When contemplating a merger and/or acquisition, one important consideration to be negotiated up front is what happens if there is a significant deterioration in the target company’s business between signing and closing. The purchase/sales agreement might be signed in, say, early May, but the parties might not expect to close for six months. If there is a significant deterioration of the target’s business, its revenues, and/or its market share, then the fundamentals of the deal, from the buyer’s perspective, are threatened. Put simply, the buyer might want out.

To handle this potential problem, the purchase/sales agreement will have what is often called a “material adverse change” clause. Depending on how it is drafted, this clause generally allows the buyer/acquiring company to back out of the deal if there is a “material adverse change.” A simple version of a material adverse change clause might look like this:

“CONDITIONS PRECEDENT TO CLOSING: The obligations of the Parties hereto to consummate and effect the Closing of the merger contemplated hereby is subject to the conditions that there is no material adverse change in the business or financial condition of TARGET from the date of this Agreement to the date of the Closing.”

The material adverse change clause can be further limited and conditioned by excepting or carving out various market or real-world events that would be beyond the control of the target company. Language here might be:

“…. provided, however, that the following shall not be grounds for claiming an adverse material effect: (1) any effect, change, event or occurrence generally affecting the industry of BUYER and TARGET or the economy, credit or financial or capital markets, in the United States or elsewhere in the world, including changes in interest or exchange rates, monetary policy or inflation; (2) any actual or prospective changes in California or US Law; (3) … ”

Furthermore, the clauses can require the target business to take various levels of effort to avoid the adverse impacts of various conceivable causes of any given material adverse effect. In general, it is difficult for a target business to make efforts to avoid the adverse impacts of something like a general downturn in the stock or capital markets. But some types of material adverse effects are within the business operations of the target business. Examples here might be responding to litigation or regulatory investigations. Language in the material adverse change clause might require the target business to use its “best efforts” or “commercially reasonable efforts” to avoid the impact of the clause.

How “materiality” is defined depends on the parties and the purposes of the transaction. Most often, mergers and acquisitions are aimed at economies of scale and at obtaining/retaining market share. With these traditional types of transactions, a “material” adverse change is one that destroys the value of the target business over the long term. As one court phrased it, a “short-term hiccup in earnings should not suffice…”

Contact San Diego Corporate Law Today

If you would like more information about mergers and acquisitions, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email. Mr. Leonard’s law practice is focused on business, transactional, and corporate matters, and he proudly provides legal services to business owners in San Diego and the surrounding communities.

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