Authored by Mani Gupta and Sajal Mendiratta

The economic decline caused by COVID-19 is unparalleled and companies/industries all around the world are currently in crisis management mode as nationwide lockdowns, disruption of supply chains and uncertainty around the future take its toll. In such uncertain times, it is likely that contract parties will seek to rely on Material Adverse Change (“MAC”) or Material Adverse Effect (“MAE”) clauses, which are ubiquitous in contracts of several kinds but more so in Mergers and Acquisition (“M&A”) documents and financing documents such as Loan Agreements. Already, countless corporate transactions are being upended in light of the crisis. For instance, Boeing terminated a $4.2 billion combination-deal with Embraer, as the jetliner market is thought to sharply shrink. Embraer is reportedly seeking legal remedies against Boeing to the tune of $100 million for wrongful termination of the agreement which had culminated after discussions spanning over the last few years. While the specifics behind the termination, or the legal grounds Boeing has taken are unknown, we anticipate (and are already seeing) that contractual parties will invoke MAC and MAE clauses to walk-away from deals which were yet to be fully performed and undoubtedly courts/arbitrators will have the herculean tasked with interpreting contrivedly worded clauses.

Before we delve into whether a MAC or MAE clause can be invoked in light of Covid-19, it is important to understand the current jurisprudence on MAC and MAE clauses in the context of M&A agreements and financing agreements, and tests of interpretation which may be used by parties and courts in the future. This piece is part of our though-leadership initiative on assessing the legal ramifications of COVID-19 under Indian law. Other posts in the series can be read here.

MAC/MAE Clauses in M&A Agreements

Material Adverse Change clauses in M&A agreements, serve as ground for a party to abandon or “walk away” from a deal without incurring any penalty, if a Material Adverse Event or MAC takes place (or is discovered), between the execution of the agreement and the closing of the transaction. MAEs could include market-wide economic or industry shocks, regulatory changes brought by governments, force majeure events, or even firm-specific events such as loss of key customers or KMPs. Though MAC and MAE clauses may include specific events in its definition, they are generally widely worded to protect the parties against unforeseeable, and unexpected material changes, and thus include any event which has a “materially adverse” effect on the business of the target company, or the ability of the acquirer to fulfil its obligation(s). MAC/MAE also generally, though not always, have detailed carve-outs or exceptions, which essentially shift the risk of certain specified events from the target company to the acquirer such as: failure to meet projections of published analysts; changes in general economic or business conditions which affect the specific industry the target company operates in; act of God; terrorism or war. Some M&A agreements define MAEs to include changes to general economic or financial market conditions but only to the extent that such a change has had disproportionate impact on the target company as compared to other companies engaged in the same industry.[1]

A study[2] in 2005 found MAEs to be the underlying cause of up to 69% of terminated acquisitions, and 80% of renegotiated acquisitions; yet, MAC clauses have been notoriously difficult to enforce legally and courts around the world have usually held that whether an event constitutes an MAE is to be determined on a case by case basis, thus, a consistent interpretation of these clauses has been far and between.

In the Indian context, there is a dearth of judicial precedents which outright pertain to enforcement of MAC/ MAE clauses to allow parties to back out from merger agreements. There are a handful of decisions of the Supreme Court of India pertaining to withdrawal of an open offer under Regulation 27 of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 in relation to securities of a listed company. Regulation 27 provided that an open offer can be withdrawn if there is (a) legal impossibility resulting from statutory refusal; (b) natural impossibility if the acquirer is a natural person and has passed away; and (c) any circumstances which in the opinion of SEBI warrant withdrawal. The Supreme Court has previously held that the third scenario has to be read in line with the first two clauses which deal with legal and natural impossibility.[3] Thus, poor financial performance or where it has become uneconomical for the acquirer are not grounds for revocation of open offer.[4] Moreover, even in a scenario where there was a two year delay in obtaining SEBI’s approval of the offer, in which time the company entered into BIFR proceedings, the Supreme Court stated that the regulations pertaining to open offer are sacrosanct and withdrawal can only be made if it falls “within the realm of impossibility”.[5] The 1997 Regulations were subsequently repealed and replaced by the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“2011 Regulations”) and the erstwhile Regulation 27 was replaced by Regulation 23(1) of the 2011 Regulations. The new regulation is of wider import and allows for an open offer to be withdrawn if, a condition mentioned in the acquisition agreement attracting the obligation to make the open offer is not met for reasons outside the reasonable control of the acquirer. In one decision after the coming into force of the 2011 Regulations, SEBI has held the analysis under the 1997 Regulations to be still be applicable.[6]  Such analysis under the 2011 Regulations may not apply in the same manner for mergers and acquisitions pertaining to unlisted companies.

Here, we may look at judicial decisions of foreign jurisdictions where usually the challenge before courts is to determine how to treat events that are neither specifically included nor specifically excluded from the definition of MAE.

