What do Exceptions in MAE Definitions Except?

Abstract

MAE cases arising from the COVID-19 pandemic such as AB Stable and KCake have focused attention on the exceptions typically contained in the definition of the term “Material Adverse Effect.” That is, merger agreements typically define the (capitalized) term “Material Adverse Effect” to be any event that has or would reasonably be expected to have an (uncapitalized) material adverse effect on the target, other than certain excepted events such as general changes in business, market or industry conditions, changes in law, or force majeure events. The COVID-19 cases have exposed a latent ambiguity in this definition because, while the definition assumes that a single event causes a material adverse effect on the target, in the COVID-19 cases the causal background to the supposed material adverse effect was more complex, with one event (the pandemic) causing a second event (e.g., governmental lockdown orders) and the second event causing the material adverse effect on the target. If the MAE definition allocates the risk of both events to the same party, then clearly that party bears the risk of any resulting material adverse effect, but what happens if, say, the risk of a pandemic is allocated to the target but the risk of changes in law (such as lockdown orders) is allocated to the acquirer? Albeit only in dicta, AB Stable and KCake answered this question by saying, in effect, that if the risk of either event is allocated to the acquirer, there is no Material Adverse Effect. This article argues that this reasoning is unsound. The argument begins from the fundamental point that, under the express terms of the typical MAE definition, a (capitalized) Material Adverse Effect is an event that causes an (uncapitalized) material adverse effect; it is counterintuitive but plainly correct that a Material Adverse Effect is thus not a material adverse effect but an event that causes a material adverse effect. Furthermore, MAE definitions allocate risk on the basis of events, not effects, and they do so not because parties care about the events in and of themselves but because of the tendency of the events to cause material adverse effects. Hence, in allocating the risk of a certain event, the parties are allocating the risk not only of the event itself but also of all other events reasonably expected to follow from the event, up to and including any reasonably-expected material adverse effect on the target. This means, for example, that if the target bears the risk of a pandemic, it also bears the risk of everything reasonably expected to follow from any pandemic that occurs, including any reasonably-expected lockdown orders, up to and including any reasonably-expected material adverse effect, even if the MAE definition includes exceptions related to changes in law that would otherwise except lockdown orders. Even if the lockdown orders are mistakenly regarded as excepted, the pandemic was not excepted, and so if the pandemic would reasonably be expected to result in a material adverse effect (via lockdown orders or otherwise), then the pandemic is a Material Adverse Effect even if the lockdown orders (because they are excepted) are not. Courts have misunderstood this point because they have conflated Material Adverse Effects with material adverse effects and treated the exceptions in the MAE definition as if they applied to material adverse effects rather than to events causing material adverse effects. The article traces the origin of this confusion to one of the author’s own law review articles from 2009. Finally, the article discusses the import of the language introducing the exceptions in the MAE definition that sometimes expands the scope of the exceptions in various ways.