By Michael Gilligan

Law360 (April 10, 2020, 4:23 PM EDT) --

Michael Gilligan

The material adverse effect, or MAE, definition is one of the more important definitions in the typical agreement for a negotiated acquisition. The MAE concept is used in the overwhelming majority of agreements for U.S. M&A transactions as a means of allocating risk, and has been a focus of interest during the current coronavirus crisis.

While relatively heavily negotiated between the parties, the typical MAE definition has become fairly standardized, consisting of the definition of MAE itself, followed by a series of carveouts, or exclusions, for events the effects of which are not to be taken into account in determining whether an MAE has in fact occurred.

The list of such carveouts, which ratchets ever upward in number and will now forever include pandemics, has also become somewhat standardized and broadly encompasses events that do not specifically relate to the target company, including such things as the condition of the financial markets generally, including in most cases the effects of the current crisis resulting from the new coronavirus.

This list of carveouts is often followed by a further exclusion to the carveouts that reads back into the MAE definition events that would otherwise be excluded that are disproportionately adverse to the target company relative to other similarly situated businesses.

In addition to the standard list of carveouts, there is one additional carveout, which specifically relates to the target company and is not included in most MAE definitions, the presence or absence of which can be viewed as materially changing the allocation of known risks between the buyer and the seller: the disclosure schedules carveout.

As an initial matter, it is useful to understand the variety of ways that the MAE concept is used in a typical acquisition agreement. First, it is used as a qualifier to the various representations and warranties of the parties. It may also be used as a qualifier to various of the parties' covenants, most substantively in connection with the use of efforts standard to obtain a required regulatory approval.

Most consequentially, however, is the use of MAE in the conditions precedent to the parties' obligation to close the transaction. MAE is frequently used a qualifier to the bring-down condition of each party's representations and warranties, i.e., one party's bring-down condition is typically satisfied if the other party's representations and warranties are true and correct as of the closing, other than failures that do not result in an MAE.

In addition, particularly in transactions involving acquisition financing, there is usually a standalone MAE condition in favor of the buyer, i.e., a condition that requires no MAE to have occurred to the target company since the time the transaction agreement was signed.

Through this usage, it should be apparent that the most important role of the MAE definition in an acquisition agreement is as one of the primary means of allocating risk between the buyer and seller — if an MAE has occurred, the buyer does not have to close.

Many people who are not seasoned M&A practitioners are surprised by the qualitative nature of the MAE definition and its usage, especially in light of its critical importance. However, this qualitative nature is precisely why the MAE definition is so useful when used as a closing condition.

Despite the hubris of many practitioners, none of us can predict all the multitude of things that can happen after a transaction is signed and before it closes.

The qualitative framework of the MAE concept provides buyers and sellers with a framework within which to negotiate and agree the equitable treatment of changes or events that could not be anticipated by the parties at the time that the transaction agreement was signed. In short, the use of the MAE concept as a closing condition can be viewed primarily as a means of allocating unknown, and indeed unknowable, risks.

The use of MAE as a closing condition is less useful in addressing, and is generally not used as a means of allocating, risks that are known and identified at the time of signing of an acquisition agreement and that can be reasonably quantified. These types of known risks are not best allocated through a broad and qualitative standard and should be allocated through a more precisely drafted and quantified standalone closing condition.

These types of standalone conditions are not common in transaction agreements, however, largely because most sellers will not agree to them. The asymmetry between the magnitude of greater damage to a seller, as opposed to lesser damage to a buyer, when a signed transaction falls apart tends to result in the seller either waiting until a known risk has passed (i.e., not signing an agreement until a later time) or a buyer agreeing to bear that known risk, after a full diligence assessment.

Among the risks that are known and identified at the time of the signing of an acquisition agreement are all of the various matters that the seller has disclosed to the buyer as exceptions to the seller's representations and warranties in the disclosure schedules to the acquisition agreement.

All items so disclosed, which the buyer has had full opportunity to assess in its due diligence investigation, are, absent some standalone condition or indemnity, generally viewed by practitioners as risks that, as between the buyer and the seller, have been allocated to the buyer and that the buyer must bear both in terms of any losses arising from such matters post-closing and in terms of not excusing the buyer from its obligations to close the transaction.

The architecture of a typical acquisition agreement makes all of this clear and generally works to achieve this typically intended result. However, many acquisition agreements unintentionally fail to fully allocate known risks, in particular risks resulting from matters disclosed on the seller's disclosure schedules, to the buyer.

Such failure could allow a buyer to be excused from its obligation to close the transaction as a result of an adverse development with respect to a matter that relates specifically to the target and that the buyer should have fully assessed and that is specifically enumerated in the disclosure schedules.

This unintentional misallocation of risk is present in every acquisition agreement in which there (1) is a standalone MAE condition, including most agreements requiring acquisition financing; and (2) is not an exclusion in the MAE definition for matters that are disclosed in the seller disclosure schedules.

While many view the bring-down condition and the standalone MAE condition to be largely duplicative as a result of the bring-down of the "absence of certain changes" representation, these two separate conditions may involve different time periods (i.e., from the date of the most recent balance sheet to closing rather than from signing to closing).

Most importantly, they differ in that the bring-down condition is fully qualified by the matters disclosed in the seller's disclosure schedules, and the standalone MAE condition is generally not so qualified unless the MAE definition includes a carveout for matters disclosed in the seller's disclosure schedules.

As a result, in agreements containing this combination of provisions, a material adverse development in a known and identified matter between signing and closing could be found to lead to a failure of the standalone MAE condition to be satisfied even in circumstances where the bring-down condition is actually satisfied.

If allowing this possibility is not the intent of the parties and allocating the risk of known and disclosed items to the buyer is actually consistent with the parties' intent, sellers should insist on the inclusion of the carveout for matters included in the seller disclosure schedules in the list of exclusions contained in the MAE definition.

The precise form of such carveouts can be the subject of negotiations between the parties, and the exclusion can be tailored to be limited to the extent of the specifically disclosed items at the time of signing or even to the reasonable and foreseeable consequences of such items as of the time of the signing.

The parties could further agree that the exclusion in the MAE definition only applies to the matters disclosed as exceptions to a limited set of representations, such as the litigation, absence of undisclosed liabilities and absence of certain changes representations, and not to the so-called listing schedules.

Such a negotiated formulation would ensure that the acquisition agreement reflected the intent of the parties and otherwise be consistent with the overall architecture of most acquisition agreements in allocating known and identified risks to the buyer through the seller disclosure schedules, while providing the parties with a framework to negotiate through the effects of unexpected occurrences in a manner consistent with their mutual intent as of the signing of the agreement.

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Michael E. Gilligan is a partner at Schulte Roth & Zabel 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.

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