This Legal Update addresses the law governing material adverse change (“MAC”) clauses1—including the rules that courts apply when interpreting MAC clauses and the showing that is necessary to successfully invoke a MAC clause—and discusses the applicability of MAC clauses in the context of public health crises such as COVID-19.
I. Law Related to MAC Clauses
A. Legal Standard
MAC clauses are a common feature of many contracts and can arise in a number of different forms. For example, much of the case law analyzing MAC clauses occurs in the context of merger agreements, which typically contain a MAC clause that allows an acquirer to “costlessly cancel the deal” if there is “a significant deterioration in the [target’s] business between signing and closing [that] threaten[s] the fundamentals of the deal.” Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347, at *47 (Del. Ch. Oct. 1, 2018). In other instances, a MAC clause may qualify some or all of a party’s representations and warranties in the agreement. See, e.g., In re IBP, Inc. Shareholders Litig., 789 A.2d 14, 40 (Del. Ch. 2001). However, courts generally treat MAC clauses the same, regardless of the specific form a particular MAC clause takes. See Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del. Ch. 2008).
Typically, determining whether a MAC clause has been breached centers on whether the adverse change in question is “material” to the agreement as a whole. See, e.g., Akorn, 2018 WL 4719347, at *53. An adverse change is material if it “substantially threaten[s]” the fundamental agreement “in a durationally-significant manner.” See id. (quoting IBP, 789 A.2d at 68). Thus, for example, “short-term hiccup[s] … [do] not suffice,” and the “mere risk of a MA[C] cannot be enough.” See id. at *53, *65; see also In re. JC’s East, Inc., 1995 WL 555765, at *3 (S.D.N.Y. Sept. 19, 1995) (a material adverse change does not occur simply because of an “expenditure of money to remedy or ameliorate [a problem]”). Further, “absent clear language to the contrary,” a party invoking a MAC clause bears a “heavy burden” to show the clause has been breached. See Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738-39 (Del. Ch. 2008).
Even with the cases above as guideposts, determining whether a MAC has occurred is highly fact- and contract-specific. See, e.g., Solutia Inc. v. FMC Corp., 456 F. Supp. 2d 429, 442 (S.D.N.Y. 2006) (determining whether a MAC has occurred “requires an assessment of all the facts and circumstances surrounding the situation”). Following Akorn, courts have observed that there is no bright-line test for whether a MAC has occurred based on “quantitative considerations.” Channel Medsystems, Inc. v. Bos. Sci. Corp., 2019 WL 6896462, at *34 (Del. Ch. Dec. 18, 2019). The Akorn court noted that, in the merger context, a decrease of 40 percent or more in the target’s revenue or profitability can often constitute a MAC. 2018 WL 4719347, at *74 n.740. But the Akorn court itself found that a MAC occurred when the target incurred “remediation costs equal to approximately [20 percent] of [its] standalone value.” Id. at *74.
The law in New York is generally consistent with these leading cases. As with any matter of contract interpretation, New York courts look to the express terms of the agreement and cotemporaneous evidence of the parties’ intent when determining whether a MAC has occurred. See In re Lyondell Chem. Co., 567 B.R. 55, 122 (Bankr. S.D.N.Y. 2017). Similar to the Delaware courts, “[New York c]ourts consider whether the alleged material adverse change was within the contemplation of the parties at the time they executed the agreement, whether it was within the control of the parties, and the magnitude of the impact on the relevant party’s business.” Id. at 123. The New York cases also clearly hold that whether a MAC has occurred is highly fact-dependent. In Pan Am Corp. v. Delta Air Lines, for example, the court found that a MAC occurred when Pan Am suffered a steep decline in earnings over a relatively short period, given that the agreement in question sought to quickly revive Pan Am’s already severely distressed business. 175 B.R. 438, 492-493 (S.D.N.Y. 1994).
Consistent with Delaware Law, in New York, the party seeking to invoke a MAC clause faces a heightened burden in demonstrating that a MAC has occurred. In In re Bank of Am. Corp. Sec., Derivative, & Employee Ret. Income Sec. Act (ERISA) Litig., shareholders’ claim alleging breach of a MAC clause was dismissed at the pleading stage because plaintiffs failed to “‘demonstrat[e] with specificity why and how’” defendants … failed to comply with the MACs.” 757 F. Supp. 2d 260, 308 (S.D.N.Y. 2010) (quoting Rombach v. Chang, 355 F.3d 164, 174 (2d Cir. 2004)).
