By Thomas Warren, Garrett Hollis and Jackson Allen

Law360 (May 18, 2020, 4:24 PM EDT )

Tom Warren

Garret Hollis

Jackson Allen

With the advent of COVID-19 and all of the related business, economic and governmental disruption it has caused, many clients that have entered into acquisition agreements are asking their attorneys whether resulting changes in the business have triggered a breach of the seller's representations or covenants, and whether they would create a "material adverse effect" relieving a buyer of its obligation to close.

We have already seen the first cases being brought and eager anticipation of potential new law from Delaware guiding us on what constitutes an MAE.[1]

Attorneys are advising their clients of the rich history of Delaware case law, the rarity of finding of an MAE, and the "durationally significant" nature of the effect that the buyer must show. But ultimately, practitioners wisely hedge their views — especially if the contract is governed by law other than Delaware's — and fall back to a caveat that it ultimately will depend on facts and circumstances and that no one knows exactly what constitutes an MAE.

Stop and think how remarkable it is that agreements drafted by the most sophisticated attorneys in the country, for billion-dollar deals, are so unclear on such critical questions: Has the seller breached the agreement? Do I have to close the deal or do I have a right to terminate?

Two key jobs of the negotiating attorneys are to help clarify the parties' respective obligations in light of future events and to fairly allocate risk between the parties. What if you could easily revise your acquisition agreement to add certainty to the parties' obligations to close and to remedies for potential breach, simplify and reduce negotiation, and improve overall fairness to both parties?

We offer a new paradigm for allocating the risks of a breach of the agreement by the seller, through eliminating the concept of material adverse effect and replacing it with remedies defined by measurable loss.

MAE Background

Every transactional lawyer is intimately familiar with MAE language. A staple in acquisition and financing agreements, attorneys have punted transactional uncertainty to MAE language since the 1940s.[2] Initially a simple provision, MAEs have evolved in recent decades into drafting monstrosities, as sellers seek to rein in the events triggering MAEs to those within the seller's control.

Drafters typically begin with a relatively simple base definition of material adverse effect. In an acquisition context, that might read: "any occurrence, condition, change, development, event or effect that has, or reasonably is expected to have, a material adverse effect on the business, properties, financial condition, or results of operations of Seller."

Today, however, attorneys subject the base definition to negotiated exceptions for everything from war, to terrorism, to labor unrest — and soon, we are sure, to epidemics. A recent survey of MAE clauses identified an average of 14.1 exceptions per definition,[3] not to mention the exceptions to the exceptions.

In addition to the MAE clause itself, attorneys extensively haggle over materiality and MAE language in the representations and warranties, closing conditions and indemnification provisions. Very rarely do drafters specifically define an MAE in terms of a dollar value or specific circumstance.

Despite all of this negotiation and careful drafting, even grizzled M&A veterans struggle to give a useful example of an MAE or helpfully define it. Courts have provided varying and ambiguous directions as to when an adverse event is "material." Delaware courts look for adverse changes in a target's business with long-term consequences over a commercially reasonable period,[4] from the perspective of a reasonable buyer,[5] and a court may consider qualitative and quantitative factors.[6]

What that means to real parties is inconsistent. A 7%-11% drop off in earnings before interest, taxes, depreciation and amortization was not an MAE,[7] nor was a 64% drop in consecutive quarterly earnings when only a short-term swing in a volatile industry.[8]

One leading treatise identifies a more than 40% drop in profits as a range where courts often find an MAE.[9] At one point, Chancellor William Allen of Delaware suggested a decline in earnings of 50% over two consecutive quarters is likely an MAE.[10] Even after 2018, when a Delaware court identified an MAE for the first time, it only served as another data point based on overwhelming facts.[11]

The result is a standard that almost all agree is high, but no one knows exactly how high. To determine how high requires judicial input.

MAEs' Function in Acquisition Agreements

To eliminate MAEs, we must ensure contracts will not suffer in their absence. That requires understanding the functional role that MAE language plays in acquisition agreements. MAE language serves three core functions.

The first is to condition the buyer's obligation to close on the absence of an MAE. Sometimes this closing condition takes the form of a stand-alone closing condition, and other times takes the form of a representation and warranty by the seller that no MAE has occurred, the agreement accuracy of which is a condition to closing.

Second, acquisition agreements often employ MAE language to qualify the bring-down of the buyer's and seller's representations and warranties to closing. This can be contained within specific representations, but often those are "scraped" (i.e., read out), and one global MAE qualifier is applied to the accuracy of all representations and warranties at closing. This is the same general purpose as the MAE condition, which is to provide relief from closing, but is applied in the context of specific representations.

Third, MAEs serve to limit indemnification claims for breaches. Indemnities depend on a breach of a representation, warranty or covenant, which may be qualified by materiality or MAE, before a party can claim indemnification due to a breach of the representations and warranties. Negotiators squabble over whether materiality or MAE qualifiers are scraped for both determining whether a breach has occurred and calculation of losses, or only as to calculation of losses.

Despite the thoroughness of practitioners to implement the intended function of MAEs, due to the interpretation of MAEs, an often overlooked gap in the buyer's remedies arising from MAE emerges. A buyer's indemnification obligations are typically capped at a percentage of the purchase price. This varies, but often falls around 10% of transaction value for deals without representations and warranties insurance.[12]

Based on Delaware case law, an MAE may not have occurred despite a loss to or drop in the value of the target by an amount in excess, possibly substantially in excess, of that range. A buyer facing a breach of a representation that is expected to lead to a loss in excess of the cap faces a Catch-22: It must close because no MAE has occurred, but its remedy is capped. Therefore, the buyer must close and accept an unrecoverable loss (or fail to close and pay damages for breach).

