COVID-19 and material adverse change clauses

As COVID-19 infections continue to spread, companies continue to suffer cash and liquidity constraints as a result of temporary business closures and diminished consumer demand. As a result, parties to a contract may seek to invoke the material adverse change clause (MAC) to terminate or renegotiate contracts. This article aims to shed light on the MAC provision in the context of M&A and project financing and whether the pandemic qualifies as a material adverse event.

What is a MAC / MAE?

A material adverse change (MAC) or material adverse event (MAE) is a clause commonly found in acquisition and project financing agreements that give the buyer (in M&A deals) or lender (in financing deals) the right to terminate the contract or a basis to renegotiate the transaction, due to adverse business or economic developments occurring between the signing and closing of the agreement.

MAC provisions typically acknowledge that business impacts attributable to a general economic downturn and industry-wide risks will not qualify as a MAC unless such impacts pose a disproportionate impact on the seller. Although the significance of COVID-19 is indisputable, the question of materiality for the MAC clause remains unsettled for M&A and financing transactions.

Determining what constitutes a MAC?

Whether a buyer or lender may validly invoke a MAC clause depends on its specific drafting in the contract as they vary among M&A and financing agreements.

Firstly, a party cannot trigger a MAC clause on the basis of circumstances of which it was cognisant of upon entering into the agreement. However, it may be possible to invoke the clause where conditions deteriorate in a way that makes them materially different in nature.

Secondly, from a historical context, parties to M&A transactions should not expect a global recession to trigger a MAC provision on its own. Unless explicitly accounted for in the agreement, buyers will struggle to establish a MAC due to extreme market volatility alone because although economic downturns produce catastrophic consequences, these adversities are typically felt by the entire industry.

Finally, activating a MAC clause requires an event to be “material”. To be considered material, the change must first be of sufficient magnitude (courts have emphasised the importance of the words "significant" or "substantial"). Secondly, the effect must be durationally significant (temporary changes will be insufficient to constitute a MAC).

Does COVID-19 breach the MAC clause?

Although the COVID-19 pandemic is a major shock that has the potential to have a lasting significant impact on companies, it does not necessarily mean that it constitutes a MAC as there may be specific exclusions in the definition that address the risk and it will depend on the specific impact to the business in question. There is not a one-size-fits-all solution as MAC clauses are contract specific, dependent on the context in which it was drafted and how it is subsequently interpreted.

Generic MAC clauses

For acquisition and financing agreements signed since the emergence of COVID-19, it may be difficult to rely on a generic MAC clause in relation to changes in the economy or market caused by the pandemic as buyers and lenders will be treated as being aware of the current global health situation, therefore accepting the risk.

For agreements signed before the emergence of COVID-19, it can go both ways. In the context of M&A, a standard MAC provision includes a general definition of a change that has, or with the passage of time could reasonably be expected to have, a material adverse effect on the seller's business upon consummation of the contemplated transaction. Certain events are excluded from this definition such as changes in general economic conditions of the seller's industry, changes in applicable law, or natural disasters.

At a high level, systematic risk is allocated to the buyer and risk specific to the seller is allocated to the seller. As such, the impact of COVID-19 will typically be placed on the buyer as a systematic risk. However, some buyers may argue that it has had a disproportionate impact on the seller, and thus constitute a MAC.

Specific MAC clauses

Unless the MAC clause specifically references a “pandemic” (or equivalent wording), the fact that we are in the midst of a pandemic is not likely to be considered a MAC in itself.

However, it is possible that the impact of the pandemic on a party’s financial position, or the impact of the Government’s actions (e.g. party is not able to lawfully carry out its business due to the business closure requirements) could technically lead to a MAC. In other words, even if the MAC clause included a specific carve-out (things which would not amount to an MAC) for a pandemic, it can still be activated during COVID-19 if it had a “disproportionate effect on the seller” as compared to other participants in the industry in which the seller operates.

Likewise, in a project financing context, circumstances not specific to a borrower (e.g. COVID-19) will not in itself constitute a MAC, however, the detrimental effects of the pandemic on a borrower's financial or business condition could theoretically lead to a MAC. For example, with regards to facility agreements, a change would usually only be deemed "material" if it would affect the borrower's ability to perform its obligations under the agreement (i.e. to repay the loan).

In conclusion, establishing whether a MAC has occurred is a highly fact-intensive issue that depends on the unique circumstances involved and the specific language used in the acquisition and financing agreement. Further, buyers and lenders face a significant burden in court to demonstrate that any event meets the criteria of a MAC.

Risk of being wrong

If Party A (lender) relies on a MAC clause and takes action by refusing to advance further sums to Party B (borrower) that they are obliged to lend under the terms of the financing agreement, and it is later proven that there had not been a MAC, Party A would be in breach of contract, and Party B would have a claim for damages, which could involve significant compensation.

It is also important to bear in mind the risk of adverse publicity and the impact on the parties’ relationship during this time, as the general consensus amongst businesses seems to be a desire to be supportive through the COVID-19 outbreak.

Conclusion

Given the global impact of the pandemic, sellers and borrowers will likely contend that COVID-19 has now taken the form of a general market risk, which should be assumed by the buyer. Additionally, even if the pandemic is a materially adverse event for a particular company, the impacts of the outbreak may qualify as an exclusion to the MAC definition. The question then will be whether the COVID-19 pandemic has had a disproportionate impact on the seller or borrower.