Material Adverse Effect Clauses in an Economic Downdraft
A version of this insight was published in Bloomberg Law, April 27, 2020
In this period of significant market volatility and economic headwinds, risk allocation provisions in M&A agreements are likely to be the subject of heightened focus by parties to deals and, potentially, the courts. One such provision is the material adverse effect (“MAE”) clause, a ubiquitous feature of corporate M&A agreements.1 In certain circumstances, an MAE clause allows an acquiror to walk away from a transaction between signing and closing if the seller’s business incurs “a significant deterioration … between signing and closing” that “threaten[s] the fundamentals of the deal.”2
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. To reacquaint readers with the dynamics of this possibility in pending deals, this article provides an overview on MAE provisions, a summary of recent MAE developments in Delaware courts, and a checklist of considerations for those who may become involved in a dispute over the meaning of an MAE provision.
Overview of MAE Provisions:
An MAE clause is among the principal tools that parties can use to allocate post-signing/pre-closing risk in an M&A transaction. These provisions are often heavily negotiated and will vary in important respects from one deal to the next, but 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. MAE clauses frequently appear in M&A agreements both as a qualifier to a seller’s representations and warranties, and as a condition to the acquiror’s closing obligations. In merger litigation, these clauses may also interact with other provisions of the agreement, such as an obligation to operate in the ordinary course post-signing, and/or to use best efforts to accomplish the closing.
Typically, MAE clauses do not define “material” or specify numerical thresholds, leaving it to courts to make fact-intensive findings in light of 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. Among the more common exclusions are general economic or industry conditions. But there is often a carveout to this exclusion—in effect an “exception to the exception”—providing that the general economic or industry condition can constitute an MAE to the extent that the condition disproportionately affects the seller. Other common exclusions include specific risks facing the seller’s business that the parties agree to shift to the acquiror; a failure to meet projections; and general calamities such as acts of God, terrorism, or pandemics—though in some cases a specific risk may be covered by a more general exclusion.3
Delaware Case Law Developments:
While MAE clauses provide a powerful recourse, acquirors face a heavy burden in invoking them as a basis to avoid closing, and have found limited success doing so in the courts. In its landmark IBP opinion, the Delaware Court of Chancery explained that an MAE 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.”4 This test cannot be met by a “short-term hiccup in earnings” or a general case of buyer’s remorse.5
In Hexion, another key MAE case (in which Vinson & Elkins represented the seller), the court required the acquiror to close while emphasizing that, to that point in time, “Delaware courts ha[d] never found a material adverse effect to have occurred in the context of a merger agreement.”6 But these decisions did not render MAE provisions toothless; a party’s bargaining leverage in amending or terminating an agreement was often informed by the possibility of an MAE finding.
That possibility finally materialized in late 2018 in Akorn, Inc. v. Fresenius Kabi AG,7 the first (and thus far only) Delaware case to find an MAE in the merger context. The dispute arose from Fresenius’s agreement to acquire Akorn, a generic drug manufacturer. After the signing, Akorn’s financial performance “fell off a cliff” when compared to prior periods and to guidance issued around the time of signing the deal.8 Additionally, widespread regulatory compliance issues came to light, which the court later estimated would cost roughly 20% of Akorn’s equity value to remedy. The court permitted Fresenius to terminate the merger because Akorn’s general business condition had experienced an MAE, and because Akorn had also breached its representations and warranties regarding regulatory compliance in a manner that could reasonably be expected to cause an MAE. The court distinguished prior cases that found no MAE on “quantitative and qualitative” grounds, including that: (i) Akorn’s regulatory problems affected the core of its business, and (ii) Akorn’s performance downturn was “dramatic” and “durationally significant” because the shortfall had “already persisted for a full year and shows no sign of abating.”9
The court in Akorn took pains to acknowledge the case’s somewhat extreme facts and to fit its reasoning within prior case law. Still, many commentators wondered whether the decision (and the Delaware Supreme Court’s affirmance) signaled an era of increased receptivity to MAE claims. But the Court of Chancery’s first significant post-Akorn MAE case—Channel Medsystems, Inc. v. Boston Scientific Corp.,10 decided in December 2019—appears to confirm that acquirors seeking to invoke MAEs will continue to face a heavy burden, even after Akorn. In Channel Medsystems, Boston Scientific sought to terminate its agreement to acquire Channel Medsystems after discovering that a Channel executive had submitted falsified documents to the FDA in seeking approval of Channel’s key product. The court agreed that the falsified application materials caused a material breach of several Channel representations and warranties, but noted that materiality was “analytically distinct” from the question of whether an MAE had occurred.11 The court held that an MAE had not occurred because Channel ultimately obtained the FDA license for its key product, and Boston Scientific had not presented sufficient evidence that the issue had dramatically impaired Channel’s long-term prospects. Suggesting that Boston Scientific invoked the MAE as a pretext to terminate the deal for unrelated reasons, the court further found that Boston Scientific had breached its covenant to use “commercially reasonable efforts” to close, and ordered the remedy of specific performance of consummating the transaction.12
Taken together, these cases indicate that an MAE finding typically requires a dramatic downturn that has persisted and/or is expected to persist over multiple quarters, and perhaps years. This analysis may turn partly on whether the downturn can be attributed to industry or market conditions that are expected to abate in the near future. The following chart summarizes the outcomes and key figures of these cases.
