The Musk Provision: Considering Materially Adverse Effect Provisions in M&A Agreements
“When the simultaneity condition does not hold, two dangers to the process of exchange arise—opportunism and unforeseen contingencies—for which the law offers remedies.”- Judge Richard Posner, The Economic Analysis of Law
An Material Adverse Effect (“MAE”) provision gives parties to a contract a way out of their contractual obligations if an event that causes a material adverse change or effect occurs between signing and closing.
Generally, MAE provisions have been narrowly interpreted and there has been a high bar to a finding that a MAE has occurred.
While there are general principles that apply to all MAE provisions, the applicability of any particular MAE provision will depend on the wording of the provision and the nature of an incident’s impact on a particular business.
It is not often that an esoteric M&A drafting concept becomes an item of public intrigue, but Elon Musk was able to grab headlines when he invoked a MAE provision in the M&A Agreement as a justification for walking away from his acquisition of Twitter.
While this may be the first time MAE provisions have captured the attention of the general public, it is not the only recent occurrence where MAE provisions have come to the fore in agreed deals.
Inflation, rising interest rates and political unrest across the globe have contributed to uncertainty in deal markets. Amid such volatility, the risk of broken deals may increase, and deal makers will likely revisit the practical utility of termination rights such as MAE provisions.
The conventional wisdom among corporate practitioners is that MAE provisions are, at best, a bargaining chip for a price negotiation and, at worst, a purely academic topic for overly fastidious attorneys. Nevertheless, they are frequently contested during negotiations, and therefore deserving of closer scrutiny.
A more detailed analysis is set forth below.
The MAE Provision
Often there is a delay between when parties to a transaction sign the merger agreement and the act of closing. This delay creates a risk that the circumstances giving rise to the agreement will change between the time the parties reached an agreement and the time the target company is exchanged for the previously-agreed-upon price.
As such, the parties typically rely on contractual provisions to allocate risk for unforeseen events that occur post-signing.
MAE provisions are standard elements in merger agreements that allow buyers to walk away from a deal in the period between signing and closing should certain events occurring during that time result in a material adverse effect on the seller’s business.
Before the 2008 financial crisis, MAE claims were rare as buyers preferred to eat the cost of a bad deal because of the reputational risk of walking away from an agreed deal. The conventional wisdom was that a reputation for walking away would raise future deal costs by deterring wary sellers. This calculus changed during the Great Recession and once again during the pandemic.
While MAE provisions are almost always dependent on the facts of a given deal, they generally begin with a basic definition that an MAE is any event, fact, circumstance, change, or development that, would (or could) reasonably be expected to have a material adverse effect on the target company and its subsidiaries as a whole, such as on its business, financial condition, or results of operations.
MAE Provisions Generally
A buyer will want to define MAE as broadly as possible to allow it to terminate the transaction if the target’s business takes a turn for the worse. A seller will want to narrow the scope of an MAE to provide as much certainty as possible that the deal will close. In light of this divide, MAE provisions can become a contentious negotiation point for certain transactions, compelling attorneys to draft language that is unique to the deal at hand. An MAE provision (as in the case of Twitter) can prompt non-performance by the buyer or compel the parties to completely renegotiate the sale.
M&A agreements will generally provide a list of carveouts which exclude certain risks from the definition of MAE, thereby shifting them back to the buyer. Sellers are typically reluctant to accept risks that relate to changes in the general condition of the economy, unforeseen regulations, or events like war and “acts of God.”
Buyers will typically push to include a series of “exceptions to the exceptions” known as “carveins”. These normally provide that the seller’s earlier carveouts will be MAEs to the extent they disproportionately affect the target company.
Judicial Enforcement of MAE Provisions
While MAE provisions are commonly featured in M&A contracts, they are rarely invoked due to the high burden of proof that a material adverse event occurred within the meaning of the provision. In fact, Delaware courts have only recognized the occurrence of an MAE as justification for terminating a transaction in just one case![1]
In light of this, a buyer may want to include objective qualifying events such as a percentage drop in the target’s revenue, or specifying the time duration for an adverse event to constitute an MAE.
Conclusion
In a change of course, the mercurial Mr. Musk has agreed to move ahead with the Twitter acquisition at the original offer price. This decision was likely based on concerns that his side would not be able to prove that Twitter’s failure to disclose an accurate number of “bots” was tantamount to a MAE under the purchase agreement.
For M&A deals that have yet to be consummated, parties should carefully draft the specific terms of MAE provisions to reflect the intent of the parties with respect to current and future uncertainties.
Sadis’ corporate practice has a wealth of experience in all aspects of M&A transactions, including the drafting and negotiation of MAE provisions. For further guidance, please reach out to Paul Marino (Partner – Head of the Corporate Group) at 212.573.8158 or via email at pmarino@sadis.com.
