Mythical Adverse Effect

The material adverse effect (“MAE”) definition in mergers and acquisitions agreements is one of the most intensely negotiated, litigated, and studied contract provisions ever. It has nearly tripled in average length over the past two decades, as lawyers haggle over almost every detail in deal after deal.

Against this inexorable trend, I argue in a forthcoming article that these endemic efforts to customize MAE definitions are in fact inefficient and counterproductive. Under Delaware law, standardized clauses could provide all the same benefits as customized ones, without any of the substantial but overlooked costs of prolonged negotiations. Rather than finetune and fight over MAE definitions, lawyers could achieve their goals more effectively by applying their limited leverage to other contract provisions.

The importance attributed to MAE definitions arises from the gap between signing and closing in large M&A transactions, when a party can walk away from the deal only if a specified closing condition is not satisfied. One of these conditions is an “MAE out,” which allows the buyer to terminate the contract if an MAE occurs. If this happened, the seller would struggle to find an alternative purchaser for the target, now considered damaged goods. Given these stakes, the contract’s definition of “Material Adverse Effect” may seem highly consequential.

Accordingly, the typical definition is lengthy and complex, beginning with a general rule that, essentially, an MAE is any event that has a (lowercase, undefined) material adverse effect on the target’s business. Next come several exceptions to that rule (or “carve-outs”) for various categories of events, followed by exceptions to those exceptions (or “carve-backs”). This structure is intended to allocate to the seller only target-specific risks within the seller’s control, leaving the buyer to bear all other risks.

While skirmishes over the general rule and carve-backs tend to be sideshows, the main event is the carve-outs, which sellers aim to add and broaden, and buyers seek to remove and narrow. Despite all this customization, the one part of the definition that parties never touch – the lowercase words material adverse effect in the general rule – is usually the only part that matters in litigation. While occupying most of a definition’s space, the carve-outs and carve-backs apply only if the relatively short general rule does; otherwise, the rest of the definition can be ignored.

Over the past two decades, the Delaware Court of Chancery has consistently set a high bar for materiality in the MAE context. They call the buyer’s burden of proving an MAE “heavy” and sometimes “nearly insurmountable” – and for good reason. An adverse effect on the target’s business, like a decrease in earnings, must be material not only in magnitude but also in duration, with extremely poor performance expected to last long into the future. This durational requirement is especially challenging because the period between signing and closing, when an MAE out would apply, typically lasts just a few months. During that short time, how can one prove that a sudden drop in earnings will last for years?

Indeed, in only one Delaware case, Akorn v. Fresenius in 2018, has a buyer established an MAE. Afterwards, many commentators expected that it would now be easier to meet this standard. But in the five years since Akorn, the Court of Chancery has continued to apply the same high standard for materiality as always. In fact, recent developments have made the buyer’s burden in establishing an MAE even “heavier” than before. If the court ever does find an MAE under this increasingly difficult standard, it will be because – as in Akorn – the facts are so egregious that no realistic alternatives to the definition’s language would change the result.

Given these stringent interpretive conventions, attempting to affect litigation outcomes cannot be the reason why lawyers spend so much time customizing MAE definitions. Nonetheless, some have suggested that negotiating these clauses could still be efficient for other reasons.

Perhaps the most common is “risk allocation.” An MAE out is supposed to allocate the “residual risk” – that is, the risks other than those specifically allocated by other provisions in the contract, like representations and covenants. Although lawyers may attempt to allocate risks through MAE negotiation, the resulting language does not achieve this goal. In fact, given Delaware’s lofty standard of materiality, the only risk that MAE definitions truly allocate is an unexpected, once-in-a-generation catastrophe that another contract provision does not already address. Because these risks are highly uncertain by nature, the parties cannot be expected to allocate them efficiently. Therefore, any attempt at risk allocation through MAE customization is unlikely to be more effective than a standardized definition.

Another longstanding justification is that an MAE out gives parties an incentive to settle claims instead of litigating. Strikingly, even without any chance of success in court, MAE claims do often lead to price renegotiations. However, this arises from an MAE clause’s mere presence, not its specific wording. Regardless of merit, a buyer’s public allegation of an MAE can significantly harm a target’s reputation, giving the seller an incentive to settle even if it would probably win at trial. In addition, while the vagueness of the words material adverse effect can help the seller if the case goes to judgment, this feature gives the buyer a procedural advantage in the meantime. Because so many facts are relevant to determining materiality, a seller cannot establish that there is no genuine issue of material fact, as required for summary judgment. Therefore, the buyer can maintain a lawsuit that will probably not succeed at trial. This is all a result of the words material adverse effect, which parties almost never negotiate. All the other language that they customize does not affect rational incentives to settle, which are the same under any realistic definition.

While not providing any substantial benefits, MAE negotiation does impose some significant costs. Although legal fees are often low in relation to M&A deal values, the opportunity costs of haggling over MAE carve-outs are far more significant. For example, if one party realizes that customized MAE language has no expected benefit, but the other does not, then the first party could grant concessions in the MAE definition in exchange for more valuable changes to other contract provisions. Since customized MAE language’s expected value is negligible, the opportunity cost of negotiating this provision equals the value of any other changes that one could obtain through logrolling in this manner. Another cost of MAE negotiation is delay. Even if money is no object in a large M&A deal, time is often invaluable, so any process that prolongs negotiation without any apparent benefit imposes a significant cost on parties under time pressure. In addition, because MAEs are primarily associated with deal failure, haggling over this definition can taint the parties’ relationship by signaling one’s doubts about the transaction. Finally, some common types of MAE negotiation, like the frequent practice of enumerating specific risks in carve-outs, could inadvertently lead to unfavorable judicial interpretations under standard canons of construction. To incur all these costs with no substantial benefit in return is simply inefficient and counterproductive.

My article considers various explanations for these problems, offers practical guidance for transactional lawyers to avoid them in M&A and beyond, and explores important implications for contract theory. For brevity, however, this post addresses only the most immediate question: What is a more efficient approach to drafting M&A contracts? Generally, instead of fighting over the MAE definition, a party should spend its limited negotiating capital on other provisions – typically representations, covenants, or conditions – where customization could allocate known risks more effectively. A standardized MAE definition, like the one in the ABA’s model merger agreement, would continue to assign unknown “residual” risks according to the typical division between seller and buyer.

In addition to allocating risks more effectively, this shift would refocus the conversation from deal failure to deal certainty, which could eventually facilitate price renegotiations more effectively than the current system of high-stakes brinksmanship. Today, parties devote valuable resources to haggling over many parts of a definition that do not matter in litigation, while ignoring the one part that does matter: the words material adverse effect. Because those words are vague, MAE litigation is so costly that sellers often settle even when they would probably prevail in court. Recognizing this incentive, buyers bring claims with no real chance of success on the merits just to wrangle a lower price when the target’s value drops slightly between signing and closing.

We can do better than this wasteful and convoluted practice. And with a more positive perspective, the brilliant lawyers who now spend so much time fighting over futile language choices could devise more direct, efficient, and predictable ways for deals to bend rather than break when circumstances change. Towards an improved approach, a departure from extensive MAE negotiation is a necessary first step.

This post comes to us from Naveen Thomas, the outgoing director of the Business Transactions Clinic at New York University School of Law and, beginning in July, a professor at Brooklyn Law School. It is based on his forthcoming article, “Mythical Adverse Effect,” available here.