In the oft quoted case of In Re IBP, Inc. Shareholders Litigation v. Tyson Foods, Inc.,[7] the Delaware Chancery Court (the leading venue in United States for resolving disputes such as collapsed corporate deals, as over more than half of the publicly traded U.S. companies are registered in Delaware) was tasked with interpreting a capaciously worded MAC clause, when a merger agreement between IBP Inc and Tyson Foods was terminated by Tyson. The definition of MAE in the contract included any event, or occurrence of event that is likely to cause a Material Adverse Effect on the financial condition, business, assets, liabilities and or results of operations of IBP and its subsidiaries taken as a whole. The Delaware Chancery Court opined that the widely worded clause protects the acquirer only from “unknown events” that “substantially threaten” the overall earnings potential of the target company and shall not include short-term setbacks. The court concluded that a MAE event is to be viewed from a long-term perspective of that of a reasonable acquirer, and the burden is to show that an event, even if it causes industry-wide effects, has caused a materially adverse change under the contours of the contract. Similarly, in Hexion Specialty Chemicals[8] the Delaware Chancery Court reasoned that the element of durationally significant adverse change is necessary as the acquirer is entering into the agreement because of a long-term strategy and thus the impact needs to be on the long-term earnings.

The decision in In re IBP also places emphasis on prior negotiations between the two parties to ascertain the importance of certain factors and on the conduct of the party claiming/invoking the MAC clause. In Akorn, Inc. v. Fresenius Kabi AG[9], the Delaware Chancery Court upon a strict reading of the terms of the contract upheld the right of the buyer to terminate the merger agreement due to MAC and noted that the buyer had complied with all its obligations and had indeed intended to close the agreement. The court stipulated that possible alternate reasons for selling must be enquired into. The court further suggested incorporation of a two-prong test of qualitative and quantitative materiality, which would need to be satisfied for a MAC clause to be invoked. Thus, the degree or significance of the departure from the position as represented by the target company, and the quantitative “valuation hit” have to be proven from the view of a long-term acquirer.

MAC/MAE clauses in Financing Agreements

In the context of lending, MAE or MAC clauses are generally inserted to protect the lender from unforeseen events which have a material adverse effect on the business, assets, operation or condition (financial or otherwise) of the borrower. MAC clauses can further be stated as a (i) condition precedent to disbursement of debt (or tranches thereof); (ii) a representation or warranty made by a borrower; (iii) an event of default, in which case in all likelihood the determination of whether a MAC has occurred will be left to the sole discretion of the lender. Upon occurrence and determination of a MAC, loan agreements may provide lenders a right to, inter alia, take all or any of the following actions: (a) terminate the loan agreement; (b) declare all obligations immediately due and payable; (c) stop advancing money or credit under the agreement; or (d) take charge against the collateral or lien.

In the absence of an unambiguous threshold for what may constitute a MAC, it is uncertain if a unilateral determination or opinion of a lender will be enforced by the courts, especially considering the consequences of wrongful, unjust invocation can be particularly severe for the borrower. In all likelihood, the standard for determination of a MAC in financing context will be similar to that used by courts in the M&A context, and the importance will be placed on the specific wordings, of the clause, with due consideration of all facts and circumstances, including the intent of the parties.

In the case of Grupo Hotelero Urvasco SA v. Carey Value Added SL and Another[10], the U.K. High Court of Justice took the view that while a borrower is entitled to enforce the literal terms of the contract, the burden of materiality will be met if an adverse impact substantially limits the borrower’s ability to repay, and is not temporary in nature. In the instant case, the MAC clause in the agreement between the parties was essentially a representation made by the borrower that no material adverse change had taken place in the financial condition since the date of signing of the Agreement. What is noteworthy is that the court read the definition of “financial condition” to not include “prospects of a company or external economic or market changes”, unless specifically stated in the agreement. In doing so, the court emphasized that it will closely examine the relevant clauses in the agreement and also stated that where the lender is aware of an event or pre-existing circumstances at the time of entering into the agreement, then such an event could not be considered as materially adverse event at a later stage.

The decision in Grupo Hotelero takes into account the decisions of the Delaware Chancery Court in In re IBP Inc., and is thus principally consistent with the decisions in the M&A context. The court in Grupo Hotelero was cognizant of the fact that the high bar for materiality is necessary to prevent lenders from suspending the financing agreements and recklessly hold an event of default when the borrower’s position does not necessitate it, thereby impelling it to face insolvency.

