The Purpose and Progression of Adverse Material Effect Clauses: An Interpretation by the British High Court

Delaware law, British courts, and a material adverse effect all converged in BM Brazil, a recent decision by the England and Wales High Commercial Court that applied Delaware law to interpret a Material Adverse Effect (“MAE”) clause in a cross-border merger dispute. BM Brazil v. Sibanye, EWHC 2566 (Oct. 10, 2024). MAE clauses are used in sale and purchase agreements (“SPA”) to give buyers protection against certain events in the merger and acquisition (“M&A”) context, allowing the buyer to terminate the contract between signing and closing. (Bloomberg Law). Although these clauses are commonly included in M&A contracts, findings that an event constitutes an MAE occurred are few and far between. (Glenn D. West, Business Law Today). While BM Brazil provides valuable insight on how courts analyze MAE clauses, courts remain unlikely to find an MAE occurred in most cases. (Charlotte Eborall, Journal of International Banking and Financial Law (UK); Glenn D. West, Business Law Today). This post discusses the details of the case, the Commercial Court’s holdings, and the application of MAE clauses to modern contract execution.  

In BM Brazil, defendant-buyer attempted to terminate an SPA acquiring two Brazilian mines from plaintiff-seller based on the buyer’s assertion that a geotechnical event in one of the mines constituted an MAE. BM Brazil, EWHC 2566 at 1-6. About two weeks after the parties executed the SPA in 2021, one of the mines experienced a landslide, resulting in cracks and displacement of a slope in the mine. Id. at 18, 34; (Glenn D. West, Business Law Today; Charlotte Eborall, Journal of International Banking and Financial Law (UK)). In early 2022, the buyer informed the seller that it would no longer close on the SPA because of the purported MAE resulting from the geotechnical event. BM Brazil, EWHC 2566 at 109-115; (Charlotte Eborall, Journal of International Banking and Financial Law (UK)). The seller voided the SPAs on the basis that the buyer’s attempt to terminate the contract was “wrongful repudiation,” resulting in the dispute. Id. at 20. The SPA’s MAE clause followed the classic format explained below, including a number of exceptions. Id. at 16.

MAE clauses follow a common construction pattern, often comprised of “(a) a listing of the ‘Underlying Predicate Events’ (‘events, acts, occurrences’), followed by (b) an ‘Expectation Metric’ (‘has, or would/could reasonably be expected to have’), followed by (c) an ‘Undefined Term’ (‘material adverse effect on’), followed by (d) the ‘MAE Objects’ (‘business, financial condition, results of operation’).” (Glenn D. West, Business Law Today). Events that have qualified as an MAE include EBITDA declines of over 50% and “where the cost of remediating [a] regulatory violation exceeded 20 percent of the target’s equity valuation.” Id. The clause then typically lists a series of exceptions that will not constitute an MAE. Id. Such exceptions can include acts of war, pandemics, and many other events. (Practical Law Corporate & Securities, Westlaw). Lastly, MAE clauses usually have a “Disproportionality Exclusion.” (Glenn D. West, Business Law Today). If a buyer is faced with an event that materially affects the target company, but it is listed in the exceptions, they cannot use it to terminate the contract. (Practical Law Corporate & Securities, Westlaw). The parties in BM Brazil used this construction in their SPA’s. BM Brazil, EWHC 2566 at 16.

In analyzing these issues, the Commercial Court turned to Delaware law because the U.S. has more case law on MAE clauses, albeit limited. Id. at 193. Despite numerous attempts of buyers alleging an MAE, the Delaware Court has only found one. (Glenn D. West, Business Law Today). In Akorn, the court focused on the fact that the target business had an unexpected but consistent decrease in business performance after the relevant agreement was signed but prior to closing. Akorn, Inc. v. Fresenius Kabi AG, 198 A.3d 724 (Del. Ch. 2018). Specifically, the business performance of the target company experienced a drop in equity of over 20%, which was deemed to be an MAE, creating a rough line for when an MAE can occur. Id. In addition to Akorn, the Commercial Court looked to other decisions, including Snow Phipps Group LLC v. KCake Acquisition Inc, where the Delaware Court determined an MAE did not occur. (Charlotte Eborall, Journal of International Banking and Financial Law (UK)). Snow Phipps analyzed an MAE clause based on whether a purported adverse effect occurred where the purchaser would experience a reduction in long-term earnings due to acquiring the target company. (Glenn D. West, Business Law Today). Similar to the reviewed U.S. cases, the court in BM Brazil focused on the financial and qualitative aspects of the MAE’s effect on the target business, while evaluating the reasonableness of someone in the parties’ position. Id.

