Material adverse change clauses – useful but not omnipotent

Material adverse change – or MAC – clauses are commonly used as a form of insurance in merger and acquisition arrangements or loan financing documents.

Generally they are designed to allow a purchaser to pull out from a purchase or a bank to refuse to allow a further drawdown of funds or to call in a loan if there has been a “material adverse change” in the position of the vendor or the borrower.

But there are limits to their application.

When to use a MAC

MACs can be a useful tool for managing the risk of a sudden deterioration in the position of a target company or a borrower. In the M&A context, it is common for purchasers to seek a condition to closing that there has been no MAC in relation to the business, financial condition, or assets of the target. In the finance context, each drawdown will usually include a warranty by the borrower that there has been no MAC.

Will there be a greater focus on MACs?

Although there hasn’t been any new judicial comment on MAC clauses arising out of the financial crisis of 2007, there have been reports of large negotiated settlements in lieu of litigation involving MAC clauses in the US (a US$30 billion settlement to Sallie Mae and a $400 million settlement to Harman International Industries when acquisitions fell over for MAC reasons).

One suspects that the failure of Lehman Brothers in September 2008 and the paralysis of the money markets thereafter resulted in a number of MAC clauses being subjected to close scrutiny. With the economic climate still subject to periodic bouts of uncertainty, it makes sense to ensure that MAC clauses in your contracts are fit for purpose.

So what is a material adverse change?

Whether a MAC has occurred depends almost entirely on a factual analysis. Case law to date suggests that the courts are likely to read a MAC clause as narrowly as possible, and in most cases a high threshold for “adverse change” has been required before a MAC is deemed to be triggered.

A MAC clause isn’t a get out of jail free card for a purchaser that changes its mind after signing a deal.

The leading US cases are In re IBP v Tyson Foods1 and Hexicon v Huntsman.2 In both these cases the purchaser attempted to pull out of an agreement to purchase, claiming a MAC had occurred in respect of the target company.

The courts in both cases held no MAC had occurred, and emphasised the need for the MAC to be something which substantially threatens the overall earnings potential of the target in a “durationally significant manner” with long term financial consequences, rather than just being a “short-term hiccup” or “blip” in the company’s business.

These cases also suggest that a MAC framed in general terms cannot be relied upon if a purchaser had knowledge at the time that the circumstances or event could occur (if so, they should have negotiated in a clause to that effect).

Factual considerations will take into account the text of the MAC clause itself, the evidence available about the parties’ intentions at the time of the negotiation, the commercial context of the transaction, alternative motivations for relying on the MAC, and whether the exercise of the MAC is reasonable and in good faith in light of the totality of the circumstances.

Reliance on a MAC clause must be reasonable and in good faith

MAC clauses often include a variation on the phrase “in the opinion of the purchaser”. Although this might at first blush seem to make the judgement subjective, recent Australian authority (Brighten Pty Limited v Bank of Western Australia Limited [2010] NSWSC 133 (1 March 2010)) suggests that the courts will read a “reasonableness” requirement into this opinion, and ask whether the party relying on the MAC has acted in good faith, fairly and commercially in determining whether a MAC has occurred.

Guidelines for using MAC clauses

When drafting a MAC clause, or when deciding to rely on a MAC clause, the following practical issues should be considered.

General MAC language will usually be read to require a long term adverse impact on business or financial condition. A short term drop in profits or difficulty in obtaining finance may not be sufficient.
Even if the MAC clause contains a reference to the purchaser’s or lender’s unqualified opinion, that opinion must be reasonably held and formed in good faith. Any evidence that a MAC clause has been invoked because a purchaser/lender has got cold feet will not find favour with the courts.
If the purchaser/lender was aware of specific circumstances that might be materially adverse to the target/borrower, those circumstances should be specifically dealt with in the drafting. For example, if the target company has volatile turnover, you need to do your diligence and identify the threshold under which a fall in turnover will become a MAC. Reliance on general MAC language in these circumstances could be dangerous.