Material Adverse Change & Material Adverse Effect

06/04/2020

Material adverse change (MAC) clauses and COVID-19

Many corporate and finance transactions may be disrupted due to the unpredictable and sudden economic effects of COVID-19. As the financial health of some corporations are put under stress, buyers, lenders and underwriters will also consider whether they could terminate or renegotiate deals by seeking to rely on material adverse change (MAC) provisions in sale, underwriting and loan agreements or reopen price/term negotiations where the value of the target/issuer has been reduced due to COVID-19 impacts. In particular, Lenders are currently focused on the potentially negative impact that COVID-19 circumstances may have on borrowers’ ability to maintain their businesses, revenues and assets and service their loans.

This is relevant both to existing contracts as well as the drafting of new contracts and we deal with each of these scenarios in turn. Although it is difficult to generalise about how MAC clauses are to be interpreted, for generally expressed MAC clauses (“would have a material adverse impact on the financial position or performance of [entity/the Group]”) the key principles are that it is necessary for the proponent to establish that the event is significant, substantial and persists for a prolonged period of time. We set out below some advice for parties in M&A, ECM and financing transactions on the approach they should take to drafting and negotiating MAC clauses as well.

Key principles for interpreting a MAC

Although MAC provisions are common, the precise language of the MAC is almost always subject to detailed negotiations so their interpretation will depend on the drafting as variations in wording may have significant consequences. Therefore generalisations about their interpretation are difficult. For example, some MAC (and the related concept of “material adverse effect” (MAE)) provisions allow the lender/ buyer/ underwriter to determine whether a MAC/MAE has occurred (rather than a MAC/MAE needing to be determined objectively). Our commentary below needs to be read in light of that consideration.

Broadly speaking MACs fall into the following categories:

Specific MAC clauses: These reference a numerical reduction in earnings or other specific metrics relating to financial position or performance (or a combination of such metrics). These are easier to rely on (provided the trigger is in fact breached) than general MAC clauses as they create an explicit bright line test. Regard also needs to be had in the M&A context to carve outs for matters disclosed during due diligence and the impact this could have on the exercise of such rights.

General MAC clauses: These do not contain express formulations or trigger points and instead describe a MAC as a change which has a materially adverse effect on the business, financial performance or similar aspects of a company or a corporate group taken as a whole. They may also contain exceptions for events such as change in law, natural disasters, war and change in markets (and even in some cases for pandemics) with widespread impacts on the whole economy or over the relevant industry as a whole. As such, they rely on a subjective interpretation of the relevant event and its consequences. In this respect, that courts have historically been reluctant to permit acquirers to rely on MAC clauses to terminate the agreement in the rare occasions when these clauses have been fully litigated.

In relation to general MACs, Australian courts are of the view that they may only be invoked where the event’s effect is significant, substantial and not temporary. In part because of the relatively high bar required to invoke a MAC, parties that wish to use to take advantage of a MAC provision, often use the threat of termination as a result of a MAC provision being triggered to re-negotiate terms and/or price.

Finance MAE clauses: In the context of finance transactions, the key related concept is Material Adverse Effect (MAE). Lenders are principally focused on events that may have a negative impact on a borrower’s ability to maintain its business and/or service its loan. These MAE provisions may appear as repeating representations, ‘drawstops’ (see below) or as Events of Default in loan agreements.

When are specific MACs enlivened by COVID-19?

An argument could be made that a specific MAC clause has been enlivened by COVID-19 only where, in accordance with the precise words of the MAC provision it has had or is likely to have an impact which is above the threshold required on the relevant value (e.g. the effects of COVID-19 has caused a [X]% decline in the company’s earnings).

When are general MACs enlivened by COVID-19?

