Business transactions don’t always go as planned—earnings may fall short, partnerships can dissolve, regulatory hurdles arise, lawsuits surface and even disasters occur (remember COVID?). This uncertainty is especially significant during the interim period between signing and closing a merger or acquisition (“M&A”) deal. Sellers typically believe that these events should not affect the agreed purchase price or terms, while buyers argue that they shouldn’t bear the risk of negative developments that might impact the target company, especially since sellers continue to manage day-to-day operations during this period.
To balance these perspectives, M&A agreements often include terms that allocate some risk to the seller, such as indemnification and termination provisions. A critical part of these agreements is the Material Adverse Effect (“MAE”) clause, sometimes called a Material Adverse Change (“MAC”) clause.
Purpose of Material Adverse Effect Clauses
MAE clauses serve two main functions in an M&A agreement.
- Limiting Seller Representations, Warranties, and Covenants: MAE clauses set a high threshold for events that must be disclosed or conditions that must be met, focusing only on significant changes in the target’s business. For instance, a seller’s representation may state that all liabilities have been disclosed “except for those that wouldn’t result in a Material Adverse Effect.” Here, the MAE clause benefits the seller by reducing their disclosure obligations and the risk of breach.
- Setting Conditions for Deal Closure: If an MAE occurs during the interim period, the buyer may have the right to terminate the agreement, also known as a “MAC out.” Over 90% of M&A agreements include such a provision. This use of the MAE clause favors buyers, giving them a chance to withdraw if the deal’s anticipated value decreases substantially.
In both scenarios, sellers aim to narrow the scope of MAE clauses to reduce the likelihood of termination, while buyers seek broader terms to allow flexibility if adverse changes occur.
Material Adverse Effect Definitions: Pro-Buyer vs. Pro-Seller
MAE definitions differ in scope and language, depending on whether the terms favor the buyer or the seller.
- Pro-Buyer Example: A broad MAE definition might state:
“Material Adverse Effect” means any event, change, circumstance, or other matter that has or could reasonably be expected to have, a material adverse effect on (a) the business, assets, liabilities, properties, or financial condition of the Acquired Companies as a whole, or (b) the ability of the Seller to fulfill obligations or complete the transaction as agreed.
This definition is broad and includes “forward-looking” language, allowing the buyer to act on potential future risks, rather than only current ones.
- Pro-Seller Example: A narrower MAE definition might say:
“Material Adverse Effect” means any event or change that has a material adverse effect on (a) the business or financial condition of the Acquired Companies as a whole, or (b) the Seller’s ability to complete the transaction, but excludes matters arising from (i) war or terrorism, (ii) regulatory changes, (iii) industry-wide changes, (iv) economic fluctuations, (v) failure to meet projections (unless due to reasons not excluded), and (vi) actions requested or consented to by the Purchaser.
This pro-seller version has limited reach and excludes certain risks beyond the seller’s control, thus reducing the likelihood of the clause being triggered.
Key Differences in MAE Definitions
- Forward-Looking Language: Pro-buyer definitions often include phrases like “could reasonably be expected to have”, allowing potential future risks to be considered.
- Targeted Impact Areas: Buyers might include narrower categories like “assets” and “liabilities” in MAE definitions to create specific triggers for potential withdrawal, while sellers favor a focus only on broad operational or financial performance.
- Exceptions: Pro-seller definitions often list events or circumstances that won’t be considered MAE triggers, like economic downturns or regulatory shifts. This list is common in most agreements, although the specific inclusions vary.
- Disproportionate Impact Clause: To moderate seller-favorable exceptions, a “disproportionately impacts” clause is frequently added, stating that if the target company is affected more severely than its industry peers by an event, the buyer may still terminate. This balances the exceptions by protecting the buyer if the target is uniquely affected by a listed circumstance.
MAE clauses are pivotal in M&A agreements, helping balance the risks between buyers and sellers during the period leading to deal closure. Buyers look for clauses that allow flexibility in the face of potential downturns, while sellers aim to limit their scope, ensuring that only significant adverse changes impact the deal terms. Through negotiation, both parties can define MAE clauses that address their unique concerns and reflect the expected risks of the transaction. These are carefully drafted provisions and just one more example of why “off the shelf” contracts are shunned.