|IBP||No MAE found where the seller experienced a 64% quarterly decline in earnings from operations, but the downturn was partially due to weather and industry cyclicality, and the seller’s performance showed signs of recovery in the following quarter.13
|Hexion||No MAE found where first-half EBITDA in the year following the merger’s signing was down 20% from prior year, but the full year was expected to fall only 7% below prior year, and the downturn was caused partly by macroeconomic challenges and known market cyclicality.14|
|Akorn||MAE found where actual year-over-year revenues fell roughly 25% and operating income by over 100%; projected EBITDA for each of the following three years was lowered by over 60%; and these struggles were caused by company-specific issues including increased competition and loss of a key contract.15|
Considerations and Best Practices:
The Delaware decisions discussed above underscore a number of key points for disputes involving MAE provisions.
- Work constructively to address issues. The courts’ reluctance to allow parties to use an MAE as a convenient escape hatch is a prominent theme running through the case law. For example, commentators have noted that the court in IBP appeared to conclude the acquiror “itself did not believe there had been a material adverse effect, but, was, instead, suffering ‘buyer’s remorse.’”16 To mitigate the risk of being characterized in this manner by a counterparty or a court, an acquiror should work constructively with the seller regarding post-signing developments. As one example, the court in Akorn noted at length that Fresenius had met with Akorn and was “working hard to figure out how the deal could still work,” including “offer[ing] to extend the Outside Date for the Merger Agreement so that Akorn could continue its investigation and remediation efforts and, if Akorn thought it was possible, cure its breaches,” but “Akorn declined.”17 By contrast, in Hexion the court found no MAE after the acquiror “made the deliberate decision not to consult with [the seller] … prior to filing [its] lawsuit.”18 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, as occurred for Boston Scientific in Channel Medsystems.
- Investigate the problem, and document the analysis. 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. For example, in Channel Medsystems the court found that the lack of any documentation evidencing Boston Scientific’s investigation of the fallout from Channel’s document falsification “casts doubt on the bona fides of the termination decision,” particularly when combined with other evidence suggesting other unrelated motives for terminating.19 In addition to supporting a party’s good-faith motives, a robust investigation may provide the building blocks for any resulting litigation. Indeed, the parties’ conduct and findings during the exploratory pre-litigation phase may be given greater weight than evidence or testimony generated after the litigation begins. All parties in a potential MAE dispute should be cognizant that that their words and actions, whether directed internally or externally, may be shaping a future trial record—and that any such trial is likely to be highly expedited, as discussed below. 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. Parties should avoid asserting an MAE in a manner that could appear pretextual or as a post-hoc “add on” to other arguments for terminating the transaction.
- Timing may dictate the result. In addition to having unparalleled experience and expertise in complex corporate law disputes, the Delaware Court of Chancery is able to resolve these disputes expeditiously—sometimes in a matter of weeks. This speed can be particularly important in M&A litigation, where disputes between signing and closing can leave the parties in limbo. The timeline of a lawsuit often has significant ramifications for MAE disputes. For instance, Channel Medsystems may arguably have turned out differently had Channel not managed to obtain the FDA license before receiving notice of termination. Relatedly, an impediment to a seller’s business that triggers an MAE dispute may either intensify or abate with the passage of time, with significant implications given courts’ focus on a “durationally significant” impairment. Such was the case in Akorn, where the court emphasized that the performance struggles had already persisted for a year. Parties therefore should view a potential MAE as an evolving situation and update their analysis and arguments accordingly.
