Material adverse effect ("MAE") or material adverse change ("MAC") definitions in transaction agreements have become more crucial as a result of the turbulence in the credit markets and the uncertain economy. In the last year numerous purchasers and their lenders have invoked these provisions in an effort to abandon transactions or to renegotiate transactions at a lower price. Because buyers are typically unable to negotiate a "financing out" in leveraged transactions, the MAE/MAC out has been asserted in numerous private equity fund transactions where the change in the credit markets and/or the economy resulted in the financing being unavailable or the deal becoming uneconomic.
The MAE/MAC definition in an acquisition agreement establishes the magnitude of a change in circumstances or a breach in the representations and warranties concerning the target that will relieve the buyer of its obligation to close. Negotiation of the MAE/MAC definition involves a balancing of the target's desire for deal certainty with the buyer's desire not to accept the risks of unknown events or changes occurring between the signing of the agreement and the closing.
It is crucial to tailor the MAE/MAC provisions of an agreement to reflect the understanding of the parties. This is difficult, however, because of the nature of the MAE/MAC definition itself. The basic definition typically reads as follows (with certain standard deviations in brackets):
"Material Adverse Effect [Change] means any event, occurrence, fact or circumstance which [, individually or in the aggregate,] has had [or is reasonably expected to have] a material adverse effect on the business, assets, condition (financial or otherwise), liabilities [,] [or] results of operations [or prospects] of the target and its subsidiaries, taken as a whole."
Because the term "material" in the foregoing definition is rarely quantified in the transaction agreement, there can still be a considerable difference of opinion between the buyer and the target as to what is material. While the purpose of a written contract is to define clearly the understanding of the parties, the MAE/MAC definition is a consistent exception to this rule. Buyers are reluctant to be more specific because they may miss something that could be material. As a result of the lack of specificity, however, the courts have struggled in the limited number of decisions addressing these types of provisions to define what is "material."
The definition of a MAE/MAC has been further muddled by the number of specific exceptions or carve-outs to the MAE/MAC definition that targets have been able to negotiate in recent years to enhance deal certainty. Any adverse effects resulting from these exceptions are not taken into consideration in determining whether a MAE/MAC has occurred. These exceptions typically include:
- changes in the economy in general
- changes in the industry in which the target operates that do not affect the target disproportionately
- changes in the financial or securities markets
- failure of the target to meet its financial projections (but not the underlying causes)
- changes resulting from entering into or announcing the transaction
- changes resulting from the parties' compliance with the agreement
- changes in law
- changes in generally accepted accounting principles
The case law addressing MAE/MAC provisions is very fact-specific and heavily dependent on the particular circumstances of each dispute, as well as the particular wording of each agreement. The cases do, however, make it clear that the materiality threshold is fairly high, at least higher than the securities law disclosure threshold and the accounting materiality threshold. The higher threshold reflects the view that the standard permitting a buyer to walk away from a transaction should be greater than that needed to trigger disclosure by a public company. In the IBP/Tyson Foods case in 2001, the Delaware Chancery Court held that the MAE/MAC clause will only protect a buyer "from the occurrence of unknown events that substantially threaten the overall earnings potential of the target" and that the events must be viewed from a long-term perspective. A short-term decline in earnings or another metric is not sufficient.
Even though the court decisions have been target friendly in the interpretation of what constitutes a MAE/MAC, the many recent disputes initiated by private equity fund buyers demonstrate the power these MAE/MAC clauses give to buyers in a turbulent credit market and a troubled economy. Even a weak argument that a MAE/MAC has occurred can provide a buyer with significant leverage in attempting to renegotiate the deal.
Whether you are the buyer or the target, do not treat the MAE/MAC provisions of the transaction agreement as being boilerplate. Rather, they should be reviewed and negotiated thoroughly and, to the extent feasible, reflect the specific understanding of the parties as to what will and what will not constitute a MAE/MAC.