Private Equity

The COVID-19 pandemic has resulted in renewed focus on Material Adverse Effect (“MAE”) clauses in public and private acquisition agreements. That focus, by both the courts and academic scholarship, has raised questions about how these ubiquitous and seemingly standardized provisions actually work. In particular, recent scholarship has raised questions about whether the various MAE exceptions found in an MAE clause follow a Newtonian determinism or something more akin to chaos theory. Simply put, does an MAE exception carve out all the events that flow from the events covered by that exception, even non-excepted events that ultimately caused the material adverse effect, or does the MAE exception only carve out the excepted event itself to the extent it was the direct cause of the material adverse effect? Moreover, if an unexcepted event results in an excepted event, is the excepted event excepted at all given that the root cause of the excepted event was an unexcepted event? Does it matter in answering these questions how the lead-in language to the list of MAE exceptions is worded? Indeed, can the wording of the lead-in make causal connectivity from event to material adverse effect irrelevant, or so remote as to be effectively irrelevant? And what does any of this have to do with Mrs. Palsgraf?

Since October of 2020, there have been four reported judicial decisions regarding an MAE clause, two in Delaware and one each in England and Canada, all arising out of efforts to terminate deals based on the pandemic’s impact on the target company.^[1] Most of these decisions have focused less upon whether a material adverse effect had occurred or was reasonably likely to occur and more upon whether the event that caused the alleged material adverse effect was included within one of the numerous exceptions to the occurrence of an MAE. Moreover, the academic literature has recently produced some meaningful articles addressing latent ambiguities in MAE exceptions depending on whether the language used to introduce those exceptions was causal or relational.^[2] While the most recent judicial decision, from Vice Chancellor McCormick of the Delaware Court of Chancery, Snow Phipps Group, LLC v. KCake Acquisition, Inc., 2021 WL 1714202 (Del Ch. April 30, 2021), reaffirms the difficulty of successfully invoking an MAE clause even in the absence of applicable MAE exceptions, it also focuses, in dicta, on the extreme breadth that exceptions to the MAE clause can have to negate the occurrence of a material adverse effect (even if one otherwise occurred) when those exceptions are introduced by the phrase “arising from or related to.”

All MAE clauses follow a basic pattern. Professor Robert T. Miller (whose articles on MAE clauses have been cited by Delaware’s Vice Chancellor Laster and England’s Justice Cockerill in two of the recent pandemic-related MAE decisions) helpfully summarizes that basic pattern as follows: A Base Definition of MAE, followed by a “lead-in” to a list of MAE Exceptions, followed by a list of MAE Exceptions, followed by a list of Disproportionality Exclusions.^[3] Randomly selecting an MAE definition from a recent publicly filed deal, reveals how this basic pattern works:

“Company Material Adverse Effect” means any fact, circumstance, effect, change, event or development that, individually or in the aggregate, (a) prevents, or has a material adverse effect on, the ability of the Company to consummate the Transactions or (b) has [or is reasonably expected to have] a material adverse effect on the business, properties, financial condition or results of operations of the Company and the Company Subsidiaries (without giving effect to the Merger), taken as a whole [the Base Definition]; provided, however, that [the lead-in to the MAE Exceptions] none of the following, nor any fact, circumstance, effect, change, event or development to the extent arising out of or relating to the following, shall constitute or be taken into account in determining whether a “Company Material Adverse Effect” has occurred or may, would or could occur under the foregoing clause (b) only: [list of MAE Exceptions], except, in the case of [list of MAE Exceptions to which Disproportionality Exclusions apply], to the extent such fact, circumstance, effect, change, event or development has a materially disproportionate effect on the Company and the Company Subsidiaries, taken as a whole, relative to others in the industries and regions in which the Company and the Company Subsidiaries operate in respect of the businesses conducted in such industries in such regions [the Disproportionality Exclusions].

