Coronavirus and the Market Decline: Material Adverse Change?
Houston — March 20, 2020 Material Adverse Change or Material Adverse Effect (“MAC” or “MAE”) provisions act as a corollary to the doctrines of force majeure, impossibility, frustration, and commercial impracticability. They are consistently used by parties in mergers and acquisitions and in obtaining debt financing. Generally, they act as a condition or representation that there has not been a material adverse change in a party’s business or operations between the time the parties sign a transaction agreement and the close of that transaction.
In these uncertain times with COVID-19, it is likely that parties will increasingly invoke MACs or MAEs in disputes involving M&A deals and financing. Judges, juries, and arbitrators will be asked to assess whether these provisions are truly triggered or whether parties are using them as a mere pretext. When faced with a MAC, parties should consider the following when evaluating the strengths and weaknesses of their position.
1. How is the MAC defined?
Defined by Subject Matter: MACs are often defined by subject matter. The financial condition of a party, such as certain assets and liabilities, can be used to define the provision. Parties can also define a MAC as meaning any material adverse change in the quality or quantity of a party’s customers. For example, in Nip v. Checkpoint Sys., Inc., the buyer of a printing business discovered that one week before closing, the seller’s second largest customer attempted to cancel all orders and move its business to a competitor. The share purchase agreement generally defined a MAC as any change (or effect) in the financial condition or business that could reasonably be expected to adversely affect the business. A Houston jury found in favor of the buyer, and the Fourteenth Court of Appeals agreed that the loss of business was a MAC because of the loss in future business prospects.
Threshold Definitions and Exclusions: Monetary thresholds, such as “greater than $50,000” or “10% of 2020 revenues,” can give further certainty as to when a party can declare a MAC. The definition can also contain events that are outside the parties’ control, such as a sharp decline in WTI or a pandemic. In those situations, it will likely be necessary in litigation for parties to retain industry or financial experts to help establish or rebut the issue of whether the event constitutes a MAC. On the other hand, many MACs contain exclusions, specifically stating, for instance, that a market fluctuation or governmental or regulatory change cannot serve as a basis to claim a MAC.
Defined by Lists: Exclusive lists, like those used in force majeure clauses, can also give the parties more predictability in defining a MAC. Non-exclusive lists can provide some flexibility but, at the same time, provide some guidance as to the nature of the type of events contemplated by the parties. More complicated definitions, however, increase the likelihood that courts will treat the provision as ambiguous. In that vein, provisions that contain exceptions to exceptions to exceptions are certainly more susceptible to a court finding of ambiguity.
Undefined: Leaving a MAC undefined gives the parties the most flexibility and, the least amount of certainty. In those instances, there is a greater probability that the parties will dispute the enforceability of the provision. That uncertainty will also make it less likely a court will grant summary judgment on the provision, thereby making the dispute more likely to go to trial.
2. Does the MAC act as a representation, warranty, or condition precedent?
Whether a MAC is a representation, warranty, or condition precedent can affect pleading requirements in litigation and which party bears the burden of proof. Typically, the party seeking to enforce a contract provision has the burden of proving that conditions precedent to filing the lawsuit are satisfied. Texas Rule of Civil Procedure 54 allows parties to globally plead that conditions precedent are satisfied. Once, however, a defendant in its answer specifically denies those conditions as satisfied, then the plaintiff is specifically required to prove those conditions.
3. How does the MAC interact with other contract provisions?
A MAC cannot be evaluated by itself. Parties should consider other provisions in the agreement and how they relate to the MAC. Oftentimes, indemnity provisions contain “materiality scrapes” that remove references to materiality qualifiers in representations and warranties for determining a breach. These scrapes should be considered when evaluating a party’s financials and financial representations. Parties should also be aware of force majeure provisions as possible evidence of what the parties intended as exclusions to the MAC when signing the agreement. Choice-of-law provisions are also particularly important. Delaware law is more established and provides the parties with more predictability as compared to Texas law, which is not as developed. Regardless, the parties should consider Delaware law in certain circumstances as a possible guide when confronted with a MAC issue in a Texas court. Also, disclaimers of reliance can pose problems for a party seeking to declare a MAC. For instance, the Delaware Chancery Court in Hexion Speciality Chems, Inc. v. Huntsman Corp. determined that the buyer could not use the seller’s financial projections to establish a MAC because the agreement included a disclaimer of reliance on those projections.
For the most part, courts are likely to consider MAC provisions to act as a backstop to protect the buyer from unknown events that substantially threaten earning potential for a significant period of time. With coronavirus and oil and gas prices declining, energy companies will be forced to evaluate their MAC provisions. Lenders and borrowers will also need to evaluate these provisions in deciding whether the lender can cease financing. In sum, each MAC provision and each circumstance will require independent evaluation. There is no one size fits all. As the bear market persists, parties should give careful scrutiny to their MAC provisions.
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