In this period of significant market volatility and economic headwinds, risk allocation provisions in M&A agreements are likely to get more attention from parties to deals and, potentially, the courts.
One such provision is the material adverse effect (MAE) clause, which, in certain circumstances, allows an acquirer to walk away from a transaction if the seller’s business incurs a significant deterioration between signing and closing.
As the economics of some pending deals are likely to deteriorate significantly in the coming weeks and months, we anticipate that acquirors will increasingly consider invoking MAE provisions in an attempt to renegotiate or terminate signed deals.
Overview of MAE Provisions
MAE provisions generally provide that an acquiror is not required to close if an event occurs that has (or is reasonably expected to have with the passage of time) a material adverse effect on the seller’s business or financial condition. Typically, MAE clauses do not define “material” or specify numerical thresholds, leaving it to courts to evaluate the totality of circumstances.
MAE clauses do, however, ordinarily contain lengthy lists of exclusions that are defined to fall outside the scope of an MAE. We anticipate that many upcoming deals will expressly address the allocation of risks arising from pandemics such as Covid-19—though in some cases such a specific risk may be covered by a more general exclusion.
Delaware Case Law Developments
To qualify as an MAE, a circumstance must substantially threaten the overall earnings potential of the target company in a durationally significant manner. That is the lesson of two landmark opinions from the Delaware Court of Chancery: In re IBP from 2001, and Hexion Specialty Chemicals v. Huntsman Corp., from 2008.
In each of those cases, the Court of Chancery found that no MAE had occurred where, although the seller experienced disappointing quarterly earnings post-signing, those earnings showed signs of recovery and were partly explained by industry conditions that were expected to abate.
In 2018, the Delaware Court of Chancery found an MAE in the merger context for the first (and thus far only) time, in Akorn, Inc. v. Fresenius Kabi AG. The MAE finding there was based on: (i) widespread regulatory compliance issues that would cost roughly 20% of the seller’s equity value to remedy, and (ii) dramatic post-signing drops in every key financial metric that had already continued for a year with no signs of abating.
While some observers wondered whether Akorn would open the door to more MAE findings by courts, the Court of Chancery’s first significant post-Akorn MAE case—Channel Medsystems, Inc. v. Boston Scientific Corp., decided in December 2019—appears to confirm that acquirors seeking to invoke MAEs will continue to face a heavy burden.
There, the acquiror sought to terminate its merger agreement after discovering falsehoods in FDA applications for the seller’s key product. The court held that an MAE had not occurred because the seller ultimately obtained FDA approval, and the acquiror had not presented sufficient evidence that the issue had dramatically impaired the seller’s long-term prospects.
Considerations and Best Practices
These Delaware decisions underscore key points for disputes involving MAE provisions:
- Work constructively. The courts’ reluctance to allow parties to use an MAE as a pretextual escape hatch in the event of “buyer’s remorse” is a prominent theme running through the case law. To avoid this characterization, an acquiror should work constructively with the seller regarding post-signing developments. A failure to constructively engage or to complete interim post-signing steps also risks a finding of a breach of a party’s obligations to use best efforts toward closing.
- Investigate and document. Relatedly, the persuasiveness of the acquiror’s concern over the MAE-triggering event will depend in part on how rigorously the acquiror has investigated the issue. In addition to supporting a party’s good-faith motives, a robust investigation may provide the building blocks for any resulting litigation. Parties should also consider how investigating MAE-related issues may intersect with any information sharing rights or restrictions under the parties’ merger agreement and/or confidentiality agreements.
- Timing is critical. The timeline of a lawsuit often has significant ramifications for MAE disputes. An impediment to a seller’s business that triggers an MAE dispute may either intensify or subside with the passage of time, with significant implications given courts’ focus on whether a “durationally significant” impairment occurred. Parties therefore should view a potential MAE as an evolving situation and update their analysis and arguments accordingly.
- MAE disputes are fact intensive and somewhat unpredictable. Courts have broad latitude to weigh all qualitative and quantitative effects on the seller in assessing an MAE claim. The court in Akorn cited commentary and case law suggesting that 40%-50% declines in revenue and profitability over a durationally significant period might suffice, but cautioned that there is no bright-line test. Consequently, MAE litigation often entails substantial uncertainty, which may incentivize the parties to compromise.
- Relationship to peer performance. The court’s analysis may also turn on the extent to which the underperformance can be explained by macroeconomic trends, as in IBP and Hexion, compared to company-specific factors, as in Akorn. Where the seller’s industry peers are likewise underperforming, and the MAE clause at issue contains the standard exclusion for general market or industry conditions and “disproportionate effect” carveout to that exclusion, the acquiror will need to establish that the seller’s incremental underperformance compared to its peers itself rises to the level of an MAE. This may be difficult during times when essentially every market participant is facing significant economic challenges.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Michael Holmes is co-head of Vinson & Elkins LLP’s complex commercial litigation practice. Based in the firm’s Dallas office, he focuses on mergers and acquisitions, securities litigation, corporate governance, directors and officer representation, and commercial disputes.
Chris Duffy is a partner in Vinson & Elkins LLP’s New York office. His practice focuses on complex commercial trials and appeals, arbitrations, and government investigations.
Jeff Crough is a senior associate in Vinson & Elkins LLP’s Dallas office. He has represented clients at the trial and appellate levels in state and federal courts in a wide range of matters, including securities, breach of contract, and breach of fiduciary duty claims.