What’s an MAE?
The Material Adverse Effect provisions in an acquisition agreement are negotiated carefully because they have important implications for both the seller and the buyer. Courts have interpreted these provisions in a relatively “seller friendly” way, requiring the buyer to prove that the target company has suffered a compelling and sustained adverse impact before finding that an “MAE” has occurred. Accordingly, private equity professionals should consider these provisions carefully to ensure that their acquisition agreements contain the protections they intend.
This newsletter will discuss why the definition of MAE is so important, certain factors to consider when negotiating the MAE provisions, how courts have interpreted these provisions and related issues of interest to private equity funds. We have also attached brief summaries of various court decisions, which highlight the facts that have led courts to conclude that an MAE has, or has not, occurred.
Why MAE is so Important
Although a buyer is eager to purchase the target business at the agreed price and terms when it signs the acquisition agreement, the buyer (and its financing sources) may not want to complete the transaction if there are material, adverse developments before the closing is scheduled to occur. Routinely, private equity funds and their financing sources include some form of MAE closing condition in their acquisition agreements. The seller, who is committed to selling the business, wants very limited circumstances (ideally none) that would permit the buyer to walk away from the deal after the acquisition agreement is signed.
Perhaps the most important purpose for the MAE definition, therefore, is usually found in the closing conditions:
- The seller usually represents that no Material Adverse Effect has occurred since the date of the target’s last audited (or unaudited) financial statements, so if this representation is untrue at closing, the buyer generally is not required to close the transaction;
- Most acquisition agreements include a closing condition requiring that seller’s representations and warranties must be true at the time of the closing (typically, ignoring materiality and MAE qualifiers contained in the representations themselves), with only such exceptions as would not in the aggregate reasonably be expected to have a Material Adverse Effect, or a similar formulation;
- The acquisition agreement often contains a specific closing condition requiring that there shall not have occurred any development that has had, or would reasonably be expected to have, a Material Adverse Effect; and
- If the acquisition agreement includes a financing condition, the lender’s financing commitment will almost always include an MAE condition so an MAE may prevent the financing condition from being satisfied.
If any of these closing conditions is not satisfied, the buyer would not be required to close the agreed acquisition—a relief for the buyer, but a real problem for the seller who must then manage both the MAE and a business that is no longer part of its long term strategy.
The MAE definition is also important after the closing, because the buyer may have a claim for breach of the seller’s representation that no MAE has occurred since a specified date, and also because certain representations and warranties may be qualified by MAE (for example, the seller may represent that a statement is true “except as has not had and would not reasonably be expected to have, a Material Adverse Effect”). The broader the definition of MAE, the broader is the exception, so the less likely it is that any such representation will be found to have been breached. The occurrence of an MAE typically also will give the buyer a right to terminate the acquisition agreement.
What the Definition of MAE Should Include (and Exclude)
The buyer’s starting point for the general definition of Material Adverse Effect is usually quite broad. For example:
“Material Adverse Effect” means any material adverse change or effect on the business, condition (financial or otherwise), assets, results of operations or prospects of the Company and its Subsidiaries, taken as whole.
The seller will almost inevitably remove the reference to “prospects” because this reference introduces the possibility that speculative developments might allow the buyer to walk away from the deal. The buyer, on the other hand, invariably wants the MAE provisions to take into account future implications. To bridge this gap, a buyer will generally require that the representations and closing conditions must consider developments that would “reasonably be expected to have a Material Adverse Effect.” The buyer may then rely on this forward-looking, but more objective, standard for qualifying the representations and determining its obligations to close.
A seller will typically want to exclude from the general MAE definition, certain specific potential developments to achieve more certainty of closing. Exceptions that are often considered include changes or effects:
- resulting from the announcement of the sale transaction or seller’s compliance with its obligations under the acquisition agreement;
- generally affecting any industry in which the target company or its subsidiaries operate;
- affecting economic market or political conditions generally;
- attributable to changes in laws, rules or regulations; and
- resulting from threats, or the commencement or continuation, of acts of terrorism or war.
These exceptions must be carefully negotiated between the buyer and seller in light of the circumstances of the particular target company and the risks that each party is willing to bear. For example, a buyer may conclude that it is willing to assume the risk of changes affecting the industry generally, but only if those changes do not have a disproportionate effect on the target company and its subsidiaries.
With most MAE definitions, there remains a significant question as to what developments are sufficiently “material” to constitute an MAE. Future disputes regarding what constitutes an MAE may be avoided if a dollar threshold is included in the definition. For example, the following qualification may be added to the definition:
“Without limiting the generality of the foregoing, a “Material Adverse Effect” shall be deemed to have occurred if the applicable change or effect, individually or in the aggregate with all other changes and effects, has resulted or would reasonably be expected to result in any liability to the Company and its Subsidiaries, taken as a whole, or a diminution in the value of the Company and its Subsidiaries, taken as a whole, in either case of $X million or more in the aggregate.” (It would be useful to describe how “value” would be determined for this purpose.)
More specific thresholds (e.g., maximum decline in EBITDA or other factors) would also help to avoid future disputes in interpreting MAE provisions. These can be difficult to negotiate, however, and a buyer will often want to retain some flexibility in the definition to capture the potential for adverse occurrences that it is unable to foresee when it signs the acquisition agreement (the “unknown unknowns”).
Court Interpretations of “Material Adverse Effect” Clauses
If an adverse development occurs but the buyer and seller disagree whether the adverse development constitutes or has caused an MAE, the dispute ultimately may have to be resolved by a court. In general:
- Courts have interpreted MAE provisions from a relatively “seller-friendly” perspective. In considering whether an MAE has occurred, the court will examine all of the facts and circumstances, including both quantitative and qualitative factors, and will find that an MAE has occurred only if the buyer can show that there has been a very compelling and sustained impact on the target company.
- Courts have expressly cautioned that the materiality standard used for SEC disclosure purposes does not apply in the context of material adverse effect provisions in acquisition agreements.
- If the definition or use of MAE in the acquisition agreement does not refer to “prospects” or potential future implications of adverse changes, the courts will not accept arguments that expected losses or liabilities support a claim that an MAE has already occurred.
- Courts tend to assess materiality from the perspective of the buyer, with attention to the buyer’s particular needs and attributes. Particularly for strategic buyers, a “short-term hiccup” in earnings would not suffice; rather, the event must be material when viewed from the longer-term perspective of a reasonable buyer.
- The MAE clause is viewed as a backstop protecting the buyer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target. The greater the buyer’s knowledge of the risks and contingencies, the less likely it is that a court will find that an MAE has occurred. Courts thus place a high value on the seller’s prior disclosure of its risk factors.