- MAE disputes are highly fact intensive, with somewhat unpredictable outcomes. As noted, MAE provisions rarely contain specific thresholds or definitions, leaving courts broad latitude to weigh all “qualitative and quantitative” effects on the seller. The court in Akorn found an MAE upon “qualitative” regulatory problems impairing 20% of the seller’s equity value and even more significant “quantitative” earnings declines over a years-long period. It also cited commentary and case law suggesting that 40-50% declines in revenue and profitability over consecutive quarters might suffice.20 But the court cautioned that there is no “bright-line test” for what level of impairment would constitute an MAE.21 The absence of a bright-line test means that parties should typically enter MAE litigation with an appreciation that the court’s inquiry will be broad, and the outcome far from certain. This dynamic, along with the fact that many MAE clauses are arguably open to multiple reasonable interpretations, often provides mutual incentive to entertain compromise. As the Akorn court observed, parties may “find it efficient to leave the term undefined because the resulting uncertainty generates productive opportunities for renegotiation.”22
- Consider the relationship between the performance of the seller versus that of its peers. 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 industry/market exception and “disproportionate effect” carveout to that exception, 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 challenges.
- MAE clauses are a creature of contract, and precise language matters. While lessons and principles can be gleaned from the case law, ultimately the result is likely to turn on the language of the particular agreement. In Akorn, the court stressed that Delaware’s “contractarian” approach requires application of the parties’ agreement, rather than reading in extracontractual concepts.23 Parties negotiating transactions during this turbulent time should therefore carefully consider how to address and allocate known risks, and any unique concerns facing the seller or its industry, in language that is as clear and unambiguous as possible under the circumstances.
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1 Some M&A agreements reference the substantially identical concept of a “material adverse change,” typically abbreviated as MAC.
2 Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347, at *47 (Del. Ch. Oct. 1, 2018) (Laster, V.C.).
3 We anticipate that many deals negotiated and signed in the near future will expressly address the allocation of risks arising from pandemics such as COVID-19. Indeed, surveys indicate that this is already underway. See Matthew Jennejohn, Julian Nyarko, and Eric Talley, A “Majeure” Update on COVID-19 and MAEs (March 26, 2020), available at https://clsbluesky.law.columbia.edu/2020/03/26/a-majeure-update-on-covid-19-and-maes/. But again, such a specific risk may be covered by a more general exclusion.
4 In re IBP, Inc. Shareholders Litig., 789 A.2d 14, 68 (Del. Ch. 2001) (Strine, V.C.).
6 Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008) (Lamb, V.C.).
7 2018 WL 4719347, at *47 (Del. Ch. Oct. 1, 2018).
8 Id. at *1.
9 Id. at *55.
10 2019 WL 6896462 (Del. Ch. Dec. 18, 2019) (Bouchard, C.).
11 Id. at *17.
12 Id. at *44.
13 789 A.2d at 22, 26, 45-48, 69-70.
14 965 A.2d at 740-46.
15 2018 WL 4719347, at *55.
16 Akorn, 2018 WL 4719347, at *92 (quoting Lou R. Kling & Eileen T. Nugent, Negotiated Acquisitions of Companies, Subsidiaries and Divisions, § 11.04, at 11-68 n.133).
17 2018 WL 4719347, at *2.
18 Hexion, 965 A.2d at 730.
19 2019 WL 6896462, at *30.
20 2018 WL 4719347, at *53, citing Raskin v. Birmingham Steel Corp., 1990 WL 193326, at *5 (Del. Ch. Dec. 4, 1990) (Allen, C.) (finding 50% decline in earnings over two consecutive quarters would likely be an MAE), and Lou R. Kling & Eileen T. Nugent, Negotiated Acquisitions of Companies, Subsidiaries and Divisions, § 11.04, at 11-66 (observing that courts may consider decreases in profits above 40% to constitute an MAE).
22 Id. at *48.
23 Id. at *77 n.756.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.