Written by Byron Tse, Bryan Haynes, Scott Bower, Ian Michael and Julia Pasieka
The unprecedented suddenness and uncertainty of the impact brought on by COVID-19 has many businesses re-evaluating their business strategies, business continuity plans and transaction proposals. In particular, businesses will need to review pending acquisition agreements and consider "material adverse change" or "material adverse effect" (MAC) clauses. These clauses typically allow a party to walk away from a transaction where a material adverse change has occurred between signing and closing.
Definition and Application
MAC clauses are often considered "a term of art" given the highly contextual interpretation used to describe a potential event that affects a target business. In the M&A context, a typical MAC clause may be defined as any change, effect, fact, circumstance, occurrence or event that, individually or in the aggregate, is materially adverse to the business, operations, assets, properties or condition (financial or otherwise) of the target business, or that could delay or impair the ability of a party to consummate the transaction.
MAC clauses are commonly relied upon in two ways:
- by the purchaser, as a condition to closing, so that it may elect not to close the deal if the target business experiences an unexpected and adverse event between signing and closing, or
- by the seller, as a qualifier to certain representations and warranties, which raises the standard by which the purchaser must prove a breach of such qualified representation or warranty.
Successfully invoking the applicable MAC clause as a condition to closing has been generally accepted to require that a high threshold be met.
Role of Carve-outs
A MAC clause is generally qualified by exceptions and exclusions that limit the application of the clause and its negotiation results in an allocation of risks between the purchaser and seller. Typically, a purchaser is expected to accept broader industry-wide and exogenous risks associated with the acquisition, while a seller accepts responsibility for business-specific and endogenous risks unique to the target business and unknown to the purchaser. Carve-outs from a MAC clause, which benefit the seller, customarily include: (i) changes in applicable laws, (ii) accepted industry-wide fluctuations or risks affecting the industry, (iii) changes in general economic or political conditions, and (iv) acts of war, terrorism, natural disasters and the like. Whether pandemics fall within the ambit of a MAC clause or are excluded by a carve-out will depend on the specific words used and surrounding circumstances. To reduce uncertainty going forward, parties may consider explicitly dealing with pandemics in the definition of a MAC clause.
As the COVID-19 pandemic is constantly evolving, its true impact remains to be seen. Whether a MAC clause can be invoked during, or as a result of, this pandemic necessarily involves contextual considerations and will depend on how Canadian courts approach MAC clauses given the idiosyncrasies of a pandemic-type event. Any purchaser contemplating invoking a MAC clause to avoid an obligation to close a transaction will need to consider the following three critical factors before proceeding:
- High standard of materiality – A material adverse change must be significant both in its duration and impact. In other contexts, this often involves a consideration of a year-over-year comparison of industry-relevant financial metrics for a specific business to determine whether there has been a sharp, sudden and prolonged decline that has drastically and fundamentally altered the financial condition of the target business.
- Disproportionate effect on target business – Where an exception to a MAC event (i.e., a carve-out) excludes "events generally affecting the industry", a material adverse change must affect the target business disproportionately or independently of any cyclical or industry-wide fluctuations. A party looking to invoke a MAC clause can prepare comparisons of the target business against its industry peers, or the market in general, to demonstrate that its decline is unique to the target business and contrary to expected market trends for that industry.
- Purchaser must not have any prior knowledge – The purchaser will usually need to demonstrate that the material decline of the target business was unforeseen. The purchaser is expected to have carried out customary due diligence of the target business and will, in all likelihood, be imputed with the knowledge of widely known systematic risks of the broader market and industry-specific cycles.
Convincing evidence is required before a purchaser can defensibly walk away from a deal based on a MAC event. Properly assessing the likelihood of succeeding in a particular case will entail a thorough review of the specific MAC clause in the context of all of the provisions of the contract and relevant circumstances surrounding the contract negotiation, together with a factual analysis of whether a material adverse change fundamentally and disproportionately altered the financial condition of the target business relative to its industry peers. While the COVID-19 pandemic likely qualifies as an unforeseen event that defies any business norm or cycle, additional time may be required until its true impact can be properly quantified and analyzed.
Qualifications to Representations and Warranties
A MAC clause may also be used as a qualification to certain representations and warranties made by the seller. The threshold of a MAC clause is very high and places a heavy burden on the purchaser to prove that a seller has breached a representation or warranty. For example, rather than prove that an adverse change occurred, a purchaser will have to prove that a material adverse change occurred or would reasonably be expected to result in a material adverse change. Depending on its usage and context, a MAC qualifier may negate the substance of a representation or warranty.
The case law in Canada examining the treatment of MAC clauses is sparse, with no well-established analysis discerning the treatment of the often intentionally broad provision.
There are recent decisions of the Delaware courts which may be considered by, but are not binding on, Canadian courts. The 2018 decision in Akorn Inc. v Fresenius Kabi AG (Akorn) has been oft-cited as a landmark case on this clause, as it became the first Delaware decision to hold that the purchaser was contractually permitted to walk away from a deal based on a MAC event. In Akorn, the purchaser was able to successfully demonstrate each of the following:
- The change to the target business was material. Materiality was construed as a threshold that would "substantially threaten the overall earnings potential of the target in a durationally-significant manner", and the purchaser argued that the target business suffered substantial year-over-year declines for a variety of financially relevant metrics. The court noted that general and systemic market fluctuations over a few fiscal quarters are not sufficient to deem a material change. The issues that brought upon the target business' dramatic downturn persisted for a full year and showed no signs of abating.
- The change did not fall under a MAC carve-out that excluded general industry conditions. To prove that the target business was disproportionately affected relative to its industry peers, the purchaser presented various financial metrics, including EBITDA comparisons and third-party analyst valuations, in addition to specific events that impacted the target business, such as the loss of a material contract, pervasive regulatory compliance issues and unexpected competition from new market entrants. These additional factors were unique to the target business, and the possibility of an imminent recovery therefrom was accepted as remote.
- The purchaser did not knowingly accept the risks that led to the material adverse change. Most of the factors raised in Akorn were highly contextual as they related to the purchaser's due diligence of the target business, the target's own surprise at its financial performance and the revelation of certain facts that were unknown at the time of signing of the transaction agreement. The court noted that the suddenness of the target business's steep decline further supported the purchaser's argument that the material change was unforeseen.
- The purchaser otherwise abided by its obligations under the transaction agreement. It was helpful to the purchaser's case in Akorn that there was evidence to support a conclusion by the court that the purchaser fulfilled its obligations under the merger agreement, including its "reasonable best efforts" covenant and only terminated the transaction if it had a valid basis for doing so. The court also noted, in comparison to cases that had been denied the benefit of a MAC condition in the past, that the purchaser in Akorn raised its concerns directly with the target before taking steps to terminate the transaction and attempted to work with the target business on these concerns.
Acquisitions often entail significant financial risk; it is important for transaction parties to be aware of the implications of MAC clauses. The sudden manifestation of the COVID-19 pandemic underscores the paramount importance of MAC clauses and will likely drive transaction parties to scrutinize the applicability, and negotiate the breadth, of such clauses.
If you have any questions regarding the content of this article, or MAC clauses in general, please contact any of the authors or members of the Bennett Jones Mergers & Acquisitions team or the Commercial Litigation team. For additional information regarding the COVID-19 pandemic, please see our COVID-19 Resource Centre.