What is a material adverse effect (MAE)?

Say Woodgrove agrees to buy Litware for $50.00 a share. Before closing, Litware's sales fall sharply, and Woodgrove no longer wants to close.

Many merger agreements make it a closing condition that no material adverse effect has hit the target since signing.

If one has, the buyer may not have to close.

Whether the buyer can also end the agreement depends on the agreement. So does what each side must then do.

The agreement defines the term. The definition matters more than the label.

It usually starts broad: any change materially adverse to the target's business, results or financial condition. Then it lists exceptions, often called carve-outs.

The carve-outs usually include:

The economy and markets

General economic, financial or market conditions.

The industry

Conditions across the target's industry.

Law and accounting

Changes in law or in accounting rules.

Events

War, terrorism and natural disasters.

Pandemics

Explicit pandemic exceptions increased quickly in early 2020. From February 1 to March 31, 2020, 13 of 17 public-target deals above $100 million had one.

The deal itself

Effects caused by announcing the deal, or by the deal being pending.

Missed forecasts

Missing projections. In many agreements, the reasons behind the miss can still count.

Some agreements let an excluded event count anyway if it hits the target harder than similar companies. Sometimes only the extra harm counts.

So if a recession hit Litware no harder than its rivals, its slump usually wouldn't count.

Many agreements are governed by Delaware law.

In IBP v. Tyson Foods (2001), the Delaware Court of Chancery said a short-term dip in earnings isn't enough.

Courts ask whether the effect is expected to reduce the target's earnings power over years, not months. The decline doesn't have to have lasted years already.

In Hexion v. Huntsman (2008), the court rejected the buyer's claim. Its analysis included a projection of 2009 earnings about 3.6% below 2006's.

Akorn v. Fresenius, in October 2018, was the first Delaware decision to find a material adverse effect. It also upheld the buyer's termination.

The target's business had suffered a large, sustained decline after signing. The Delaware Supreme Court affirmed the decision in December 2018.

A buyer can raise a material adverse effect as a reason not to close. The buyer has to prove it, and the target may dispute it in court, as in the cases above.

How a claim ends depends on that agreement's definition and on the facts.

If the buyer's claim is upheld, the deal can end without holders being paid the offer price.