A New Theory of Material Adverse Effects

Robert T. Miller is Professor of Law and F. Arnold Daum Fellow in Corporate Law at the University of Iowa College of Law. This post is based on his recent paper, forthcoming in Business Lawyer, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here).

In a paper forthcoming in Business Lawyer, I propose a new, systematic understanding of material adverse effects that resolves the major outstanding problems in the Delaware caselaw on MAEs.

As is well known, business combination agreements almost never define the phrase “material adverse effect,” and so the meaning of that key expression derives primarily from a line of Delaware cases starting with In re IBP Shareholders Litigation. In that case, the court said that a material adverse effect requires an event that substantially threatens the overall earnings potential of the target in a durationally-significant manner. In implementing this standard in IBP and subsequent cases, the courts have had to determine how the target’s earnings should be measured (e.g., by EBITDA or by some other measure of cashflow), how changes in earnings should be determined (e.g., which fiscal periods should be compared with which), and how large a diminution in earnings must be in order to count as material. Neither IBP nor subsequent cases have provided clear and compelling resolutions of these issues. On the contrary, later cases have introduced yet new problems, such as whether it matters that the risk that has materialized and adversely affected the target’s business was known to the acquirer at signing, whether material adverse effects should be measured in quantitative ways, qualitative ways, or both, and whether a material adverse effect must be felt by the company within a certain period of time after the occurrence of the event causing the effect.

The new theory of MAEs proposed in the paper offers a new and systematic understanding of material adverse effects that solves all of these problems. Beginning from the foundational premise that a material adverse effect should be understood from the perspective of a reasonable acquirer, the paper argues that such an effect is a material reduction in the value of the company as reasonably understood in accordance with accepted principles of corporate finance—that is, as a material reduction in the present value of all the company’s future cashflows. Hence, to determine if there has been a material adverse effect, the court has to value the company twice, once as of the date of signing and again as of the date of the alleged material adverse effect, in each case much as it would in an appraisal action. This sounds daunting, but as the paper explains, valuing the company is easier and more reliable in the MAE context than in the appraisal context, not only because the court need obtain only a range of values for the company at the two relevant times (and not pinpoint valuations as in appraisal proceedings) but also because it turns out that there is a canonical way to determine if a reduction in the value of the company would be material to a reasonable acquirer.

Besides presenting a systematic understanding of MAEs, the new theory presented in the paper also solves all of the outstanding problems noted above and explains why those problems could not be solved with the conceptual resources available in the existing caselaw.

The complete paper is available for download here.

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