Material Adverse Effect Clauses

Things rarely go according to plan. Earnings are missed. Commercial relationships end. Regulatory approvals don’t materialize. Lawsuits get filed. And disasters happen. Such are the vicissitudes of business. But what happens when they transpire during the gap period between signing and closing an M&A transaction? Most sellers would argue that little if anything should happen—the deal should still close at the previously agreed-upon purchase price. Buyers, on the other hand, would counter that they shouldn’t bear the risk of adverse developments, particularly because sellers remain responsible for day-to-day operations of the target throughout the gap period.

Usually, the parties find a middle ground, where at least some of the risk is allocated to the seller. This is achieved through indemnification and termination provisions in principal transaction agreements, one important component of which is the concept of Material Adverse Effect (MAE), sometimes called Material Adverse Change (MAC).

In this post on The M&A Lawyer Blog, I will:

1. introduce the concept of Material Adverse Effect and explain its principal functions,
2. 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
3. describe key cases that provide important context for the preparation of MAE clauses.

Functions of Material Adverse Effect Clauses

MAE serves two primary functions in a transaction agreement. First, it qualifies (i.e., limits) various seller representations, warranties and covenants, establishing a relatively high threshold for disclosure or compliance relating to risks associated with changes in the target’s business. For example, a representation may provide that all liabilities of the target have been disclosed, “except for liabilities that would not have a Material Adverse Effect.” Thus, the MAE qualification renders some adverse events irrelevant and non-actionable under the agreement. Note that, in this context, the inclusion of the MAE concept is favorable to the seller because it reduces the disclosure obligations and risk of breach by the seller.

Second, MAE is operative in the conditions to be satisfied or waived before the buyer is required to consummate the deal. Specifically, an MAE must not have occurred during the gap period. Otherwise, the buyer may terminate the acquisition agreement. This is often referred to as a MAC out. Some 95% of M&A deals include a MAC out. In contrast with its use in reps, warranties and covenants, this application of the MAE concept favors the buyer by presenting it with the option to walk from a deal after its anticipated value has changed.

In both contexts, however, the seller will want to minimize the likelihood of occurrence of an MAE by narrowing which events and circumstances will satisfy the definition, and the buyer will seek to achieve the opposite.

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:

“Material Adverse Effect” means any event, change, circumstance, effect or other matter that has, or could reasonably be expected to have, either individually or in the aggregate with all other events, changes, circumstances, effects or other matters, with or without notice, lapse of time or both, a material adverse effect on (a) the business, assets, Liabilities, properties, condition (financial or otherwise), operating results, operations or prospects of the Acquired Companies, taken as a whole, or (b) the ability of the Company or the Seller to perform its obligations under this Agreement or to consummate timely the transactions contemplated by this Agreement.

By contrast, a relatively pro-seller definition intended to be difficult to satisfy might provide:

“Material Adverse Effect” means any event, change, circumstance, effect or other matter that has a material adverse effect on (a) the business, financial condition or results of operations of the Acquired Companies, taken as a whole, or (b) the ability of the Seller to consummate timely the transactions contemplated by this Agreement; provided, however, that none of the following, either alone or in combination, will constitute, or be considered in determining whether there has been, a Material Adverse Effect: any event, change, circumstance, effect or other matter resulting from or related to (i) any outbreak or escalation of war or major hostilities or any act of terrorism, (ii) changes in Laws, GAAP or enforcement or interpretation thereof, (iii) changes that generally affect the industries and markets in which any Acquired Company operates, (iv) changes in financial markets, general economic conditions (including prevailing interest rates, exchange rates, commodity prices and fuel costs) or political conditions, (v) any failure, in and of itself, of any Acquired Company to meet any published or internally prepared projections, budgets, plans or forecasts of revenues, earnings or other financial performance measures or operating statistics (it being understood that the facts and circumstances underlying any such failure that are not otherwise excluded from the definition of a “Material Adverse Effect” may be considered in determining whether there has been a Material Adverse Effect), (vi) any action taken or failed to be taken pursuant to or in accordance with this Agreement or at the request of, or consented to by, the Purchaser, or (vii) the execution or delivery of this Agreement, the consummation of the transactions contemplated by this Agreement or the public announcement or other publicity with respect to any of the foregoing.