Typically courts start an MAE analysis by first determining whether a materially adverse effect had occurred, or is reasonably expected to occur (as did Vice Chancellor McCormick in Snow Phipps), and then, to the extent it was determined that a material adverse effect had occurred or was reasonably expected to occur, determine whether an MAE Exception applied. But in the first pandemic-related Delaware case, AB Stable VIII LLC v. Maps Hotels & Resorts One LLC, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020), Vice Chancellor Laster determined that given that the target was in the hotel business, it was more straightforward to assume that the consequences of the COVID-19 pandemic “were sufficiently material and adverse to satisfy the requirements of Delaware case law.” After all, it would be pretty hard to deny the devastating impact of the COVID-19 pandemic on the hotel industry. 

The seller relied upon the following four MAE Exceptions in arguing that an MAE had not occurred (the lead-in to which read “other than any event, change, occurrence or effect arising out of, attributable to or resulting from”):

• “general changes or developments in any of the industries in which the Company or its Subsidiaries operate,”
• “changes in regional, national or international political conditions (including any outbreak or escalation of hostilities, any acts of war or terrorism or any other national or international calamity, crisis or emergency) or in general economic, business, regulatory, political or market conditions or in national or international financial markets,”
• “natural disasters or calamities” and
• “changes in any applicable Laws.”

The buyer argued that all but the “natural disasters or calamities” exception required a “root cause” determination; i.e., that in order to qualify as an exception the seller had to demonstrate that it was “changes” in the industry, or economic or business conditions or applicable laws that caused the material adverse effect, rather than the pandemic which lead to the “changes.” In other words, if the pandemic was the ultimate cause of an excepted event, but the pandemic itself was not an excepted event, then the fact that an excepted event occurred as a result of the pandemic would not permit the resulting excepted event to apply and prevent an MAE that had otherwise occurred from occurring. Vice Chancellor Laster did not buy that argument because he expected that when that approach is intended there would be a carve-out that addressed it.^[4] In other words, Vice Chancellor Laster seemed to suggest that, in order to eliminate an unexcepted event from causing an excepted event and the resulting excepted event then resulting in no MAE having occurred, you would need to carve out from each excepted event something to the effect of “(unless such event was the [direct/ultimate] result of an event not otherwise included in these exceptions).”^[5]

Notwithstanding Vice Chancellor Laster’s rejection of the root cause approach to the other exceptions (and the implication, at least in dicta, that some one or more of them might have applied), he determined to focus only upon the one exception that the buyer conceded did not lend itself to the root cause approach—the exception for “natural disasters or calamities.” As applied to the target’s hotel business, Vice Chancellor Laster had no problem concluding that “[t]he COVID-19 pandemic fits within the plain meaning of the term ‘calamity.’” And in this case there were no Disproportionality Exclusions to consider.

So, because the negative impact to the target’s business was caused by the COVID-19 pandemic and the COVID-19 pandemic was a “calamity,” which was expressly excepted from being an MAE, the buyer was denied the right to terminate the deal, even assuming that the target had suffered a material adverse effect.^[6] And Justice Koehnen, in the Canadian case of Fairstone Fin. Holdings Inc. v. Duo Bank, 2020 ONSC 7397 (2 Dec., 2020) reached a similar conclusion to that of Vice Chancellor Laster. She held, without addressing the root cause question, that MAE Exceptions that included natural disasters and changes in general market conditions (and the lead-in to which stated “to the extent that the material adverse effect results from or is caused by:”), both applied to prevent an MAE from having occurred as a result of the pandemic.^[7]

