Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

Akorn, Inc., v. Fresenius Kabi AG et al will undoubtedly become known as the first case where a Delaware court found a material adverse effect, or MAC (often referred to as a material adverse effect, or MAE), to exist. The opinion also contains a helpful description of how to read an MAE clause. MAE clauses often contain a litany of exceptions of seemingly unrelated matters, and the opinion brings some order to the analysis.

According to the Delaware Court of Chancery, in any M&A transaction, a significant deterioration in the selling company’s business between signing and closing may threaten the fundamentals of the deal. Merger agreements typically address this problem through complex and highly-negotiated ‘material adverse change’ or ‘MAC’ clauses, which provide that, if a party has suffered a MAC within the meaning of the agreement, the counterparty can costlessly cancel the deal.

The Court observed that despite the attention that contracting parties give to these provisions, MAC clauses typically do not define what is “material.” Commentators have argued that parties find it efficient to leave the term undefined because the resulting uncertainty generates productive opportunities for renegotiation.

Rather than devoting resources to defining more specific tests for materiality, The Court noted the current practice is for parties to negotiate exceptions and exclusions from exceptions that allocate categories of MAE risk. The typical MAE clause allocates general market or industry risk to the buyer, and company-specific risks to the seller. From a drafting perspective, the MAE provision accomplishes this by placing the general risk of an MAEon the seller, then using exceptions to reallocate specific categories of risk to the buyer.

Exclusions from the exceptions therefore return risks to the seller. A standard exclusion from the buyer’s acceptance of general market or industry risk returns the risk to the seller when the seller’s business is uniquely affected. To accomplish the reallocation, the relevant exceptions are qualified by a concept of disproportionate effect. For example, a buyer might revise the carve-out relating to industry conditions to exclude changes that disproportionately affect the target as compared to other companies in the industries in which such target operates.

The Court pointed out a more 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.

  • 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.

According to the Court, generally speaking, the seller retains the business risk. The buyer assumes the other risks.