DEAL LITIGATION SERIES: PART THREE OF FOUR
WHAT YOU NEED TO KNOW IN A MINUTE OR LESS
Material Adverse Effect (MAE) or Material Adverse Change (MAC) clauses are common in merger and acquisition (M&A) agreements. They allow a buyer to opt out of a deal if some significant negative change occurs to the target company prior to closing. While simple in concept, MAE clauses are difficult to implement. Parties often dispute what rises to the level of a material adverse change or effect, and courts have noted the lack of bright-line test. A well-drafted MAE definition is key to avoiding ambiguity and potential litigation.
In a minute or less, here is what you need to know about negotiating and drafting MAE clauses to avoid uncertainty.
When crafting MAE clauses, particular attention should be paid to the changes excluded from the MAE definition. Sellers should identify those anticipated or probable events that could impact their company’s earnings—especially if they are industry-specific—and push for their inclusion in the list of exceptions. For example, a seller in the hospitality industry might push to include pandemic-related losses in the exceptions list, or a health care seller may seek protections surrounding the rate of government procedure reimbursement.
Buyers, on the other hand, should carefully scrutinize and limit the list of carve-outs. Buyers should negotiate an exception, stating that some or all carve-outs are not to be excluded from the MAE definition if their occurrences disproportionately affect the target company in comparison to similarly situated companies. Should an adverse event (such as a pandemic) disproportionately affect the target company, it may be due to the target company’s own ill-planning (worse distribution, access to supply, etc.). In these circumstances, the seller should bear the risk.
Consideration also should be given to whether the MAE clause is forward-looking. Most definitions cover events that have had—or are “reasonably expected to have”—a material adverse effect on earnings. This allows a buyer to declare a MAE based on reasonably anticipated earnings losses, even when such losses have not yet occurred. Of course, such forward-looking language benefits buyers, while excluding such language (to focus solely on events causing current losses) favors sellers.
Many courts have held that, to invoke MAE clauses, buyers must demonstrate adverse changes in the target company that are consequential to the company’s long-term earning power. This has proven a difficult standard to meet.
As a work-around, many MAE definitions include an impairment clause, stating that a MAE occurs if a change materially impairs the seller’s ability to close the transaction. This potentially allows buyers to declare a MAE based on more short-term disruptions impacting the seller’s ability to close, even if the disruptions are not long-lasting enough to otherwise constitute a MAE.
Other considerations include whether the MAE definition should include:
Events and circumstances known to the parties at the time the agreement is executed;
The departure of key personnel; or
A description of specific non-exclusive financial outcomes that would trigger a MAE.
To avoid costly litigation, it is critical that parties give careful consideration to the circumstances under which a buyer can or cannot walk away from closing.