Effectively Defining Material Adverse Change Amid COVID-19

By Phillip Cushing
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Law360 (March 3, 2021, 4:21 PM EST) --
Phillip Cushing
Phillip Cushing
Deal makers' response to the COVID-19 pandemic highlights a continuing oversight with respect to a key term in mergers and acquisitions purchase agreements:[1] material adverse change, also known as a material adverse effect.[2]

Shortly after the outbreak of COVID-19, many buyers attempted to walk away from pending M&A transactions involving businesses affected by the pandemic, leading sellers to file suit.

For example, consider Bed Bath & Beyond Inc. v. 1-800-Flowers.com and 800-Flowers Inc. In this Delaware Chancery Court case, Bed Bath sought in April 2020 to force the buyer to close on the acquisition of PersonalizationMall.com after the buyer attempted to delay closing to assess whether COVID-19 had caused a MAC under the purchase agreement.

Also, look at Level 4 Yoga LLC v. CorePower Yoga LLC and CorePower Yoga Franchising LLC. In this case, Level 4 in April 2020 asked the Delaware Chancery Court to make CorePower close its acquisition of certain yoga studios after CorePower claimed Level 4's actions in response to COVID-19 excused closing.

Though neither buyer explicitly invoked a MAC under the purchase agreement, the allegation was implied in communications between the parties, causing each seller to address the point in its complaint.

In response to these and similar cases, practitioners are focused on using the MAC definition to specifically allocate the risk of COVID-19 and similar circumstances between the parties in future transactions.

Practitioners took the same approach in the wake of market volatility in the late 1980s and 1990s, terrorist attacks on Sept. 11, 2001, and the credit crisis and economic downturn in 2008.

That focus, though important, is too narrow, and reflects a common mistake — thinking about MACs solely as forward-looking risk allocation tools in the purchase agreement's closing conditions.

MACs are also backward-looking tools for disclosure in the representations and warranties, but practitioners rarely draft the MAC definition that way, even when the transaction calls only for that application.

As the world emerges from the COVID-19 pandemic and deal making gains momentum, both functions of the MAC definition will be crucial to contracting parties, making this the right time to take a more thoughtful approach to the definition.

The MAC Definition

A simple MAC definition often resembles the following:

Material adverse effect means: Any change, circumstance, effect or occurrence that individually, or together with any other change, circumstance, effect or occurrence, (a) has materially impaired, or would reasonably be expected to materially impair, the sellers' ability to effect the closing or to perform their respective obligations under this agreement or (b) has had, or would reasonably be expected to have, a material adverse impact on the financial position, results of operations, properties and assets of the Company or the business, taken as a whole;

provided, however, that in the case of clause (b), no change, circumstance, effect or occurrence resulting from any of the following, alone or in combination, shall be taken into account in determining whether there has been a material adverse effect, or one would be reasonably expected to occur: (1) conditions generally affecting the industries in which the Company operates or participates, the U.S. economy or financial markets or any foreign economy or financial markets in any location where the Company has material operations or sales; (2) national or international political or social conditions, including terrorism or the engagement by the United States in hostilities or acts of war; (3) changes in any generally applicable laws; (4) any natural disaster or weather conditions; or (5) any failure by the Company to meet any projections, forecasts or revenue or earnings predictions — but, in each case, not the underlying cause of such failure; 

provided further, however, that any change, circumstance, effect or occurrence referred to in clauses (1) – (4) will be taken into account in determining whether there has been a material adverse effect, or one would be reasonably expected to occur, if such change, circumstance, effect or occurrence has, or would be reasonably expected to have, a disproportionate effect on the Company relative to other similarly situated businesses in the industries and locations in which the Company operates.

The definition includes three distinct sections — (1) the somewhat abstract base definition, (2) carveouts or exclusions from the base definition,[3] and (3) a "disproportionate effect" carve-in or inclusion with respect to matters carved out in section 2.

While sophisticated practitioners stake out positions in the base definition, it typically elicits far less attention from the parties than the carveouts and carve-ins.

Whether or not a matter is included in a carveout or carve-in dictates whether, and to what extent, it may be considered in determining if a MAC has occurred.

