On the Meaning of ‘Material’

The adjective material is ubiquitous in business acquisition agreements. Designed to ensure that whatever is being represented or covenanted will not be deemed breached unless the impact of any inaccuracy or failure to perform is actually significant (which is itself a word that fails to convey a clear-cut standard), the word material is fraught with an uncertain meaning as applied to a particular set of circumstances.

One of my faithful readers recently asked me whether I had ever written anything about the use of the term material as a qualifier in a purchase agreement. The answer was, “Of course I have.” But perhaps a reminder is necessary. Conveniently, Vice Chancellor Laster, in a recent Delaware Court of Chancery decision, In re Dura Medic Holdings, Inc. Consolidated Litigation, had occasion to reiterate Delaware’s approach to determining the meaning of the word material when it is used as an adjective qualifying a covenant or representation.

It is tempting to view the word material standing alone (or as used in the phrase “in all material respects”) as having a similar meaning to the term material when used in the phrase “material adverse effect.” But legally the two have nothing to do with one another. Caselaw has declared that material when used in the phrase “material adverse effect” requires not only a truly significant (in the sense of really, really bad) negative impact, but also a negative impact that is “durationally significant.” The word material standing alone or as used in the phrase “in all material respects,” however, has a different meaning. In Dura Medic Holdings, Vice Chancellor Laster reminds us:

When used to qualify a representation, the adjective “material” “seeks to exclude small, de minimis, and nitpicky issues that should not derail an acquisition.” For the breach of a representation to be material, there need only be a “substantial likelihood that the . . . fact [of breach] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information.” That interpretation “strives to limit [a contract term with a materiality qualifier] to issues that are significant in the context of the parties’ contract, even if the breaches are not severe enough to excuse a counterparty’s performance under a common law analysis.”

In other words, a “materiality” qualifier imposes a much lower standard for measuring the significance of a breach than does the term “material adverse effect.” And it specifically serves to lessen the high bar that the common law imposes for permitting a counterparty to treat the other party’s breach as significant enough to excuse that counterparty’s own performance.

But it is far from clear how material, on the one hand, simply means more than de minimis, but on the other, means important enough to have “significantly altered the ‘total mix’ of information” upon which a counterparty relied in entering into the purchase and sale agreement. One could well wonder when a breach would not be deemed “material” as a practical matter. Indeed, according to Ken Adams, one of the foremost authorities on syntactic ambiguity and contract drafting clarity generally, the word “material is not only vague but also ambiguous.”

This is particularly true given the fact that the “significantly altered the ‘total mix’ of information” standard for determining materiality appears to have been borrowed from the U.S. Supreme Court decision of TSC Industries, Inc. v. Northway, Inc. TSC Industries involved the determination of what was material in the context of securities fraud, specifically allegations that a proxy statement “was materially misleading.” In that context, the Court held:

The general standard of materiality that we think best comports with the policies of Rule 14a-9 is as follows: an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. This standard is fully consistent with Mills’ general description of materiality as a requirement that “the defect have a significant propensity to affect the voting process.” It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. What the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder. Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

So—important enough to have been significant in the “deliberations” being made by the recipient of the information, but not important enough to have actually affected the decision that was made. Huh?

Adams has suggested that the “significantly altered the ‘total mix’ of information” standard is just another way of saying nontrivial, with the other understanding of material (the common-law definition) being equated to his term dealbreaker—i.e., significant enough to have actually made the counterparty not want to do the deal at all. After all, the whole point of a materiality threshold is to lessen the “dealbreaker” requirement that the common law imposes for a counterparty’s contract breach to excuse the other party’s performance. But that stark dichotomy between material meaning simply “nontrivial” and its common-law meaning of an actual “dealbreaker” is not what most transactional lawyers are seeking to convey with the word material. Instead, it’s something a little more than the merely “nontrivial” meaning and a lot less than the “dealbreaker” meaning.

Another faithful reader of my contract musings pointed out that “[i]n the securities fraud context, courts in [the Second] Circuit have ‘typically’ used five percent as ‘the numerical threshold . . . for quantitative materiality.’” Setting aside that materiality in the securities law context also requires a qualitative analysis, courts have applied the quantitative five percent rule alone in cases not involving securities fraud. Indeed, in Stone Key Partners LLC v. Monster Worldwide, Inc., the court applied that rule to determine, in a dispute over whether a financial adviser was entitled to a fee, that a sale of less than four percent of a company’s “total assets” did not constitute a “sale of a material portion of the assets or operations of the Company and its subsidiaries taken as a whole.”

Five percent seems intuitively to be well past nontrivial, but well below dealbreaker status. And recall that Vice Chancellor Laster, in Akorn, Inc. v. Fresenius Kabi, AG, used a decline of more than 20 percent of the target’s equity value as sufficient to declare a material adverse effect, for purposes of a bring down condition. And the material required for a material adverse effect seems closer aligned to Adams’s dealbreaker concept. But is 1 percent still trivial and 2 percent nontrivial? Who knows.

So, to repeat what I have in fact said before on this subject:

If a matter will matter it may be best to recast a material liability, a material contract or a material litigation as a liability, contract or litigation involving (or that potentially could involve) [an impact of] more than a specified dollar amount [or specified percentage of equity value, net income, or assets] (below which dollar [or percentage] threshold any such liability, contract or litigation would be considered insignificant [or immaterial]). But, . . . [s]ometimes the vague, if not ambiguous, “material” is all you can get and is perhaps good enough (but at least know that the term is fraught with uncertainty).

Keep on musing.