Material Adverse Effect/Material Adverse Change Clauses

The Anatomy of a Deal Newsletter

This is the first piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions.

What is it?

A “Material Adverse Effect” is a common clause found in purchase agreements that impacts a deal’s closing and can have significant benefits for either Sellers or Buyers, but only if it’s written correctly. Here’s the complicated definition:

“Material Adverse Effect" means any event, occurrence, fact, condition or change that is, or could reasonably be expected to become, individually or in the aggregate, materially adverse to (a) the business, results of operations, financial condition, assets, liabilities, or prospects, or (b) the ability of the Seller to consummate the transactions contemplated in an agreement on a timely basis.

What does it really mean?

“Material Adverse Effect” (MAE) and “Material Adverse Change” (MAC) are mostly interchangeable terms that set a threshold for acceptable negative effects on a business. While they may vary depending on industry and scale, and could cover events ranging from failing to meet projections to terrorism, these clauses are primarily used in two ways:

  1. to qualify the Seller’s representations and warranties in the agreement (i.e., even if the Seller makes an inaccurate representation about the condition of the business during its sale, unless that inaccuracy causes a MAE/MAC to the business, this qualifier will save the Seller from liability to reimburse the Buyer); or
  2. as a condition to the closing of the transaction (i.e., the Buyer is excused from closing the transaction if a MAC/MAE occurs prior to closing).

MAE and MAC may seem straightforward, but the terms actually carry with them many years of litigation over their meaning. In fact, Delaware courts – the gold standard of corporate law (yes, seriously) – have never found a MAE/MAC that excuses a Buyer from closing on a deal. In order for a MAE/MAC to exist, the Buyer must prove a consequential effect on the company’s earnings that:

  1. exists over a long period of time (think years, not months); and
  2. was unforeseeable at the time the Buyer and Seller entered into the agreement.

Why Should I Care?

Buyer: Buyers should be very judicious in permitting Sellers to introduce MAE/MAC qualifiers in representations and warranties, as they create major hurdles for proving a breach. Using them, a Seller can easily and effectively shift much of the risk of unknown pre-closing liabilities to the Buyer. However, Buyers are not resigned to simply accept this risk. Although the terms often favor Sellers, careful crafting of an agreement’s definition of a “Material Adverse Effect” can give the Buyer a better chance of showing a MAE/MAC has occurred. For example, the definition at the beginning of this piece is favorable to Buyers because of its forward-looking language, broad categories, and few exceptions.

Seller: Obviously, Sellers would love to sprinkle MAE/MAC qualifiers everywhere throughout the agreement to minimize the risk of a post-closing claim against them. However, sophisticated Buyers will strongly resist this. Therefore, especially in a delayed-closing transaction (i.e., when the agreement is signed on one date, with the closing occurring later – much like a real estate transaction), the Seller should focus on using a MAE/MAC “bring down” standard so that the Buyer remains obligated to close the transaction in all cases, except only if a massive and unforeseeable event should occur prior to closing (e.g., the Seller’s only customer goes out of business prior to closing). A “busted deal” can be an enormous problem for a Seller as they may thereafter be viewed as “broken goods” in the market. So, the Seller should do everything possible to make sure the Buyer is obligated to close the deal. A MAE/MAC “bring-down” standard does just that.

Also, as noted above, the MAE definition shown at the beginning is extremely Buyer-favorable. Savvy Sellers will carefully negotiate this definition to (1) remove forward-looking language (e.g., “could reasonably be expected” and “prospects”), (2) limit the MAE/MAC to financial effects, as a qualitative change in the business that doesn’t affect its financial position arguably shouldn’t be considered a MAE/MAC, and (3) adding customary carve-outs so that certain events aren’t considered a MAE/MAC in any case (e.g., changes resulting from general economic conditions, political conditions, etc.).

Next Month: The Definition of Knowledge