This makes the carveouts and carve-ins important mechanisms to parse and allocate a key risk in M&A transactions — the passage of time — and leads practitioners to focus on them in the wake of events like the COVID-19 pandemic. In doing so, however, they often seem to forget that they serve another important purpose elsewhere in the purchase agreement.

MACs and the Interests of the Parties

The MAC defined term often appears in several sections of a purchase agreement. Its most prominent location is in the closing conditions. There, it often plays at least two roles — as a stand-alone "MAC-out" closing condition addressing changes between signing and closing, and — at least in a seller-friendly M&A market — as a "bringdown" closing condition setting the standard for measuring the accuracy of nonfundamental, operational representations and warranties made by the target or the sellers at signing.

The MAC-out closing condition typically resembles the following:

The obligation of buyer to consummate the closing is subject to the satisfaction or waiver at or prior to the closing of each of the following conditions … no material adverse effect shall have occurred during the period from the signing date to the Closing Date.

The bringdown closing condition is similar:

The obligation of buyer to consummate the closing is subject to the satisfaction or waiver at or prior to the closing of each of the following conditions … each of the representations and warranties of the sellers, other than the fundamental representations, shall be true and correct in all respects on and as of the Closing Date, as though such representation or warranty were made on and as of the Closing Date, except where the failure of any of such representations and warranties to be so true and correct would not have a material adverse effect.

Thus, if a MAC occurs after signing or if the representations and warranties made at signing by the target or the sellers are inaccurate at closing, and such inaccuracy rises to the level of a MAC, these conditions establish that the buyer is excused from closing.

In the closing conditions, the carveouts and carve-ins serve the forward-looking risk allocation function that most practitioners focus on.

The parties identify circumstances that will not be valid bases for backing out of a transaction and add them as carveouts from the MAC definition, thus foreclosing the buyer's ability to allege a failure of the MAC-out or bringdown closing condition based on those circumstances. In that sense, the buyer bears the risk of those circumstances coming to pass.

In this context, the seller's interest in certainty of closing is pitted against the buyer's interest in maintaining optionality for its capital. The seller wants the carveouts to be as broad and numerous as possible so as to limit the buyer's ability to establish a MAC and excuse closing. The buyer wants the opposite.

The MAC defined term does not only appear in the purchase agreement in this forward-looking fashion, though. It is also used in a backward-looking sense in the representations and warranties of the purchase agreement.

There is often a stand-alone "no-MAC" representation, in which the seller or target represents that a MAC has not occurred during a certain period of time in the past — e.g., "since the most recent fiscal year end, there has not been any material adverse effect." The defined term MAC may also qualify many other representations and warranties, acting as a higher — or lower, depending on one's perspective — level of materiality; e.g., "No consent is required to be obtained, given or made by the company for the consummation by the company of the transactions contemplated by this agreement that, if not obtained, would have a material adverse effect."[4]

In the representations and warranties, the carveouts play a different role. Rather than representing future risks that are borne by the buyer, they represent limitations on the seller's disclosure obligations.

The carveouts are past events or circumstances that the buyer cannot use to establish a breach of the no-MAC and other MAC-qualified representations. Thus, at least with respect to those representations and warranties, the seller does not need to disclose those events or circumstances to buyer.[5]

In this context, the primary tension is between the buyer's interest in full disclosure of past events and current circumstances and the seller's interest in limiting required disclosure — both to conserve transaction resources and limit potential post-closing liability.

The buyer wants fewer carveouts so that it can receive more assurances with respect to the presigning business. The seller wants the opposite.

Where the MAC defined term appears, whether it is used in a forward-looking or backward-looking manner, and how it impacts the parties' interests, are largely driven by the nature of the M&A transaction, in particular whether it is a simultaneous sign-and-close transaction or a separate sign-and-close transaction.

Transaction Structure and the Purchase Agreement

Contracting parties face the early threshold decision of whether to structure the transaction as a simultaneous sign-and-close transaction or a separate sign-and-close transaction. In the former case, as the name suggests, the parties sign the purchase agreement and close the transaction at the same moment — or at least close enough in time that the purchase agreement does not need to address any interim period.

The parties do not sign the purchase agreement until all prerequisites to the transaction are satisfied, and they are prepared to close. In a separate sign-and-close transaction, the parties sign the purchase agreement and later wire funds or exchange consideration and close the transaction.

