Pandemic Risk and the Interpretation of Exceptions in MAE Clauses

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 the Journal of Corporation Law. Related research from the Program on Corporate Governance includes Are M&A Contract Clauses Value Relevant to Target and Bidder Shareholders? by John C. Coates, Darius Palia, and Ge Wu (discussed on the Forum here), and Deals in the Time of Pandemic by Guhan Subramanian and Caley Petrucci (discussed on the Forum here).

The MAE cases arising from the COVID-19 pandemic have focused attention on the exceptions found in typical MAE definitions. As is well known, such definitions commonly except from the definition events related to certain systematic risks, such as changes in business, market or industry conditions, changes in law, or force majeure events. Cases such as AB Stable and KCake in Delaware and Fairstone in Canada have involved the interpretation of such exceptions in two ways—one simple and one complex—both of which I discuss in a new paper forthcoming in the Journal of Corporation Law and in a shorter related article in Business Law Today.

The simpler issues involved whether a pandemic is a “natural disaster” or “calamity” (AB Stable) or perhaps an “emergency” (Fairstone) under an exception in the MAE definition for force majeure events. Courts have had little trouble resolving such issues using traditional methods of contract interpretation. Some of the literature surrounding such decisions has confused force majeure clauses with exceptions in MAE definitions for force majeure events (the former excuse a seller from performing, while the latter require a buyer to perform and so are almost functional opposites), but that is a relatively minor issue.

Much more important is the fact that the recent MAE cases have exposed a latent ambiguity in the typical MAE definition. Such definitions define a capitalized “Material Adverse Effect” to be any event that has, or would reasonably be expected to have (the exact language varies), an (uncapitalized) material adverse effect on the target, except for certain excepted events (perhaps subject to exclusions for events affecting the company disproportionately). It is counterintuitive, though patently correct under the plain language of the typical MAE definition, that a Material Adverse Effect is not a material adverse effect but an event that causes a material adverse effect. The definition is thus inherently causal. The tacit assumption underlying the definition is that, for a given event, we can say unambiguously whether that event causes (e.g., “would reasonably be expected” to result in) a material adverse effect on the target or not. In the recent MAE cases, however, the causal background to the alleged material adverse effect was more complex. The claim, for example, was that a first event (the pandemic) caused a second event (governmental lockdown orders), which second event caused the material adverse effect on the company. If the MAE definition allocates the risk of both events to the same party, then of course that party bore the risk of any resulting material adverse effect. But what happens if the MAE definition allocates the risk of one event (such as the pandemic) to the target but the risk of the other event (such as lockdown orders) to the acquirer (under an exception for changes in law)?

Albeit only in dicta, AB Stable and KCake both said, in effect, that in such cases the exceptions in the MAE definition would apply, and there would be no Material Adverse Effect. I think this is mistaken. The argument starts from the plain text of MAE definition, which, as noted above, defines a capitalized Material Adverse Effect to be an event that has, or would reasonable be expected to have, an uncapitalized material adverse effect on the target, and then excepts from that definition certain other events that are thus not Material Adverse Effects, regardless of their effects on the target. In other words, MAE definitions allocate risk on the basis of events, with the target bearing the risk of all events other than the excepted events, with respect to which the acquirer bears the risk. But when parties to a merger agreement allocate in an MAE definition the risk that a certain event may occur, they do so not because they care about the event in and of itself; rather, they care about the risk that the event will occur and cause a material adverse effect on the target. Hence, when the parties allocate the risk of a certain event in an MAE definition, they are allocating as well the risk of any material adverse effect that would reasonably be expected to result from the event. Events are reasonably expected to have effects, however, only through reasonably-expected casual pathways. To allocate the risk of an earthquake, for example, is to allocate as well the risk of damage to the company’s property caused by the earthquake. To allocate the risk of a change in interest rates is to allocate the risk of a resulting change in the company’s cost of equity capital, which would affect the present value of its future cashflows. In other words, when an MAE definition allocates the risk of a certain event, it allocates as well the risk of all events reasonably-expected to follow from that event, up to and including any reasonably-expected material adverse effect on the target.

This principle resolves the causally-complex issues in cases like AB Stable. If an MAE definition allocates the risk of a pandemic to a certain party, that party bears the risk of a pandemic and all events reasonably expected to follow from any pandemic that actually occurs, up to and including any reasonably-expected material adverse effect on the company. If there occurs a pandemic that would reasonably be expected to result in governmental lockdown orders, then the party bearing the risk of a pandemic bears as well the risk of such orders. This remains true even if the party to whom this risk is allocated is the target and the MAE definition includes an exception for changes in law; while such an exception applies to changes in law generally, it should not apply to changes in law that were specifically, albeit implicitly, allocated to the target along with the risk of a pandemic. The specific governs over the general.

In such cases, the acquirer could also simply say that, even if the change in law was excepted and so not a Material Adverse Effect, the pandemic was nevertheless not excepted, and since the pandemic would reasonably be expected to have a material adverse effect on the target, the pandemic is a Material Adverse Effect under the plain terms of MAE definition. That some other event—the change in law—is not a Material Adverse Effect does not change the fact that the pandemic is a Material Adverse Effect. Courts have not accepted such arguments—and parties have often not even made them—because discussions of MAEs routinely conflate Material Adverse Effects with material adverse effects (i.e., events causing material adverse effects with the material adverse effects that they cause), a confusion made especially easy since the abbreviation “MAE” is used indiscriminately for both concepts. At a critical point in the argument in AB Stable, the court falls into this confusion and makes the exceptions in the MAE definition apply to effects rather than events causing such effects, thus reading the definition as if it meant that, if an excepted event has a material adverse effect, then that effect is excepted, and so even if another unexcepted event would also reasonably be expected to result in that material adverse effect, somehow that unexcepted event becomes excepted. For example, if the target bears the risk of a pandemic and the acquirer bears the risk of a change in law, and if the pandemic causes a change in law (lockdown orders) and the change in law causes a material adverse effect, then since the effect is “excepted” (since it was caused by an excepted event), the pandemic is not a Material Adverse Effect. But all this is a confusion, since it makes the exceptions in the MAE definition apply to effects when by their plain terms they apply to events causing effects, not the effects themselves. Still, courts that have fallen into this confusion ought not be judged harshly, for the confusion antedates the recent MAE cases and, as far as I can tell, originated in one of my own law review articles published in 2009. If anyone is responsible for this mistake, I am.

Finally, in their fine article on Deals in the Time of Pandemic (discussed on the Forum here) Professor Subramanian and Ms. Petrucci have called attention to the language introducing the exceptions in the MAE definition, noting how such language can expand the scope of such exceptions. I discuss the import of such language too, both in the Journal of Corporation article and then more extensively in the final section of the Business Law Today article.

The article on Pandemic Risk and the Interpretation of Exceptions in MAE Clauses forthcoming in the Journal of Corporation Law is available here, and the shorter article on What do Exceptions in MAE Definitions Except? in Business Law Today is available here.

Trackbacks are closed, but you can post a comment.

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>