Protecting Contracts in the Age of COVID-19: ‘Material Adverse Change’ Clauses

By Louis Lehot
March 18, 2020

“When looking to determine whether a material adverse change clause has been breached, a court would likely assess whether the adverse change in question is ‘material’ to the transaction as a whole, and over a substantial period of time and amount. A temporary condition that exists during a short period won’t cut it.”

virusAs outside general counsel to over 150 emerging growth companies in recent years, as well as to their venture capital and growth equity investors, and as someone who represents buyers and sellers in M&A transactions, I am often asked how to protect businesses from interruption to their key customer and supplier relationships. Specifically, in the age of COVID-19, now characterized by the World Health Organization as a “global pandemic,” I am being asked whether a counter-party can trigger a “material adverse change” clause to terminate a contract.

What is the legal standard for a material adverse change?

“Material adverse change” or “MAC” clauses have been ubiquitous in commercial and investment contracts for decades and can take many forms. Much of the case law that interprets MAC clauses arises in the context of merger agreements, which often contain a MAC clause that allows a buyer to walk away from a deal if there is a major degradation of the target’s business between signing and closing that threatens the fundamentals of the deal. MAC clauses can also be used to qualify some of the target’s reps and warranties in an agreement.

When looking to determine whether a MAC clause has been breached, a court would likely assess whether the adverse change in question is “material” to the transaction as a whole, and over a substantial period of time and amount. A temporary condition that exists during a short period won’t cut it. Nor will the risk of a MAC be grounds to trigger the MAC. The MAC must have actually occurred. Not only would the party triggering the MAC need to demonstrate this over time and quantity, but also be very specific as to the how and why. If a potential consequence was foreseeable or known at the time of entering into the contract, courts would be less likely to consider that its occurrence was a MAC if such occurrence was not specifically spelled out. MAC clauses have more teeth when they relate to unknown events.

Parties looking to trigger a MAC bear a heavy and evidentiary burden in proving that a MAC has actually occurred. A famous example of a MAC was between a buyer and seller of a sugar refinery after the subject refinery was nationalized by Fidel Castro following the Cuban revolution in 1960. The application of the law does not differ materially across the states, with Delaware and New York jurisprudence being the most persuasive.

As to a specific definition or guide rails, there is no bright line test. Courts interpreting the question would look at all the facts and circumstances.

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Could the declaration of COVID-19 as a global pandemic constitute a MAC for your company’s agreements?

Applying the legal standard of what constitutes a MAC to your agreement, whoever seeks to trigger a MAC clause will have a heavy burden to meet. From a policy perspective, courts will look to preserve the economic substance of agreements in light of the potential consequences to the economy of allowing the unraveling of commerce.

Questions to ask:

  • Was the existence of COVID-19 already known or contemplated at the time your company entered into the contract?
  • Has the crisis caused a change so adverse, so material, as to render it economically unfeasible?
  • How long is the outbreak’s duration, to the extent this is even knowable, relative to the period of performance of the contract?
  • Will the economic consequences of enforcement of the contract without triggering the MAC cause the other party such financial harm that it would cease to be able to operate as a going concern?
  • Does the contract specifically call out pandemics?
  • Would the passage of more time allow the parties to fulfill the agreement’s terms without substantial harm?

What should you do now to protect your agreements?

Businesses would be well advised to review their most important contracts to see what it actually says about the outbreak of a pandemic and assess risks and opportunities on a case-by-case basis.

With the outbreak of COVID-19 now being called a global pandemic, we should now foresee how to handle them in the course of business. As such, businesses should review their standard terms and conditions of doing business, customer, supplier and vendor agreements, and tailor them according to their experiences and expectations for the future, including that matters get worse before they get better.

Smart entrepreneurs and management teams will take a long-term view of their business, not over-react to what should be a temporary circumstance, honor their commitments to the extent commercially feasible, and look for opportunities to earn trust and confidence that will enable future growth.

Image Source: Deposit Photos
Image ID: 58868455
Copyright: vitstudio 

 

The Author

Louis Lehot

Louis Lehot is the founder of L2 Counsel, P.C. Mr. Lehot is a corporate, securities and M&A lawyer, and he helps his clients, whether they be public or private companies, financial sponsors, venture capitalists, investors or investment banks, in forming, financing, governing, buying and selling companies. Helping a business get big, go public or get acquired is what he does.

For More information or to contact Louis, please visit his Firm Profile Page.

Warning & Disclaimer: The pages, articles and comments on IPWatchdog.com do not constitute legal advice, nor do they create any attorney-client relationship. The articles published express the personal opinion and views of the author and should not be attributed to the author’s employer, clients or the sponsors of IPWatchdog.com. Read more.

Discuss this

There are currently 3 Comments comments. Join the discussion.

  1. Deepak Gupta March 18, 2020 10:55 am

    This virus is really ruining online and offline industries all around the world. I hope this should be cured soon.

  2. TFCFM March 18, 2020 11:37 am

    A helpful article — thanks. One small addition:

    LL: “The application of the law does not differ materially across the states, with Delaware and New York jurisprudence being the most persuasive.

    While that’s generally true within the US, keep in mind that application of force majeure and similar changed-circumstances provisions CAN vary significantly among nations (especially civil law nations, and especially China). Be sure to consult an advisor well versed in the law pertaining to your agreement/situation.

  3. Pro Say March 18, 2020 11:49 am

    Thanks Louis — great information about an important subject and contractual consideration that I hadn’t considered.

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