A variant of the root cause argument was highlighted in the English MAE case decided last fall, before AB Stable was decided, Travelport Limited v. WEX Inc., [2020] EWHC 2670 (Comm) (12 Oct., 2020). Unlike AB Stable, the MAE clause in Travelport did contain a Disproportionality Exclusion, and, like most Disproportionality Exclusions, it only applied to certain of the MAE Exceptions. In this case there was an MAE Exception both for pandemics and for changes in law. But the Disproportionality Exclusion only applied to the pandemic exception, not the changes in law exception. Among other findings by Justice Cockerill in Travelport was her conclusion that because the Disproportionality Exclusion only applied to the pandemic exception to the MAE definition and not to the changes in law exception, and because the alleged adverse impacts on the target were principally caused by the various governmental restrictions that arose out of the pandemic and the changes in law exception was not subject to the Disproportionality Exclusion, the Disproportionality Exclusion did not apply. In other words, it did not matter that the pandemic had been the ultimate cause of those governmental restrictions and that there was a separate MAE Exception for changes resulting from the pandemic (to which the Disproportionality Exclusion did apply). Interesting, however, Justice Cockerill did not appear to consider how the lead-in to the MAE Exceptions might have impacted the breadth of those exceptions and correspondingly impacted the breadth of the Disproportionality Exclusion—i.e., if the pandemic exception included events that were “resulting, arising from or in connection with” the pandemic, and that exception was subject to the Disproportionality Exclusion, why wouldn’t the buyer get to count the impact of laws and regulations that resulted from or were connected with the pandemic as part of the pandemic exception (which of course was subject to the Disproportionality Exclusion)? After all, just because the Disproportionality Exclusion did not apply to changes in law generally did not necessarily mean that it would not apply to changes in law that were directly linked to the pandemic when the pandemic was subject to the Disproportionality Exclusion.

In the most recent Delaware case, Snow Phipps, following the time honored standards that require a material adverse effect to have a long-term effect on the company’s earnings, Vice Chancellor McCormick determined that despite the impact of the pandemic, which was not a listed MAE Exception, the target’s cake decorations business had not suffered a material adverse effect. But then for completeness, she also addressed the issue of whether the MAE Exception for changes in law and governmental regulations would have applied because the decline in the target’s sales “arose from, or at the very least related to, those governmental orders.” Vice Chancellor McCormick concluded that the changes in law exception applied because the lead-in “language ‘arising from or related to’ is broad in scope under Delaware law …[and] [a] particular effect is excluded if it relates to an excluded cause, even it also relates to non-excluded causes.” As a result, “revenue declines arising from or related to changes in law fall outside the definition of an MAE, regardless of whether COVID-19 prompted those changes in the law.” In other words, it was not necessary to determine a root cause for an exception to apply. Even if a non-excluded event caused the excluded event, the excluded event still applied.

Which brings us to the recent academic literature. In a soon to be published study of MAE clauses and Ordinary Course Covenants, Deals in the Time of Pandemic, by Guhan Subramanian & Caley Petrucci,^[8] the authors address a number of MAE clause and Ordinary Course Covenant variants and their potential consequences, all of which are important additions to the scholarship in these areas. But what caught my attention was an observation by the authors that a substantial portion of the acquisition agreements in their study used broad lead-in language to the MAE Exceptions and their conclusion that there was a significant difference between causal language and non-causal language in terms of the potential breadth of the lead-in clauses.^[9] In other words, depending on the wording of a particular lead-in clause, we have to not only be concerned with excepted events causing unexcepted events which then cause a material adverse effect, but also with excepted events having some relationship or connectivity to unexcepted events and thereby bringing an unexcepted event into the non-causal orbit of an excepted event. If that is the case, then we really have moved from Newtonian determinism to potential chaos theory in our negotiation and interpretation of MAE clauses.

Curious about Subramanian’s & Petrucci’s observations and conclusions, I randomly pulled the MAE definitions from some recently filed acquisition and merger agreements. And sure enough, there is a wide variety of lead-in language that appears in those definitions. A fairly bland version was the following:

provided that none of the following shall be deemed in and of themselves, either alone or in combination, to constitute, and none of the following shall be taken into account in determining whether there is, or would reasonably likely to be, a Material Adverse Effect: [list of exceptions]

While this lead-in avoids the broad “arising from or related to” formulation, it does raise the question as to what is meant by “in and of themselves.” Could that phrase suggest that, if there was an unexcepted event that caused one or more of the excepted events listed in the MAE Exceptions that then resulted in a material adverse effect, the excepted event so caused by another unexcepted event was thereby non-excepted (because the excepted event depended upon the occurrence of an unexcepted event and did not arise in and of itself). In other words, is this language carving out from the MAE Exceptions unexcepted root causes?