Financing, regulatory approvals and third-party consents — actions required to consummate a transaction, but ones that parties may not wish to undertake without the assurances and protections of a signed agreement — often necessitate a separate sign-and-close structure.

The key difference, then, between these two structures is the passage of time. In a simultaneous sign-and-close transaction, the purchase agreement needs to consider only the past and present states of the business. In a separate sign-and-close transaction, the purchase agreement must address a future, unknown state and how that may affect the parties' willingness to consummate the transaction.

The target's business, the buyer's business, the relevant industry, the economy, the law — much can change in the period between signing and closing.

This time element necessitates a different approach to the purchase agreement. In order to address the tension between the buyer and the seller with respect to certainty of closing in a separate sign-and-close transaction, the parties typically draft and negotiate complex termination provisions, closing conditions and preclosing covenants to identify the events that may excuse closing and the parties' rights and obligations in connection therewith.

Also, the parties often draft and attach to the purchase agreement forms of important ancillary agreements that will be executed at closing to minimize the risk that disagreements over them after signing will jeopardize closing the transaction.

None of this is required in a simultaneous sign-and-close transaction because the tension with respect to closing risk does not exist — the parties do not sign the purchase agreement until closing is assured.

And just as a different transaction structure dictates a different approach to the foregoing elements of the purchase agreement, so too does it implicate a different approach to the MAC definition.

MACs in Simultaneous Sign-and-Close Transactions

As noted, the purchase agreement in a simultaneous sign-and-close transaction does not need to address the passage of time. The purchase agreement contains no closing conditions, and thus no MAC-out, and representations and warranties are made at only one moment in time, and thus there is no MAC-qualified bringdown.

The MAC definition's forward-looking functions are irrelevant.

In a simultaneous sign-and-close transaction, the MAC defined term should only be used in its secondary, backward-looking role in the no-MAC representation and, occasionally, as a qualifier of other representations and warranties.

The buyer is only interested in whether a MAC exists or one occurred in the relevant past.

In this context, the carveouts and carve-ins that one typically sees in the MAC definition should be inapplicable. It is logical that general economic and political conditions, changes in law, natural disasters and, more recently, COVID-19 and other pandemics are common carveouts in the closing conditions because they are exogenous events and circumstances, the risk of which parties often allocate to the buyer.

Likewise, sellers are typically unwilling to guarantee future results between signing and closing, so a "failure to meet projections" carveout from the MAC definition makes sense in the closing conditions. But in the representations and warranties, the carveouts only serve to limit the seller's disclosure obligations, and the rationale for the typical suite of MAC carveouts is much weaker in that context. Why shouldn't a buyer receive disclosures regarding a devastating hurricane or adverse change in law six months prior to closing?

Likewise, sellers' unwillingness to accept the forward-looking risk of missing projections in a separate sign-and-close transaction should have no bearing on whether they are willing to forego a "failure to meet projections" carveout and disclose past failures to meet projections in a simultaneous sign-and-close transaction.

The new COVID-19 carveouts may highlight the issue best. In the wake of the pandemic, it is crucial for buyers to understand how COVID-19 impacted target businesses and how they responded to it, but these new carveouts may severely limit buyer's ability to do so.

Even if the market tends to allocate risks with respect to the future effects of COVID-19 to buyers in separate sign-and-close transactions, that does not necessarily dictate that buyers should not receive any assurances or disclosures from sellers with respect to the past effects. The typical suite of MAC carveouts is overbroad in most simultaneous sign-and-close transactions.

It may be that MAC carveouts and carve-ins can be eliminated entirely in many, if not most, simultaneous sign-and-close transactions. That approach is rational in transactions in which the value to the buyer of heightened preclosing disclosure outweighs the costs of irrelevant or overly broad or burdensome disclosures. Given the high bar for finding a MAC, one would expect this to often be the case.[6]

However, that will not be so for all transactions. In some simultaneous sign-and-close transactions, a new set of MAC carveouts may be appropriate, one that is different from what most practitioners are accustomed to seeing.

These carveouts would focus less on exogenous events and circumstances — although some may still be relevant for avoiding broad or burdensome disclosures — and more on events and circumstances connected to the transaction or the buyer, such as the seller seeking a third-party consent at the buyer's request before closing, the effects of which the parties agree should not be considered in evaluating the representations and warranties or establishing a post-closing indemnification claim.

