Four Types of Risk Addressed by MAE Clauses, and Where COVID-19 Fits—Lessons from the Delaware Court of Chancery
Back in March, Ryan Holt discussed how COVID-19 was impacting contractual force majeure clauses and certain statutory defenses involving contractual obligations that are impossible to perform. This post follows up on Ryan’s work by summarizing developments from the Delaware Court of Chancery and material adverse effect (“MAE”) deal litigation spawned by COVID-19. Courts have identified four types of risk addressed by MAE clauses. Depending on how it manifests within a company, COVID-19 could fit into multiple risk categories. Ultimately, however, MAE clauses are imprecise tools that are ill-suited to allocate specific business risks. To the extent buyers and sellers are aware of a risk, they are well-advised to address and allocate the risk in their M&A agreements—rather than relying upon MAE clauses.
…typical MAE clauses allocate “general market or industry risk to the buyer” while “company-specific risks” remain with the seller.
As an introduction to MAE clauses generally, it is common in M&A agreements for a buyer’s obligation to perform an agreement (i.e., go through with a purchase) to be conditioned upon the non-occurrence of an MAE. In other words, no event has occurred that would create a “material” and “adverse” effect on the target company’s business prospects.
In many ways, the question of whether or not an MAE has occurred is a catch-all. Rather than focusing on known-risks, MAE clauses are designed to allow parties to re-negotiate the deal consideration if an unexpected event arises in between the signing and closing of a transaction. Indeed, these deals frequently do not provide a positive definition of “MAE.” Rather, they define the term negatively—describing what it is not.
Any discussion of MAE clauses must cite Vice Chancellor Laster’s decision in Akorn v. Fresenius, 2018 WL 4719347 (Del. Ch. Oct 1, 2018). In this groundbreaking opinion, Vice Chancellor Laster found that an MAE clause had been triggered in Fresenius Kabi AG’s agreement to acquire Akorn, Inc. The Vice Chancellor made this finding by distinguishing other cases from the court—which has, and continues to, “criticize buyers who agreed to acquisitions, only to have second thoughts after cyclical trends or industrywide effects negatively impacted their own businesses.” Drawing from the Akorn case:
A  nuanced analysis of the types of issues addressed by MAE provisions reveals four categories of risk: systematic risks, indicator risks, agreement risks, and business risks. Generally speaking, the seller retains the business risk. The buyer assumes the other risks. Akorn, 2018 WL 4719347, at *49-50 (internal quotations omitted).
- Systematic risks are beyond the control of all parties (even though one or both parties may be able to take steps to cushion the effects of such risks) and … will generally affect firms beyond the parties to the transaction.
- Indicator risks signal that an MAE may have occurred. For example, a drop in the seller’s stock price, a credit rating downgrade, or a failure to meet a financial projection is not itself an adverse change, but rather evidence of such a change.
- Agreement risks include all risks arising from the public announcement of the merger agreement and the taking of actions contemplated thereunder by the parties. Agreement risks include endogenous risks related to the cost of getting from signing to closing, e.g., potential employee flight.
- Business risks are those arising from the ordinary operations of the party’s business (other than systematic risks), and over such risks the party itself usually has significant control. The most obvious business risks are those associated with the ordinary business operations of the party—the kinds of negative events that, in the ordinary course of operating the business, can be expected to occur from time to time, including those that, although known, are remote.
Stated differently, typical MAE clauses allocate “general market or industry risk to the buyer” while “company-specific risks” remain with the seller.
At least three additional lessons can be drawn from Akorn. First, MAE litigation is fact intensive. Given the ill-defined nature of what constitutes an MAE, the analysis calls upon the factfinder to consider wide swaths of evidence. Akorn involved 1,892 exhibits, 54 deposition transcripts from 40 fact witnesses, and 14 experts.
Second, the burden of proving that an MAE occurred rests with the party purporting to exercise its termination rights (i.e., the buyer).
Third, given the nature of MAE litigation (a buyer attempting to excuse its non-performance based upon negative developments in-between signing and closing), the litigation proceeds quickly. The parties prepared for trial in Akorn in just 11 weeks notwithstanding the fact-intensive nature of litigation. In short, MAE litigation is intense and compressed—placing significant burdens upon buyers to assemble evidence in support of their claim on short notice.
It is against this backdrop that the Court of Chancery has confronted litigation involving some variant of a buyer claiming that COVID-19 has caused an MAE on a target company. In the early months of 2020, with a few notable exceptions, the Court of Chancery has shown that it will convene expedited trials to adjudicate these claims. For example, on July 14, 2020, Vice Chancellor Glasscock refused to continue a trial involving an MAE dispute, noting that the longer a deal is forced to sit in litigation limbo, the more likely the “equitable relief” sought by seller (specific performance) becomes “practically unattainable.” See Forescout Tech., Inc. v. Ferrari Group Holdings, L.P., 2020 WL 3971012, at *1 (Del. Ch. July 14, 2020). Instead of continuing the trial, Vice Chancellor Glasscock ordered that the trial proceed remotely via Zoom. Notwithstanding this willingness, I am not aware of a pandemic-based MAE claim that has reached a final adjudication on the merits. Instead, all parties have used MAE litigation as a means to negotiate more favorable deal terms out of court.
Depending on how it interacts with a target company, COVID-19 and its negative effects could, conceivably create a MAE that justifies a seller’s non-performance.
This means that in (what we hope are) the last months of the pandemic, parties must rely upon Vice Chancellor Laster’s guidance from Akorn when analyzing whether COVID-19 has caused an MAE. Depending on how it interacts with a target company, COVID-19 and its negative effects could, conceivably create an MAE that justifies a seller’s non-performance. In this inquiry, the contractual language at issue, such as the precise definition of “MAE,” is paramount. Many M&A agreements provide that an MAE must disproportionately harm the target’s business compared with a broader benchmark. The agreement at issue in Akorn had this definition, and it was critical to Vice Chancellor Laster’s reasoning.
A target could, for example, experience a particularly disruptive COVID-19 outbreak at one of its facilities—leading to loss of long-term customers, legal claims, or even the death of key employees. Even though firms in many industries have experienced a COVID-19-related downturn, such drastic harm could rise to the level of an MAE. More generally speaking, the MAE formula from Akorn is a “dramatic, unexpected, and company-specific downturn” in a target’s business that begins after an agreement’s signing.
To the extent the foregoing analysis leaves too much ambiguity, parties should consider whether to include a more-precise definition of MAE in their M&A agreements. To the extent an agreement allocates a discrete risk to a specific party, that choice will control the more generalized analysis from Akorn.