COVID-19 and MAC/MAE clauses

From the above discussions, we can observe that for effective enforcement of MAC and MAE clauses, the party invoking the clause may need to consider the following factors:

• It would need to be demonstrated that the effect of the pandemic has resulted in MAE or MAC under the contours of the contract. The specific wording of the clause in this regard, would be crucial. If the agreement stipulates that force majeure events, or a pandemic/epidemic or natural disaster is to be considered as a MAC/MAE, the courts or arbitrators may be duty bound to give effect to express provisions of the contract. The specific carve-outs, if any, would also be essential for a determination of an event as MAC/MAE.
• In most cases the wordings of MAC and MAE clauses is intentionally broad, and they do not definitively resolve the question of risk allocation for specific events or specify the threshold for materiality. Consequently, a court or an arbitrator may look at the negotiation history, the bargaining power between the parties and the specific facts and circumstances.[11]
• In the context of M&A agreements, the buyer would have to show that the effect of Covid-19 is substantial and material in a durationally significant manner.[12] Whether, an MAE has occurred will be considered from the perspective of a reasonable acquirer and if there is a substantial adverse change to the long-term earning capacity.[13] Likewise, in the context of lending agreements, the reasoning usually applied by courts is similar to that in the context of M&A transactions, and there must be a significant effect on the borrower’s ability to pay the loan and the effect should not be short-term in nature.
• If the MAC/MAE clause is triggered based on circumstances that a party was reasonably aware of while entering into the contract, the same will not be enforceable.[14]
• The conduct of the parties post signing of the agreement, especially the conduct of the party seeking to terminate the agreement is also looked into by the court to ensure the intentions of the buyer are truly premised on the exigent circumstances of the materially adverse event.[15]

Thus, whether the MAC/MAE clauses can be invoked in the light of Covid-19 will depend on a holistic analysis of the facts and the specific wordings of the prevailing contract in each case.

As countries all over the world lift lockdowns, stimulus packages and government schemes are announced to boost the economy, companies will soon get a chance to truly assess the long-term impact of COVID-19 on their business and their specific industry. Certainly, some industries will face a far greater challenge in overcoming the deep setback, the impact for which may have a stronger temporal effect, and even then courts/arbitrators may only enforce the MAC/MAE clauses if it can be proven that the impact on the target company or the borrower is materially greater than its other competitors located in the same industry.[16] It is possible, and it would not be without precedent, that courts after due consideration of all facts and circumstances, may choose to refrain from enforcing MAC or MAE clauses, especially when the termination of an agreement may amount to putting the borrower or a target company under more duress. Meanwhile, several policy decisions such as the Reserve Bank of India permitting financial institutions to provide 3 month moratorium on payment of installments for term loans falling due between March 1, 2020 to May 31, 2020, Government suspending several provisions of the Insolvency and Bankruptcy Code for a period of one year, and the relief package announced by the Government to allow some degree of comfort to micro, small and medium size companies and businesses, may also have a bearing in the judicial decision making. Such policy decisions and its review by courts could possibly make invocation of MAC and MAE clauses tougher.

Conclusion

COVID-19 certainly has affected the general financial conditions and the durational impact of the pandemic and its ripple effects are unprecedented and indefinite.  However, it is uncertain that even such effect will satisfy the materiality threshold in each case, for invocation of MAC/ MAE clauses. What is certain however, is that there will be a renewed focus on the MAC/MAE clauses in financing arrangements, and negotiations on the specific phraseology for what is included in the definition of these clauses will be far more detailed. Buyers and sellers, borrowers and lenders will also need to carefully review their existing agreements, and would need to be exceptionally vigilant before entering into new ones. Nevertheless, it is advisable that lenders and buyers are cautious in exercising and acting upon the MAC/MAE clause. Companies and businesses concerned about the adverse impact on their financing agreements should seek legal advice to mitigate risks effectively.

[1]See Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715 Del. Ch. 2008.
[2]David J. Denis and Antonio J. Macias, Material Adverse Change Clauses and Acquisition Dynamics, The Journal of Financial and Quantitative Analysis, Vol. 48, No. 3 (JUNE 2013), pp.819-847.
[3]See Nirma Industries Ltd. and Anr vs. Securities & Exchange Board of India, (2013) 8 SCC 20.
[4]Id.
[5] See Pramod Jain and Ors v. Securities and Exchange Board of India, (2016) 10 SCC 242.
[6]See Jyoti Private Limited, before SEBI, [WTM/SR/CFD/39/08/2016] available at: https://www.sebi.gov.in/sebi_data/attachdocs/1470054168949.pdf

[7]In re IBP, Inc. Shareholders Litigation v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch.).

[8]See Supra Note 1.

[9]Akorn, Inc. v. Fresenius Kabi AG 198 A.3d 724 (Del. Ch.).

[10] Grupo Hotelero Urvasco SA v Carey Value Added SL and Another [2013] EWHC 1039 (Comm).
[11]See Supra Note 8.

[12]See Supra Note 6.

[13]See Supra Note 1.

[14]See Supra Note 8.

[15]See Supra Note 9

[16] See Supra Note 8.