Rising costs and falling valuations have left many acquirers questioning deals that seemed sound just months ago. Kasowitz attorneys Sheron Korpus and Andrew Schwartz examine how material adverse effect provisions might offer exit strategies, analyzing court precedents from Covid-19 disputes and explaining why tariffs present different legal challenges, especially when “disproportionate effects” hit some companies harder than their peers.
While public discourse is currently dominated by tariffs, another taboo “T” word weighs heavily on the minds of many behind closed doors: Termination. Costs are rising, valuations are falling, and agreements heralded just months ago seem incongruous and unworkable in today’s economy.
Private equity firms that agreed to buy a company dependent on overseas manufacturing, for example, no doubt have second thoughts. Much like they did in the wake of Covid-19, savvy acquirers are analyzing agreements to determine their termination rights and whether they can invoke a potential escape hatch through material adverse effect/change provisions (MAEs or MACs).
MAEs grant a contracting party the right to terminate an agreement or not perform certain obligations when an unexpected event significantly affects the value, operations or financial condition of the other party. In theory, MAEs work to allocate specific industry, company or global risks between the parties. Most commonly, a contractual MAE provision will open with a general definition of a “material adverse effect” and then carve out certain events as “exceptions.” Agreements will then often include “exclusions” from those “exceptions,” which restore the applicability of the MAE.
Materiality
In evaluating MAEs, courts typically first ask whether the change or event was “material.” Materiality is an ever-evolving term that will always be debated by differing minds. However, that may be a feature rather than a bug.
As some scholars have noted, parties may intentionally leave the term undefined because a vague MAE can offer opportunity for mutually beneficent renegotiation. Generally though, as outlined in Akorn, Inc. v. Fresenius Kabi AG, “the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror.”
Courts consider the impact of the event or change over years, not just months. Poor earnings between signing and closing, for example, may be relevant, the Akorn court held, insofar as they are expected to “persist significantly into the future.”
The nearly $5 billion terminated merger in Akorn contained, subject to certain exceptions and exclusions, a typical MAE definition:
“[A]ny effect, change, event or occurrence that, individually or in the aggregate (i) would prevent or materially delay, interfere with, impair or hinder the consummation of the Transactions or the compliance by the Company with its obligations under this Agreement or (ii) has a material adverse effect on the business, results of operations or financial condition of the Company and its Subsidiaries, taken as a whole.”
The Akorn court found that a material adverse change had occurred because the target company’s earnings declined by 86% and would likely continue dropping after the rise of unexpected competition, the loss of a large contract and data integrity issues.
While the percentage of change is paramount, questions of continuity and industry expectation are also important. The court in In re IBP, Inc. Shareholders Litigation, for example, declined to find materiality, even though there was a 64% drop in quarterly earnings, because the downslide was not expected to continue: “Swings in [the company’s] performance” the court reasoned, “were a part of its business reality.”
Other courts have similarly held that uncertainty — for instance, in the form of “technological and economic changes in [a company’s] industry which undoubtedly affected the business of all who had dealings with that industry” — is the one constant certainty.
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Read moreDetailsExceptions
Following a materiality analysis, the next question is whether the event or change is an exception under the agreement. The role of the exceptions (and exclusions thereto) was summarized by the Akorn court:
“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 MAE on the seller, then using exceptions to reallocate specific categories of risk to the buyer. Exclusions from the exceptions therefore return risks to the seller.”
The agreement in Akorn carved out numerous exceptions, including “any effect, change, event or occurrence [] generally affecting … the economy, credit or financial or capital markets, in the United States or elsewhere in the world, including changes in interest or exchange rates, monetary policy or inflation.”
Not every risk, however, can be dreamt up and explicitly addressed in an agreement. Who, after all, could predict the global lockdowns of the pandemic when drafting a contract before 2020? Corporations’ attempts to use MAE provisions to halt deals during Covid illustrate how parties and courts may treat similar arguments for tariffs.
At the height of the pandemic, a private equity firm attempted to terminate its agreement to acquire a majority interest in Victoria’s Secret (VS). The MAE there largely mirrored the one in Akorn. The definition then carved out various exceptions, including, among others, changes (1) in social or political conditions (such as the results of elections), (2) in economic markets or conditions, (3) in interest, currency or exchange rates, (4) in legal or regulatory conditions and (5) generally affecting the industry. The PE firm argued that when VS could not operate in the ordinary course because of Covid (i.e., furloughing employees, closing stores, reducing compensation), an MAE occurred.
Although the parties jointly dismissed the case without court intervention, some courts had an opportunity to address similar arguments. In AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, for example, the court found that because the relevant MAE clause excepted “natural disasters and calamities,” there was no MAE because the pandemic was, in the court’s view, a “calamity.” And in Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., the court reasoned that even if the MAE provision did not specifically preclude pandemics, Covid should be excepted if it brought about events or changes that were contracted-for exceptions. Thus, because government policies were explicitly excepted — and were the result of Covid and a proximate cause of the decline in performance — an MAE had not occurred.
Like Covid, it is hard to argue that the impacts of tariffs are not, in layman’s terms, material. Opponents, however, will no doubt claim that tariffs are a natural part of the global economy and akin to normal industry fluctuations. They will also likely claim that tariffs are potentially temporary, the policies of a rotating executive branch, akin to consistent, immaterial seasonal shifts found in other disputes. And, of course, tariffs arguably constitute a change in government policy or “change[] in interest or exchange rates, monetary policy, or inflation,” which are often explicitly exempt, like in the Akorn agreement.
As the Akorn court explained, however, MAE provisions typically contain exclusions from the exceptions. And unlike Covid, these carve-outs may save recalcitrant buyers from the new burdens of tariffs:
“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.”
In Akorn, the target company’s business suffered a deep decline “disproportionate to its industry peers” due to “unexpected new market entrants who competed with Akorn’s three top products” and the unexpected loss of a key contract. Rather than industry headwinds generally affecting pharmaceutical companies, the court found these issues to be specific business risks allocated to Akorn, sufficient to trigger an MAE.
Under the recently announced regime, a 10% baseline tariff applies to most countries equally, but an “individualized reciprocal higher tariff” will hit “countries with which the United States has the largest trade deficits,” unless those countries have been able to reach a more favorable trade deal with the Trump Administration first.
In other words, companies facing the 10% baseline tariff are in the same boat as most others — they are all facing factors “generally affecting … the economy, credit or financial or capital markets, in the United States or elsewhere in the world, including changes in interest or exchange rates, monetary policy or inflation.”
But not all tariffs were created, or are evolving, equally, and some companies — especially those based in countries with a high reciprocal tariff rate (or relying on the manufacturing or goods of those countries in their supply chains) — will undoubtedly be experiencing a unique, “disproportionate effect.”
And so, while MAE terminations are few and far between, the strategic litigation opportunity to shed a deadweight target company with shrinking margins is hard to ignore. Not all tariffs or deals are the same, and creative arguments regarding the applicability of MAE’s should be considered by both acquirers and the targets alike.
Sheron Korpus
Andrew L. Schwartz 
