By contrast, a relatively pro-seller definition intended to be difficult to satisfy might provide:
A "Material Adverse Effect" refers to any event, change, circumstance, or other matter that significantly and negatively affects: (a) the combined business, financial status, or operational outcomes of the Acquired Companies; or (b) the Seller's capability to timely complete the transactions described in this Agreement. However, certain factors, whether individually or in combination, will not be considered in determining a Material Adverse Effect, including events related to: (i) war, major hostilities, or terrorism outbreaks, (ii) alterations in laws, accounting principles, or their enforcement, (iii) general changes affecting the industries and markets where the Acquired Company operates, (iv) shifts in financial or economic conditions, including interest rates, exchange rates, commodity prices, and political conditions, (v) failure of the Acquired Company to meet projected financial performance unless underlying circumstances not excluded from the Material Adverse Effect definition are evident, (vi) actions taken in compliance with this Agreement or at the request or consent of the Purchaser, or (vii) the execution or fulfillment of this Agreement or the transactions outlined here or any public announcement concerning these matters.
Forward-Looking Language
Buyers aim for forward-looking language in defining an MAE to cover potential events or circumstances that haven't yet caused a significant adverse effect but could do so in the future. Without such language, certain eventualities that could markedly reduce a target company's future value, without affecting its current operations and earnings, might not qualify as an MAE. For instance, the failure to secure FDA approval for a new drug is an example.
Interestingly, while M&A lawyers vigorously negotiate the inclusion of the term "prospects" in the MAE definition, they don't grapple with incorporating the phrase "could reasonably be expected to have," which has a similar effect. Consequently, less than 5% of deals include "prospects," while over half involve the "could reasonably be expected to have" language. This reflects a slightly favorable outcome for buyers in most deals.
Material Adverse Effect on What?
Another contrast between the buyer-oriented and seller-oriented versions of MAE concerns the scope of the effect. The buyer's version seeks to encompass assets, liabilities, properties, and non-financial condition, aspects that were omitted from the seller's version. The buyer's intention here is to decrease the scope of assessment for materiality. An event or circumstance that might qualify as a significant adverse effect on, for instance, a company's liabilities or properties alone may not be considered significant when viewed in the context of the entire company, especially if the target company had minimal liabilities or properties to start with. Once more, the buyer aims to increase the likelihood of a particular event or circumstance being deemed an MAE.
MAE Exceptions
The seller's version includes an extensive list of exceptions, which is absent from the buyer's favorable draft. However, almost all MAE definitions contain such lists in some form, although they may vary in their details. Some prevalent exceptions pertain to:
changes in the economy or business in general,
changes in general conditions of the specific industry,
changes in the securities markets,
changes in the trading price or trading volume of a target’s stock (in public deals),
acts of war or major hostilities,
acts of terrorism,
Acts of God,
changes in political conditions,
changes in laws or regulations,
changes in interpretations of laws by courts or government entities,
effects of announcement of the transaction,
changes caused by the taking of any action required or permitted or in any way resulting from or arising in connection with the agreement,
changes in Generally Accepted Accounting Principles (GAAP) and
failure by the target to meet revenue or earnings projections.
Less frequently, you may encounter exceptions relating to:
changes in interest rates,
changes in exchange rates,
national calamities,
international calamities directly or indirectly involving the U.S.,
changes resulting from bankruptcy or actions of a bankruptcy court,
changes in applicable taxes or tax law,
employee attrition,
changes in the target’s relationship with any labor organization or union,
reduction of the target’s customers or decline in its business,
seasonal reductions in revenues,
delays or cancellations of orders for services or products,
developments arising from any facts that were expressly disclosed to the buyer or the public,
expenses incurred in connection with the transaction,
actions required to be taken under any law or existing contract by which the target is bound and
litigation resulting from any law relating to the agreement or the transactions.
The specifics of the exceptions list hinge on the transaction's details and the parties' assessment of risk areas. However, the MAE definitions I previously shared lack a crucial feature now present in almost all exception lists—the inclusion of disproportionately impactful language. This aspect carves out exceptions from the MAE clause to ensure that buyers are protected under the provision if the target experiences a more significant impact than comparable companies from a specified event or circumstance.
Such language is often appended to the end of the exceptions list and may provide as follows:
"excluding, for clauses (i) through (iv), unless such event, change, circumstance, effect, or other matter negatively impacts the Acquired Companies significantly more than other entities in their industry and markets."
This has a moderating effect on the pro-seller list of exceptions and makes the inclusion of exceptions less objectionable to the buyer.