Material Adverse Effect – A Lifeline or an Illusion?
- Criteria for Defining MAE
- Exceptions to MAE
- What Will the Court Decide?
- Contact our lawyer for more details
In venture capital and M&A transactions, there is often a significant time gap between the signing of binding documents and the closing of the deal (sometimes several months). During this period, there is a risk of events occurring that could negatively affect either party involved in the transaction.
Can either party withdraw from the deal in such a case? The material adverse effect (MAE) clauses provide such an opportunity.
Let’s break down what MAE clauses are, how they work, and when they can be applied:
| Material Adverse Effect (MAE) – A significant unfavorable change that could impact a party’s ability to perform under the terms of the deal. |
For reference: in transaction documents, you might come across both the term “material adverse effect (MAE)” and “material adverse change (MAC)”.
The MAE condition gives the parties to the agreement (usually the investor) the ability to unilaterally withdraw from the deal or renegotiate key terms of the binding documents (SPA, SHA) if a significant change occurs between the signing and closing of the transaction. MAEs are typically included in the section dealing with representations and warranties or are set as one of the conditions precedent to closing the deal.
Most transaction documents define MAE as an event, change, circumstance, or fact that, either individually or collectively, significantly and negatively impacts (or could impact) the business, assets, liabilities, or financial condition of a party to the transaction, and consequently, its ability to perform under the terms of the agreement. For example, in the case of a startup, such an event might include the loss of key clients, a decline in profits, or a significant violation of legal regulations. On the investor's (or buyer’s) side, negative events could include a sharp deterioration in financial condition, or changes in control or management.
Thus, the main goal of an MAE provision is to allocate the risks of unforeseen events occurring after the signing of the binding documents and before the deal closes.
Criteria for Defining MAE
There are no clear criteria for determining whether a circumstance constitutes an MAE. The parties negotiate and outline these criteria in the transaction documents. In the event of disputes over the implementation of an MAE, courts and business practices distinguish several criteria to qualify changes as MAEs:
- Long-term Effect
Changes must be of a lasting nature, not temporary. For example, based on case law, a revenue drop in a single quarter would not be considered an MAE. - Significance of the Changes
The circumstances must go beyond normal fluctuations in business. A 5–10% reduction in profits or revenue is often not considered material, whereas a 50% or greater drop in key financial indicators could be grounds for recognizing an MAE. - Comparative Nature
The court will consider how the change has affected the industry as a whole. For a change to be recognized as an MAE, it must have an impact on the target company or affect it more than other companies in the industry. If negative changes affect the entire industry, rather than a specific company, they are typically not considered MAE. - Unknowability of the Event
Typically, the event cited by a party to the transaction as the basis for applying the MAE clause should not have been known to them at the time of entering the deal. If a party consciously accepts a certain risk, they should not later be able to withdraw from the deal simply because this risk materialized in a way unfavorable to them.
Exceptions to MAE
As previously mentioned, MAE provisions are a subject of active negotiations between the parties. To minimize risks and avoid misinterpretations, the transaction documents often outline circumstances that will not be considered MAE. It is in the investor's interest to agree on as few of these exceptions as possible, while the startup typically tries to include as many as possible. These exceptions generally do not relate to the actions or inactions of the parties:
- Circumstances known to the parties prior to signing the documents;
- Significant changes in the securities markets;
- General macroeconomic changes;
- Force majeure events (pandemics, natural disasters);
- Changes in applicable legislation (new restrictions or licenses in a specific industry, tax reforms).
| Important: Even if an event falls under an exception, if it disproportionately affects one party compared to similar businesses (disproportionate impact), it may still be considered an MAE. |
What Will the Court Decide?
Despite the challenges in proving and the ambiguous stance of courts on MAEs, there are instances in legal practice where such a provision has been enforced. One of the most notable and precedent-setting cases is Akorn, Inc. v. Fresenius Kabi AG (2018), where the court upheld the buyer's right to withdraw from the deal based on the occurrence of an MAE:
Akorn, Inc. – an American generic drug manufacturer (target company). Fresenius Kabi – a German pharmaceutical company (investor). Fresenius decided to withdraw from the deal to acquire Akorn, citing the occurrence of MAE – a significant deterioration in Akorn’s financial and operational condition after the agreement was signed.
Akorn filed a lawsuit claiming that Fresenius's withdrawal was unjustified, as Akorn's issues were caused by industry trends, not internal factors.
Fresenius, on the other hand, argued that after the deal was signed, Akorn’s financial performance deteriorated drastically (EBITDA fell by 86%, operating profit decreased by 292%, and stock price dropped by 300%).
The Delaware court concluded that the MAE was indeed present and upheld the buyer's withdrawal from the agreement, noting that Akorn's revenue decline was significant, sudden, and prolonged. Additionally, the court considered not only the financial losses' magnitude but also their duration and reputational damage.
Thus, the material adverse effect clause is not a cure-all or a 100% guarantee of withdrawal from the transaction. However, with proper drafting of the wording and exceptions, this tool allows parties to allocate risks between the signing and closing of the deal, and in certain cases, it can play a crucial role in protecting the interests of the party facing unforeseen events. For the investor, it reduces the risk of investing in a company whose financial or operational condition has significantly worsened after signing the documents, while for the seller, it provides an opportunity to agree on exceptions and criteria for assessing such changes, thus reducing the likelihood of an unjustified withdrawal from the transaction.
Authors: Alexandra Kovalyova, Kryltsova Dziyana
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