And here’s how the two definitions differ:

“Material Adverse Effect” means any event, change, circumstance, effect or other matter that has, or could reasonably be expected to have, either individually or in the aggregate with all other events, changes, circumstances, effects or other matters, with or without notice, lapse of time or both, a material adverse effect on (a) the business, assets, Liabilities, properties, financial condition (financial or otherwise), operating or results, of operations or prospects of the Acquired Companies, taken as a whole, or (b) the ability of the Company or the Seller to perform its obligations under this Agreement orSeller to consummate timely the transactions contemplated by this Agreement; provided, however, that none of the following, either alone or in combination, will constitute, or be considered in determining whether there has been, a Material Adverse Effect: any event, change, circumstance, effect or other matter resulting from or related to (i) any outbreak or escalation of war or major hostilities or any act of terrorism, (ii) changes in Laws, GAAP or enforcement or interpretation thereof, (iii) changes that generally affect the industries and markets in which any Acquired Company operates, (iv) changes in financial markets, general economic conditions (including prevailing interest rates, exchange rates, commodity prices and fuel costs) or political conditions, (v) any failure, in and of itself, of any Acquired Company to meet any published or internally prepared projections, budgets, plans or forecasts of revenues, earnings or other financial performance measures or operating statistics (it being understood that the facts and circumstances underlying any such failure that are not otherwise excluded from the definition of a “Material Adverse Effect” may be considered in determining whether there has been a Material Adverse Effect), (vi) any action taken or failed to be taken pursuant to or in accordance with this Agreement or at the request of, or consented to by, the Purchaser, or (vii) the execution or delivery of this Agreement, the consummation of the transactions contemplated by this Agreement or the public announcement or other publicity with respect to any of the foregoing.

Broadly speaking, there are three differences between the definitions. First, the pro-buyer version includes forward-looking language, such as the phrase “could reasonably be expected to have” and the word “prospects.” Second, the list of direct objects on which effects will be measured in the buyer definition includes narrower categories, e.g., “assets” and “Liabilities,” and, third, the pro-seller definition includes a long list of exceptions.

Let’s consider each of these in turn.

Forward-Looking Language

The forward-looking language sought by buyers is intended to capture events or circumstances that have not yet, but may in the future, result in a materially adverse effect. Without this language, it’s conceivable that an eventuality that would certainly reduce a target company’s future value without having any impact on its current operations and earnings would not qualify as an MAE. An example would be a failure to obtain FDA approval for a new drug.

Interestingly, while M&A lawyers often get fairly animated in negotiating whether to include the word “prospects” in the MAE definition, they do not similarly struggle with inclusion of the “could reasonably be expected to have” language, which should be viewed by a court as having the same effect. The result is that less than 5% of deals include the word “prospects” while more than half include the “could reasonably be expected to have” language, reflecting a slightly buyer-favorable outcome here in most deals.

Material Adverse Effect on What?

The second difference between the pro-buyer and pro-seller versions of MAE relates to the object of the effect. The buyer version looks to include assets, liabilities, properties and non-financial condition, all of which were omitted from the seller version. The buyer’s objective in this case is to reduce the size of the denominator in assessing materiality. What may qualify as a material adverse effect on, say, a company’s liabilities or properties alone may not be material to the company as a whole, particularly where the target company didn’t have a lot of liabilities or properties to begin with. Once again, the buyer looks to make a given event or circumstance more likely to constitute an MAE.

MAE Exceptions

The final material variation between the two MAE definitions is the seller’s proposed inclusion of a long list of exceptions. Despite being omitted from the buyer favorable draft, virtually all MAE definitions include such lists in one form or another, though they may differ in their specifics. Some of the more common exceptions are those relating 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 particular configuration of exceptions depends on the specifics of the transaction and the parties’ expectations of areas of risk.  Importantly, though, the example MAE definitions I provided above have omitted an important feature that is today found in virtually all such lists of exceptions—that is, disproportionately impact language, which carves out exceptions from the MAE clause to assure that buyers have the protections of the provision if the target suffers more greatly than similarly-situated companies from a specified event or circumstance.

Such language is often appended to the end of the exceptions list and may provide as follows:

“except, in the case of clauses (i) through (iv), to the extent that such event, change, circumstance, effect or other matter adversely affects the Acquired Companies in a substantially disproportionate manner relative to other participants in the 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.