Another basic form of lead-in language was the following:

provided, however, that Material Adverse Effect shall not be deemed to include the impact of: [list of exceptions]

At first blush, excepting the “impact of” the listed exceptions does not appear to add much because, unless the excepted events have an impact (in the sense of causing a material adverse effect), there is really nothing to except. On the other hand, one could argue that the “impact of” an excepted event could itself be another event and so “impact of” is the same as “resulting or arising from;” i.e., unexcepted events arising from excepted events, therefore, might themselves be excepted.

And finally, a version of the lead-in that introduces chaos theory to the MAE Exceptions:

provided that no effect, event, development or change resulting from, arising out of, attributable to or relating to any of the following shall be deemed to be or constitute a “Company Material Adverse Effect,” and no effect, event, development or change (by itself or when aggregated or taken together with any and all other such effects, events, developments or changes) to the extent resulting from, arising out of, attributable to, or related to any of the following shall be taken into account when determining whether a “Company Material Adverse Effect” has occurred or would reasonably be likely to occur: [list of exceptions]

This lead-in seems to effectively make a listed exception out of every conceivable event that is related to or connected in any way to a listed exception and the occurrence of a material adverse effect; and causality (however remote) is not even a potential governor on the extent to which that relational connectivity could extend. And according to Subramanian & Petrucci, language like this is to be found in a significant portion of the merger and acquisition agreements being negotiated and signed.

Professor Robert T. Miller (who has published numerous articles on MAE clauses in the past and who has been cited frequently by the courts) has also written a soon to published article on the means of properly interpreting MAE Exceptions, Pandemic Risk and the Interpretation of Exceptions in MAE Clauses.^[10] In that article Professor Miller provides some interpretive guidelines for resolving what he calls the “causal ambiguity problem.” But, for those of us facing the task of negotiating MAE Exceptions when judicial clarity regarding the “causal ambiguity problem” is lacking, we may need to rethink our lead-in language and what we actually intend should happen if an unexcepted root cause results in a listed MAE Exception (i.e., did we really want that excepted or not?). And we may need to ask important questions as to exactly how far down the chain of causation (setting aside the potential breadth of non-causal lead-in language like “related to”) are we intending that an unexcepted event that results from an excepted event can be treated as if it were an excepted event?

And now to what any of this has to do with Mrs. Palsgraf. Every law student learns about the unfortunate Mrs. Palsgraf in first year torts class.^[11] Innocently waiting for a train for which she held a ticket, a coin-operated scale falls on her as a result of an explosion caused by a package of fireworks being dropped by a passenger boarding another departing train. Even though the fireworks were alleged to have been dislodged negligently by the station’s employees who were assisting the passenger in boarding the train, and there was no question that Mrs. Palsgraf would not have been injured but for the dropped package and resulting explosion, Justice Cardozo refused to recognize a cause of action in favor of Mrs. Palsgraf against the station because the employees could not have foreseen the danger to Mrs. Palsgraf from assisting another passenger in boarding a train while holding an innocent-looking package. In other words, the cause and effect were too remote.

While we are not first year law students debating the fairness of concepts like proximate cause that provide brakes on the unending causal connections that could extend liability to unforeseen persons and dangers, we may need to reacquaint ourselves with Mrs. Palsgraf and think through the potential causal connections that could create exceptions beyond those expressly stated, based on the lead-in language to the MAE Exceptions in the MAE clause we are negotiating.Indeed, we may even need to borrow from Justice Cardozo’s reasoning and modify our lead-in language (even when clearly causal and not merely relational) so that only reasonably foreseeable or expected consequences of excepted events are thereby also excepted.^[12]