To resolve the dispute in BM Brazil, the Commercial Court addressed two questions: (1) whether the geotechnical event was an MAE, and (2) if yes, whether the event fell under an exception to an MAE. BM Brazil, EWHC 2566 at 190. In answering the first question, the court made three initial determinations as to the construction of the MAE clause. Id. at 217. First, if a “change, event, or effect” occurs between signing and closing and is not material, it cannot be made material by relating it back to something that existed before signing. Id. at 239. Second, material effects should be evaluated by reasonable party considerations at the time one party notifies the other of the MAE claim to terminate, and a risk of materiality is not itself enough. Id. at 244-45. Third, Justice Butcher acknowledged there is no clear test for determining if an event is “material.” Id. at 251. However, he agreed with prior determinations by the Delaware Court that “material” means “significant or substantial” in this situation, and the event affects the target company’s “earnings power over a commercially reasonable period,” likely indicating years. Id. at 249-50. 

After making these three initial determinations, the Commercial Court moved to evaluating both qualitative and quantitative effects of the geotechnical event to answer question (1). While Justice Butcher expressed skepticism for the relevance of quantitative aspects of the geotechnical event, he noted the geotechnical event is not an uncommon event in mines, there was no loss of equipment, operations in the mine were not delayed long after the event, and the slope did not experience a detachment. Id. at 259-60. As for quantitative aspects, the court determined the geotechnical event likely resulted in costs below 5%, and certainly below 10% of the target business price. Id. at 266-69. Justice Butcher also determined “at the date of termination, the [geotechnical event] was not and would not reasonably have been expected to be material.” Id. at 303. The court’s analysis of all the factors relating to materiality led to the conclusion that an MAE did not occur. Id. at 327.

To answer the second question, though not necessary given the finding that the geotechnical event did not qualify as an MAE, the court focused on an exception to the MAE clause which stated “any action, omission, change, effect, circumstance or condition attributable to or contemplated by the execution, delivery or performance of this Agreement . . .” did not qualify as an MAE in the transaction. Id. at 301. Justice Butcher determined this exception applied only to events occurring because the parties entered into the contract, “and which would not have occurred if it had not been entered into.” Id. at 309. The geotechnical event would not fall under this exception. Id. at 310.

Reinforced by the BM Brazil holding, courts rarely find an MAE occurred, likely because it provides an out for a buyer in carefully contemplated contracts, often involving a significant amount of money and informed parties. (Glenn D. West, Business Law Today). BM Brazil provided a valuable synthesis of U.S. law, and reaffirms that an MAE is “an extremely high threshold” to meet. (Practical Law Corporate & Securities, Westlaw). To avoid disputes over an MAE, and because there is still ambiguity regarding these clauses, parties to M&A contracts may spend more time refining their MAE clauses. (Bloomberg Law). While buyers typically prefer a broad MAE clause to favor their potential rescission of a contract and sellers prefer a narrow MAE clause to protect their sale, contracting parties will likely attempt to find ways to avoid litigation. Id. Where a court must interpret a disputed MAE clause, it is unlikely that the court will look outside the words used in the MAE, so parties are impliedly encouraged to list every possible MAE, including specific numerical figures. (Carl Reisner et al., The M&A Lawyer). MAE clauses will likely continue to be ambiguous and disputed if parties do not have a precise understanding of what the agreement entails. Id.

Although MAE clauses attempt to specify what does and does not qualify as an MAE, the clauses still fail to provide a definition of “material,” a key part of an MAE. (Michelle Shenker Garrett, Columbia Journal of Law and Social Problems). The time between signing and closing is needed to ensure the necessary finalizations for such an agreement, and MAE clauses “attempt[] to ensure” a buyer is getting what it agreed to. Id. While MAE clauses are intended to allocate risk equally between buyers and sellers, courts continue to favor sellers and rarely find for buyers. Id. Ultimately, MAE clauses serve as a “last resort” for buyers attempting to terminate a contract. Id. As reinforced in BM Brazil and other sources, courts’ fact specific inquiries into whether an MAE occurred will likely continue to produce an unfavored outcome for buyers, resulting in a need to provide detailed information in MAE clauses. (Glenn D. West, Business Law Today).