Key Material Adverse Effect Case Law

Unfortunately, case law interpreting MAE provisions is meager. However, three Delaware cases stand out as particularly important. They are:

• IBP, Inc. v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch. 2001);
• Hexion Specialty Chemicals, Inc. v. Huntsman Corp., C.A. No. 3841 (VCL) (Del. Ch. Sept. 29 2008), and
• Osram Sylvania, Inc. v. Townsend Ventures, LLC, C.A. No. 8123-VCP (Del. Ch. Nov. 19, 2013).

A quick Google search will reveal numerous articles about each of these cases, so I won’t retread old ground here. Instead, I’ll offer you the key takeaways from each case.

IBP vs. Tyson

After signing a merger agreement to acquire IBP for about $1.6 billion, Tyson asserted that IBP’s decline in performance (including a 64% drop in same quarter sales over the prior year) and a $60.4 million impairment charge arising from improper accounting each constituted an MAE.

In rendering its opinion, the court stressed that MAE must be interpreted in the larger context in which the parties were transacting. In particular, IBP’s past performance revealed strong swings in annual EBIT and net earnings. In addition, for a buyer that seeks to purchase a company as part of a long-term strategy, the impact of changes in the target’s earnings power must be considered over a “commercially reasonable period,” which the court stated should be measured in years rather than months.

The court stressed that a buyer must make a strong showing to invoke a MAC out, explaining:

Merger contracts are heavily negotiated and cover a large number of specific risks explicitly. As a result, even where a Material Adverse Effect condition is as broadly written as the one in the Merger Agreement, that provision is best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner. A short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror.

The court thus concluded that an MAE had not occurred and granted IBP’s request for specific performance to enforce the merger agreement.

Hexion v. Huntsman

Prior to this litigation, Hexion Specialty Chemicals attempted to exercise a MAC out under its agreement with Huntsman on the basis of a deterioration in Huntsman’s business during the gap period. Hexion focused its arguments on Huntsman’s repeated failure to achieve its forecasts as well as an increase in Huntsman’s net debt as compared to its projected decrease and the underperformance of two of Huntsman’s operating divisions.

The court concluded that, because Huntsman had specifically disclaimed any representations regarding projections, the failure to achieve targets could not be the basis of an MAE. The court also concluded that the proper way to determine the existence of an MAE is to compare current results against the prior historical period and found only a small decline (3-6%) over annual periods. In addition, the increase in net debt had been small (5%), and the Huntsman business units affected by the downturn contributed only 25% of overall EBITDA. Thus, all considered, no MAE had occurred.

The court then ruled that Hexion was obligated to consummate the acquisition, a transaction for which financing was no longer available.

Key takeaways from the decision include:

• It reaffirms the holding in IBP v. Tyson that parties seeking to invoke MAC outs bear a “heavy burden” to demonstrate that an MAE has occurred.
• Parties can reallocate the burden of proof in their agreement.
• The court noted that, as of the date of the opinion (2008), Delaware courts had never found a material adverse effect to have occurred in the context of a merger agreement.
• An MAE ordinarily will be “measured in years rather than months” and, thus, an MAE will not be found unless an adverse change is “consequential” to the target’s long-term earning power, rather than a “short-term hiccup.”
• The case suggests that buyers may wish to include specific metrics and benchmarks in their agreements because reliance on generalized MAE definitions to terminate will be difficult.
• MAE clauses will not be read in isolation, but will be viewed in the context of the entire agreement and the overall transaction.

Osram Sylvania

Unlike in IBP v. Tyson and Hexion v. Huntsman, here the court ruled in favor of the buyer. This case, though, involved a post-closing indemnity claim based on a purported MAE, rather than exercise of a MAC out. Specifically, Osram Sylvania Inc. (OSI) was a shareholder of Encelium Holdings that bought out the other shareholders. OSI sought indemnity for an MAE based on Encelium’s failure to meet sales forecasts and manipulation of financial results.

In considering the sellers’ motion to dismiss OSI’s contract and tort-based claims, the court held that:

• Acts of financial manipulation prior to execution of the agreement could lead to an MAE.
• Failure to meet sales forecasts could be an MAE.
• Failure to notify a buyer of missed forecasts usually will not constitute fraud.
• “Materiality scrapes” should generally not apply to “absence of MAE” representations.

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If you’d like more information about current practice in drafting Material Adverse Effect clauses, a terrific resource is Nixon Peabody’s Annual MAC Survey. The 2020 Survey is available here.