A Better Way

We propose eliminating the MAE definition and redesigning affected provisions to clearly state the parties' intent. Specifically, we propose the following:

1. Remove the general MAE representation and any stand-alone MAE closing condition.

• The buyer loses the protection of the MAE condition. Given the difficulty in proving an MAE, the buyer should view this as a limited sacrifice. The buyer would accept the risk of the business between signing and closing that is outside of the seller's control — which is the direction the MAE definition has been heading for some time and the driver of all of the lengthy list of MAE exceptions. By signing the agreement to acquire the target, the buyer assumes risks endemic to the business. The buyer should focus its due diligence efforts to affirmatively identify key risks to the seller's business and require representations and warranties on any points of concern.

2. Remove materiality and MAE qualifiers from representations and warranties.

• Some acquisition agreements painstakingly qualify every representation with materiality or MAE, and then go on to scrape materiality for all relevant purposes (with a closing condition scrape and global qualifier, and a similar scrape for indemnification). We advocate eliminating the individual qualifiers altogether and addressing the question of whether the breaches have risen to a level to permit the other party not to close, or to entitle the other party to indemnification in those provisions, as described below.

• Though representations can rightly be viewed as merely allocating risk and not imposing any moral or other duty of accuracy, simple drafting techniques can alleviate any concerns by a party that it cannot make a representation because it does not know with certainty that it is accurate without a materiality qualifier, while preserving our proposed clarity of economic result between the parties.

3. Address materiality for indemnification with one or more baskets or deductibles.

• Because representations and warranties will not be qualified by materiality or MAE, parties should establish a numerical indemnification threshold. This actually is tantamount to existing practice for agreements where materiality is scraped both for purposes of determining a breach and determining the indemnified loss. Small post-closing claims could fill a mini-basket, which may be more appropriate in light of no other materiality threshold. A general basket or deductible would set a liability threshold for all claims taken together, based on a dollar amount or percentage of deal value. This provides certainty and avoids the arguably inappropriate possibility that a breach that triggered a loss greater than the deductible may still not be recoverable if the breach itself is found to be immaterial or not constituting an MAE.

4. Set the closing condition for accuracy of representations and covenants at the level of the indemnification cap.

• To avoid the often-overlooked gap that we mentioned above, the buyer would be entitled not to close if the expected losses from a breach exceed the cap on damages that the buyer is permitted to recover. This avoids the possible buyer Catch-22. It should still give sellers confidence in the likelihood of closing — practitioners know that the indemnity claims they have seen where the buyer's claim was capped out are few and far between. And it has the salutary effect on negotiations of aligning the parties' interests in negotiating the cap — a higher cap for the buyer means lesser right to back out of the deal based on breaches, and vice versa for the seller. This also creates a fundamentally fair result, that the buyer cannot be forced to close into a loss due to a breach by the seller.

Conclusion

We are confident that if parties adopt this approach, they will reduce negotiation time and expense, produce clearer, fairer agreements, and reduce the likelihood of disputes requiring litigation to resolve.

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Thomas H. Warren is a partner, and Garrett D. Hollis and Jackson M. Allen are associates, at Eversheds Sutherland LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Bed Bath & Beyond, Inc. v. 1-800-Flowers.com and 800-Flowers, Inc., No. 2020-0245 (Del. Ch. Apr. 1, 2020); Level 4 Yoga, LLC v. CorePower Yoga, LLC and CorePower Yoga Franchising LLC, No. 2020-0249 (Del. Ch. Apr. 2, 2020); Khan et al. v. Cinemex Holdings USA, Inc. et al., 2020 WL 1808264 (S.D.Tex.).

[2] Michelle Shenker Garrett, Efficiency and Certainty in Uncertain Times: The Material Adverse Change Clause Revisited, 43 Colum. J.L. & Soc. Probs. 333, 36 (2010).

[3] Nixon Peabondy LLP, MAC Survey: NP 2019 Report (2019); https://www.nixonpeabody.com/-/media/Files/PDF-Others/mac-survey-2019-nixon-peabody.ashx?la=en.

[4] Akorn, Inc. v. Fresenius Kabi AG , No. CV 2018-0300-JTL, 2018 WL 4719347, at *53 (Del. Ch. Oct. 1, 2018),aff'd,198 A.3d 724 (Del. 2018),

[5] Id. at *57.

[6] Id. at *65.

[7] Hexion Specialty Chemicals, Inc. v. Huntsman Corp. , 965 A.2d 715 (Del. Ch. 2008).

[8] In Re IBP Inc. v. Tyson Foods Inc. , 789 A.2d 14 (Del. Ch. 2001).

[9] Lou R. Kling & Eileen T. Nugent, Negotiated Acquisitions of Companies, Subsidiaries and Divisions § 11 .04[9], at 11-66 (2018 ed.).

[10] Raskin v. Birmingham Steel Corp. , 1990 WL 193326, at *5 (Del. Ch. Dec. 4, 1990) (Allen, C.).

[11] Akorn, supra note 3, at *1 (Akorn's equity "fell off a cliff" at the same time Buyer discovered misleading representations as to massive compliance failings).

[12] ABA2019 Private Target Mergers & Acquisitions Deal Points Study (Dec. 5, 2019), 98.

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