Whether a general MAC clause has been enlivened will depend on:

an assessment of the impact of the crisis noting that there are no litigated examples in other common law jurisdictions of MAC provisions being enlivened due to pandemic events such as the SARS virus or global economic events such as the 2008 global financial crisis. The COVID-19 crisis may be distinguishable due to its pace and severe impact upon businesses / industries which is uncertain but likely to be at least into the medium term. Australian courts have only recognised events as having a ‘material adverse impact’ where the effects were ‘significant’, ‘substantial’ and ‘not ephemeral’; and
the precise words of the provision. For example, if a clause depends on a party’s reasonable opinion that a MAC had occurred, this requires evidence that the opining party actually considered the event as having a material adverse effect and that the event objectively had such effect on the company, its earnings, or the relevant value noted in the drafting.

Drafting MAC clauses in new contracts

Drafting negotiations should be informed by the complexities of the specific industry the business operates within and known risks (apart from COVID-19) identified through due diligence.

Recommendations in a M&A Context
Buy-side Advice:	Expressly state in the contract whether future unexpected impacts from COVID-19 can trigger a MAC. Remember that buyers entering transactions in the current climate will be treated as being on notice of the reasonably foreseeable consequences of COVID-19. Include specific trigger points to assist the parties in determining in a clear and objective manner whether a MAC has occurred. These could be: quantitative thresholds of change to key financial metrics (e.g. EBITDA or balance sheet items), falls in revenue or increases in net indebtedness. Based on analysis that G+T has undertaken annually over the past decade for its Takeovers and Schemes Review of public M&A transactions, customary thresholds on average range from a 10% -15% decline from original value.
Sell-side Advice:	Seek carve outs for the specific exclusion of COVID-19. Consider including wording to exclude the use of MAC termination rights or conditions precedent where the company is not being more adversely impacted by economy-wide or industry-wide events than others in its industry. Ensure that satisfaction of a MAC condition does not rely on the buyer’s opinion. Definitions should be confined to financial impact that goes above an agreed threshold and should not use phrases such as ‘in the reasonable opinion of the buyer’. Resist any prospective component of a MAC clause - if possible, limit the MAC to actual and current impacts as opposed to potential future impacts. Make it clear that any seller warranties given around accounts or the company are not warranting prospects or future trading profits of the business.
Recommendations in an ECM Context
Advice to Issuers:	Given the variation between the degree to which COVID-19 affects different issuers, any deviation from the standard drafting of the MAC termination event will need to be tailored to the deal. One approach could be to seek a carve out of impacts that are common to the whole industry or economy. However, be aware that any departure from the standard drafting may be an unacceptable position to underwriters or may increase the discount applied to the offer price (therefore increasing the dilutionary impact of the raising).
Advice to Underwriters:	Consider the need for any departure from the standard drafting in the circumstances of the specific transaction, including, for example the duration of the underwriter’s risk period and the nature of the issuer and its exposure to COVID-19. If there are specific risks to the issuer presented by COVID-19 consider more broadly how those risks should be managed through the various provisions of the underwriting agreement, not just through the MAC provision.
Recommendations in a Finance context
Advice to Borrowers	Akin to the M&A sell-side advice, borrowers entering into new loans should pay particular attention to how their MAC/MAE provisions are drafted. This is because they should want to make it clear that current circumstances surrounding the COVID-19 pandemic cannot at any stage in the future be made to establish a MAC/MAE (i.e. because Lenders are already aware of the Covid-19 pandemic).
Advice to Lenders:	Lenders have been traditionally reluctant to call an Event of Default and accelerate repayment of a loan agreement based on a MAC/MAE alone (as was the case during the GFC). Despite this, lenders typically are not obliged to fund new requests for drawdowns if an event of default is subsisting or if a representation is incorrect. These are commonly referred to as ‘drawstops”. In other words, whilst Lenders may decide to not call an Event of Default, they have in the past used the situation to prevent further drawdowns. Whilst this has likely not occurred in the COVID-19 context in Australia, it may be on the horizon (especially if liquidity continues to tighten). Lenders entering into new loans need to pay attention to the drafting of their MAC/MAE provisions, because (as above) it will be difficult for them to establish at a later time that they were unaware of the circumstances surrounding the COVID-19 crisis if they enter into a new loan agreement with a borrower at the current time.