In any event, the tradeoffs implicated by the MAC carveouts are much different when applied solely to representations and warranties than they are when applied to closing conditions, and those different tradeoffs deserve equally different approaches.

MACs in Separate Sign-and-Close Transactions

The same reasoning calls for a more thoughtful approach to the MAC definition in separate sign-and-close transactions. In this context, both the forward-looking and backward-looking functions are relevant, but using a single MAC definition, like the example above, in all instances may be blunt and clumsy.

As applied to the MAC-out and MAC-qualified bringdown closing conditions, the full MAC definition with the typical suite of carveouts is appropriate.

This application was the original inspiration for the carveouts and carve-ins practitioners are accustomed to seeing. The parties decide who should bear the risk of unknown future events — macroeconomic conditions, "acts of God", pandemics and the like — and then add them to sections 2 and 3 of the definition accordingly.

In the representations and warranties, the parties should use the same MAC definition as in the simultaneous sign-and-close context. Only the backward-looking functions of the definition are relevant to this application, and so the parties should rework the carveouts and carve-ins to fit the context or eliminate them entirely, as appropriate.

To differentiate the definition for each application, the parties could use two MAC definitions — a "rep MAC," with carveouts appropriate for representations and warranties, and a "closing MAC," with carveouts appropriate for closing conditions — or a single, bifurcated MAC definition, in which all or some of the carveouts apply only to the closing conditions.[7]

For example, the parties could carve out COVID-19 from the closing MAC definition to give the seller more certainty that the pandemic will not threaten closing, but forego the carveout in the rep MAC to bolster the buyer's presigning COVID-19 due diligence. This approach allows each party to satisfy its key interest without undermining the other's.


The MAC definition is a powerful tool in purchase agreements, and the high bar established by Delaware courts for finding a MAC is not a reason to use it carelessly.

Parties often simultaneously spend too much time and too little time on the MAC definition — too much time arguing over MAC carveouts that are irrelevant, but too little time thinking about the drafting in one context versus another.

Context is everything with the MAC definition, and just as each transaction has nuances, so too should each application of the MAC definition.

The COVID-19 pandemic makes it apparent — by using MAC definitions that are appropriately tailored to each application, contracting parties can adequately respect each party's interests and capture the full benefits of each function of the MAC.

Phillip Cushing is an associate at Bartlit Beck 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] Merger, purchase and other forms of acquisition agreements are referred to as "purchase agreements" in this article.

[2] Each is referred to in this article as a "MAC", consistent with common usage among practitioners.

[3] These carveouts are abbreviated for brevity's sake; they are often more voluminous and detailed than reflected here.

[4] Buyers often strongly resist MAC-qualified representations and warranties, even in seller-friendly M&A markets. Because Delaware courts have set a high bar to establish a MAC — the Delaware Court of Chancery has found that a MAC occurred in only one case before it, Akorn, Inc. v. Fresenius Kabi AG , which involved particularly egregious facts — buyers are often able to successfully argue that a MAC-qualified representation and warranty provides little to no assurances and entirely erodes insurance coverage in transactions covered by a representations and warranties insurance policy. Still, a MAC-qualified representation is frequently the compromise struck by buyers with respect to ancillary business matters or when faced with the alternative of losing a representation entirely.

[5] Under an agreement with the "no MAC" representation and warranty copied above, for example, the seller or target would customarily list on a disclosure schedule matters that, without such disclosure, would have made the "no MAC" representation untrue. If a matter is included in a MAC carveout, it cannot be the basis for a MAC and, thus, the seller or target does not need to disclose it in order to make the "no MAC" representation true.

[6] However, it may be the case that the bar for finding a MAC with respect to a representation is lower than with respect to a closing condition. Seeking indemnification for losses resulting from an inaccurate representation is usually a less drastic remedy than using the closing conditions to back out of the transaction. That different posture may inspire different analysis from courts.

[7] Under the latter approach, sellers could attempt to argue that disclosures with respect to the rep MAC portion of the definition also serve as disclosures with respect to the closing MAC portion for purposes of the bringdown. To foreclose this possibility, buyers would need to take care to ensure that rep MAC disclosures made by sellers are restricted to the presigning period. Presigning occurrences and interim period occurrences should be subject to separate analyses.

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