Opinions and insights from Roythornes' corporate and commercial law team.
Covid-19 and commercial contracts: Material Adverse Change
- AuthorJulia Seary
In some types of contracts/agreements it is common to see a Material Adverse Change or MAC clause to deal with one party’s significant and damaging changes in commercial circumstances. This is particularly the case in financing documentation (such as facility agreements) where the lender has agreed to advance further funds in the future, and also in corporate transactions where the parties have agreed to split exchange and completion and accept an interim period during which the buyer will be contractually committed to purchase whilst the seller retains ownership and control.
MAC clauses are normally bespoke and specific to the business sector, so the drafting can vary significantly from contract to contract. This means that, regardless of the type of contract, the court’s interpretation of any individual MAC clause will be very fact-specific and language-specific, and so each clause must be assessed carefully on its own wording. Any party seeking to rely on the MAC clause will have a heavy burden to prove to a court that there is sufficient evidence that a MAC has occurred and, historically, English courts have interpreted MAC clauses on only a handful of occasions, meaning there is some uncertainty as to the likely outcome in the event of litigation.
It is fair to say that relying on MAC clauses can be a risky business. The stakes are high as if a party (Party A) gets it wrong and refuses to fulfil its obligations to the other party (Party B) or calls an event of default on Party B when not entitled to do so, Party A risks becoming liable for a repudiatory breach of contract. On the other hand, if Party A decides not to exercise MAC clause rights in circumstances where Party B’s position has deteriorated and continues to do so, Party A may end up substantially out of pocket should Party B enter administration or insolvent liquidation.
In order to assess the effect of any Material Adverse Change clause within your contracts and be able to make an informed decision as to what action may be available, you should ask the following key questions:
Has the coronavirus outbreak resulted in a Material Adverse Change?
What ‘Material Adverse Change’ means for you will depend on how it is defined in your contract. 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 (for instance a party not being able to lawfully carry out its business due to the business closure requirements) could technically lead to a MAC.
Has the change in market conditions triggered a Material Adverse Change?
It is suggested that, in finance arrangements, where a lender knows that its borrower intends to generate the funds necessary to repay a loan through trading but the borrower's ability to trade has been significantly curtailed if not stopped altogether by Covid-19, this may of itself constitute a MAC to the borrower's financial condition. However, since each clause is interpreted on its own language, if the drafting does not include ‘prospects’ or ‘external/market conditions’, it is unlikely that a party will be able to rely on this type of unanticipated change in market conditions if it is seeking to enforce the MAC clause.
What counts as ‘material’?
As the name suggests, to rely on a MAC clause, the event must be ‘material’. This means that it must be substantial, significant and for a significant period of time. If it is only temporary or a blip, it will not be sufficient to constitute a MAC. Parties may face a challenge in demonstrating that with the coronavirus outbreak, the change is long term as opposed to temporary and recoverable; whilst the period of impact is unknown, we do not expect it to last forever. Again, the wording of the clause itself is critical; for example, in finance documents a change is likely to only be considered material if such change directly impacts the borrower’s ability to repay monies.
What is the effect of a Material Adverse Change clause?
Typically, MAC clauses operate to alter the situation between the parties in the event that something significant happens to affect the circumstances or one or other party. For example, in a corporate transaction a MAC event may give the buyer the ability to walk away from a deal, and in a finance context may give a lender the ability to prevent further drawdown of funds.
What if the other party disagrees that there is a Material Adverse Change?
It is worth noting that if Party A relies on a MAC clause and takes action (for example if Party A as a lender refuses to advance further sums that they are obliged to advance, assuming Party B, as the borrowing party, is compliant in all other areas), and it is later proven that there had not been a MAC event, Party A relying on the clause would be in breach of contract, and Party B would have a claim for damages, which could involve significant compensation.
It is 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 coronavirus outbreak. Overall, the risk of enforcing a MAC clause in these circumstances is high for the party seeking to rely on it and it is usually recommended to have early conversations with the other party in order to understand their thoughts and position with regard to the operation of the contract and continued dealings.
As a general rule, MAC clauses are seen as a catch-all concept - a ‘contractual fallback’ which helps a party to bring the other party back to the table during a downturn, rather than being used as a cause of action on their own. As mentioned above, there is very limited case law around MAC clauses, showing that whilst they are often included in financing and corporate agreements, they are rarely litigated. In particular, there is no case law around the effectiveness of MAC clauses during a pandemic and given the fast-paced nature of the current crisis and how quickly things progress, the position may change rapidly leaving you exposed in terms of any steps taken in haste.