The material adverse effect clause, or MAE, allows a party to terminate the deal before closing if triggered. The clause typically states that if a pre-closing event occurs that could reasonably be expected to have a material adverse effect on the condition of the business, assets, liabilities or results of operations of a party to the transaction, the other party can walk away from the deal. MAE clauses, buried deep in most merger agreements, are sometimes treated as boilerplate. But as Philip Brown’s National Post, March 15, 2006 article shows, boilerplate drafting in this area can come back to hurt you.
He points out that Johnson & Johnson tried to invoke the clause in its proposed merger with Guidant, after Guidant issued product recalls and announced related regulatory investigations. Johnson & Johnson was worried the underlying reasons for the merger had been undermined. In fact, it threatened to terminate the merger, which led to a renegotiation of the purchase price in J&J's favor.
He goes on to point out that sometimes an attempt to invoke an MAE clause leads to litigation, such as in the IBP v. Tyson case. Tyson had tried to rely on the MAE clause to terminate its proposed merger with IBP principally because, after the merger was announced, IBP experienced a significant drop in quarterly earnings and took an impairment charge because of improprieties, including fraud, at one of its operating entities. The court focused on what Tyson knew before it signed the merger agreement with IBP in determining whether the corporation could rely on the material adverse effect clause to terminate the deal.
He details many of the errors that led to an adverse result and suggested the following precautions:
1) It is essential to understand the business objectives underlying the negotiations and the allocation of business and transaction risks and reflect them in the MAE and other clauses of the agreement. If you fail to do this, and treat a MAE clause as boilerplate, it is not likely to protect you in the way you expect. You may end up in court.
2) If you expect a quarterly drop in earnings, if you contemplate an impairment charge, think a potential environmental liability may arise or significant litigation may proceed before the closing, deal with each of these matters in the merger agreement.
3) It is common to exclude general market conditions, stock market disruptions or cyclical drops in earnings from the ambit of MAE clauses. But one or more of these events may be appropriate triggers if both merger parties agree. It’s all a question of risk allocation and making matters clear in the merger agreement, so the courts are not left to divine what was intended from ambiguous or boilerplate clauses.
4) Communications with the press and analysts should be scrubbed to ensure the views expressed are consistent with what the parties intended in the merger. Otherwise, undue weight may be given by the courts to what is said or is inferred from these communications. Of course, internal e-mails and other communications that are inconsistent with the views expressed to a court will be very damaging.
5) Particular focus should be placed on the words of the MAE clause. MAE clauses are at the very core of the merger and should reflect what the parties intend. Spend time on them and draft them carefully so they are clear and deal specifically with known or anticipated issues. The negotiation and drafting objective should be to produce an unambiguous clause that will operate as the parties intended, and not be the subject of expensive and risky litigation.
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