When does the risk of a deal become the responsibility of one party rather than another? Once executed, does a contract, lease, purchase agreement, etc. become binding whether or not events in the wider world make the contract a very different proposition than before the event?
This has been a recurring theme for the law courts for over a hundred years with the seminal case for all first year law students in their contracts class considering the famous case in which leveling some land encountered unknown bedrock which made the task far too expensive to make it economically viable for the earth mover. Did that void the contract and relieve the earth mover of his obligation to level the land? Go to law school and find out…
The courts have traditionally utilized a mixture of criteria to determine if a contract will remain binding upon a party if there is a mistake that is bilateral as to the actual conditions…such as the bed rock…or whether the mistake is unilateral…e.g. only one party made the error. Negligence of the party or parties; economic validity of the end product; impossibility of performance; alternative methods to avoid economic waste, all these play into the courts’ decisions on enforcing such contracts. See our article on this site on Mistake in Contracts.
A different question is posed if neither party made an error, but unforeseen events occur which negate the value of the contract or make it a burden rather than a benefit to a party. Again, in the absence of contractual provisions, the courts have utilized a wealth of criteria discussed below but the wise party will anticipate that danger by use of specific provisions which the courts almost always follow…Material Adverse Change provisions, discussed below.
The Basic Provision:
Material Adverse Change provisions (“MAC”) are intended to protect a party from unknown events that could substantially threaten the long-term value of the agreement or lease. Often used in business purchase agreements, they could be used in any possible transaction. Force Majeure are a particular type of MAC provision but are normally restricted to disasters of magnitude that destroy the value of the agreement, or make it practically impossible to perform, such as fire, storm, governmental actions, strikes, unforeseen shortage of basic materials, epidemics and the like. The actual Force Majeure provision normally specifies precisely what disastrous events would trigger the voiding of the agreement. If triggered, such provisions may allow a party to terminate the agreement prior to closing or even after closing and walk away from the deal. MACs are often broader and not dependent on a disaster or catastrophic event, merely any event that alters the economic value of the transaction for one or both parties, as defined in the clause.
How much economic change allows imposition of MAC? That depends on the clause itself, but it is usually more than a minor alteration. Typically, a drop in sales or gross profits by more than X before close invokes the clause at the option of the buyer. In a lease environment, it could be a neighboring alteration in use that eliminates the value, such as a factory opening next to a retail outlet. It all depends on the wording of the MAC.
Clearly these provisions can alter the risk of the transaction significantly. As one professor commented, the essence of an agreement is to bind the parties and the MAC eliminates the binding element in the event of economic alteration of circumstances…but is that risk not what the parties automatically assume when they contract?
Not if they put in a provision that changes the burden of that risk and such provisions are of vital import to any party considering entering into a business transaction. Such provisions are often confused with Force Majeure but the criteria for imposition of MAC differs widely from Force Majeure. No catastrophe is necessary, only an economic event.
MAC in business purchases or merger agreements commonly allow a buyer to terminate a transaction prior to closing in the event of a development, change, event or condition that has had, or would reasonably be expected to have, a material adverse effect on the business, assets, financial condition or results of operations of the company being purchased. These provisions normally do not become invoked for mere general economic, market, industry, and political risks that do not drastically affect the target company relative to other businesses in the industry.
Although MAE clauses are negotiated at length in many contractual contexts, there is often no express definition of what types of events or dollar amount of losses constitute a MAE. Such questions have largely been left to the courts to determine on a case-by-case basis. In doing so, courts have tended to narrowly interpret MAE clauses and find that they do not to give rise to a termination right. In fact, the Delaware Chancery Court recently confirmed the buyer’s heavy burden of proof in attempting to invoke a MAE clause in holding that a buyer must show that the effect will “substantially threaten the overall earnings potential of the target in a durationally-significant manner.”
It is far better for a party to precisely define what will constitute an MAE rather than leave it to the discretion of a judge or arbitrator who often are not particularly familiar with the details of a business or lease and do not necessarily have the expertise to determine what is a material adverse change. And if the parties during negotiations can not agree, then it is vital for them to confront that fact since it is likely that the judge will also have difficulty.
For agreements that have already been signed without specific inclusion of MAC or Force Majeure provisions, then the occurrence of a pandemic such as COVID-19 or earthquake or similar event will ultimately require a fact-based inquiry by the trier of fact as to whether the impact will threaten the transaction’s economic viability in a significant manner such as to defeat the entire economic motivation of the transaction. The courts normally impose a very high criteria on the party seeking to void the transaction, holding that the risk should shift when the signature is place on the paper. Or as one judge told the writer, “It had better make the entire deal utter insanity or it’s going to be enforced, as far as I am concerned. They signed the deal; they take the risk.”
However, a well drafted MAC clause can alter that criteria since the court or arbitrator will normally be bound by the specific provision. The key is the correct wording in the documents. Absent such wording, then the party seeking to void the transaction faces an uphill but by no means impossible task of proving that the agreement is no longer valid.
For ongoing negotiations and prospective transactions, parties should carefully consider how to draft the MAC provision in light of the COVID-19 outbreak and the other unanticipated events that seem prevalent in today’s world. In particular, sellers may want to include express exclusions for pandemics, epidemics and other global health conditions from the definition of a MAC in order to prevent buyers from terminating agreements on the basis of such events.
Business is risk: it is the essence of business. And every contract or lease carries with it both economic opportunity and economic risk. How far the situation must alter due to unexpected events so as to void the risk undertaken can be up to a trier of fact…or agreed upon by the parties in negotiations. But the parties who wish to ignore this possibility face extreme dangers if the world alters due to war, epidemics, earthquakes, flood or fires.