Courts have applied these principles outside the context of merger agreements. For example, in Capitol Justice LLC v. Wachovia Bank, N.A., plaintiff alleged that Wachovia breached the parties’ Loan Commitment Agreement when Wachovia invoked a MAC clause in connection with a downturn in the CMBS market.2 706 F. Supp. 23, 26-27 (D.D.C. 2009). Citing Hexion, the court held that the party invoking a MAC clause bears the burden of demonstrating a MAC occurred. Id. at 29. In a determining whether a MAC had occurred, the court focused on whether significant changes in the CMBS market were reasonably foreseeable at the time the contract was drafted. Id. The court agreed that “parties often include MAC clauses to protect against unknown, not known, events,” see id. at 30 (emphasis added) (citing Hexion, 965 A.2d at 738), which supports the notion that invoking a MAC clause is only proper when doing so relates to a change in circumstances that was unforeseeable at the time the contract was drafted. See, e.g., In re. JC’s East, Inc., 1995 WL 555765, at *3 (holding that a MAC had not occurred because the adverse change in question was “foreseeable at the time of the transaction.”). In the end, however, the court did not rule on whether a MAC had occurred, and instead found that there were triable factual issues related to materiality and foreseeability. Id.
B. Policy Considerations
The policies underlying MAC clauses can also guide courts in determining whether a MAC clause has been breached. For example, in the merger context, “[t]he typical MA[C] clause allocates general market or industry risk to the buyer, and company-specific risks to the seller.” Akorn, 2018 WL 4719347, at *49. Company-specific, or business, risks are those “associated with the ordinary business operations of the party—the kinds of negative events that, in the ordinary course of operating the business, can be expected to occur from time to time, including those that, although known, are remote.” Id. at *50. The seller assumes these risks because it “is better placed to prevent such risks … and has superior knowledge about the likelihood of the materializations of such risks that cannot be prevented.” Id. at *52. The buyer, by contrast, assumes systematic risks, which are those that are “beyond the control of all parties (even though one or both parties may be able to take steps to cushion the effects of such risks) and … will generally affect firms beyond the parties to the transaction.” Id. at 49. Generally speaking, systematic risks would include risks related to “acts of war, violence, pandemics, disasters, and other force majeure events.” See id. at *52.
II. Material Adverse Changes Related to Public Health Crises
As discussed above, whether a public health crisis such as COVID-19 is sufficient to trigger a MAC clause depends, first, on whether the party invoking the MAC clause can meet its “heavy burden” to show that the crisis has caused an adverse change that is material to the agreement as a whole. In most cases, to meet its burden, the invoking party would need to show that the crisis has had a substantial adverse impact on the seller’s or borrower’s financial condition or operations, and that this impact will persist for a significant duration. With respect to COVID-19, assuming the invoking party can show that COVID-19 has or will have a substantial adverse impact on the financial condition of the counterparty, the primary question may be whether COVID-19, and the harm it has caused, will persist for a significant period of time. The answer to this question remains open—however, to the extent the harm caused by COVID-19 persists, and economic dislocation increases in severity and duration, the argument that a MAC clause has been triggered may well grow stronger. How severity and duration are defined is again an open question, which will need to be carefully considered in relation the language of the MAC clause, including, where applicable, the specific carve-outs contained in the agreement.
Thus, the risk allocation that the parties contemplated when drafting the MAC clause will be very relevant in determining whether a MAC clause has been breached. In Akorn, the court analyzed a MAC clause that included a general statement of what constitutes a MAC, with carve outs for certain types of events that otherwise could give rise to a MAC. See 2018 WL 4719347, at *51. One type of event the parties carved out was “pandemics, earthquakes, floods, hurricanes, tornados or other natural disasters, weather-related events, force majeure events or other comparable events.” Id. Importantly, the court observed that these events were typical “systematic risks,” which, consistent with what the court perceived as contracting norms, were ordinarily allocated to the buyer. See id. Thus, under Akorn, the risk that a public health crisis, including COVID-19, could cause harm to a contracting party’s business would be borne by whichever party assumed the systematic, or general-market, risk when the contract was drafted. The language of the MAC will obviously be a key factor in this analysis.
Finally, any analysis of the impact of a MAC clause must be considered in the context of whether the transaction is an acquisition or financing, or both. Typically, in an acquisition, there is a fairly long duration between the time of the purchase agreement and closing. That obviously creates more time to evaluate the facts underlying the possible MAC. In a typical lender/borrower financing, the time period from commitment to closing is typically much shorter. As a result, it may be more difficult to ascertain whether such events will develop into a MAC event during such period or, with the passage additional time, cure themselves in a manner that no longer qualifies as a MAC event. Lastly, where the acquisition is financed, it is vitally important to understand the potential different interests of the lender and acquirer in analyzing the MAC.
All of this is, of course, dependent on the MAC clause itself, along with the facts and circumstances prompting consideration of the MAC. Time will tell with respect to COVID-19.
2 The MAC clause in Capitol Justice provided that Wachovia could terminate the agreement if there was a “material adverse change in the capital, banking and financial market conditions that could impair the sale of the loan by Lender as contemplated in the term sheet.” 706 F.Supp.2d at 29.