Can Coronavirus Pandemic Trigger Material Adverse Change Clause?

Among the many uncertainties unleashed by the coronavirus pandemic is its impact on M&A agreements which have been signed but not yet closed, or on agreements which are under negotiation. The question being asked is: will coronavirus and its potential fallout trigger a material adverse change (MAC), thereby increasing the risk of buyers terminating transactions which have not yet closed? Although the pandemic has caused widespread economic upheaval, MAC clauses are typically read in conjunction with other contractual provisions and need to consider several associated factors.

Changes resulting from every adverse event do not automatically trigger the MAC clause. The changes need to be material and durationally significant. Short-term disruptions in target companies’ earnings are not considered sufficient grounds for triggering a MAC clause. The adverse change has to be material such that it is reasonably expected to substantially impede a target company’s business – assets, liabilities or financial position – over a period of time which spans several years.

The issue of determining a MAC for parties seeking a discharge is not easy. Courts have generally interpreted MAC provisions narrowly and set stringent standards to determine if a transaction can be terminated.

If a contract includes specific provisions regarding what constitutes material changes, the issue of materiality can be determined within the ambit of those provisions and the overall context of the agreement. However, when no such provisions exist, then the issue of materiality is decided by an appropriate court of law. Although there is no judicial precedence of such an event in India, US courts have set a high bar to determine if a MAC has taken place.

In 2018, the Delaware Court of Chancery, adjudicating in the case of Akorn v. Fresenius, ruled for the first time that a MAC had occurred which had a materially adverse impact on the target company (Akorn, Inc.). The court considered all the evidence to observe that Akorn’s business had suffered a substantial downturn and its performance had fallen “off a cliff” after the signing of the merger agreement. The court also observed that Akorn’s decline in financial performance was “durationally significant” and was on account of company-specific factors.

A far-reaching ruling in Akorn v. Fresenius was that “a buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close.” Although buyers bear a high burden of proof to establish a MAC, sellers typically run a significantly higher litigation risk. Usually, the MAC clause can be triggered with regard to conditions already existing on the date it is invoked, but anticipated changes may also be sufficient grounds to invoke the clause in specific cases. However, it must be clearly demonstrated that such anticipated changes are expected to occur.

There are several uncertainties – particularly regarding the duration and economic impact – associated with the coronavirus pandemic. Parties to M&A transactions are likely to be embroiled in long-drawn legal proceedings in case they invoke a MAC clause.

Many MAC provisions in M&A agreements specifically exclude changes resulting from “pandemics”, “epidemics”, “health emergencies” or “acts of God”, unless such changes have a disproportionate effect on either of the contracting parties. Since it is largely believed that the coronavirus pandemic will be a short-lived crisis and the full scale of its economic impact is still uncertain, the acquirer/target invoking the MAC clause will need to prove beyond doubt that the aftermath of the crisis will have a material adverse impact on a long-term basis.

Before either the acquirer or the target decides to invoke MAC provisions under an M&A agreement, they should carefully consider the potentially high litigation risks involved. Whether an agreement was signed before January 2020 or after the coronavirus outbreak was declared a pandemic, the acquirer/target should be fully aware of the facts and circumstances existing at the time of invoking the clause. They should also possess sufficient evidence to prove that the likelihood of a significant material impact could not have been known at the time of signing the contract.

In the Indian context, it is likely that MAC provisions will be read in conjunction with section 32 (contingent contracts) and section 56 (Agreement to do the impossible act) of the Indian Contract Act, 1872. As has been the case in other countries, Indian courts are expected to take a narrow view when parties invoke MAC clause seeking discharge from a contract. In 2014, the Supreme Court had, in a landmark judgment, ruled that companies could not withdraw an open offer on the grounds that the offer lacked commercial reasonableness or had become economically unviable.

Courts will need to consider multiple factors before considering the coronavirus pandemic as a MAC warranting the termination of a contract.

Following the 2014 Supreme Court ruling, courts in India are expected to take a conservative view while ruling on MAC clauses in the context of the coronavirus pandemic. Given the likelihood of significantly high litigation costs and long-drawn-out legal processes, parties may possibly settle for a renegotiation of contract terms. The pandemic will also change the way MAC clauses are negotiated and drafted in future M&A agreements.

Whether or not the coronavirus pandemic will be considered an event triggering a MAC clause will depend on several factors: the wording of MAC provisions in contracts; the scope of definitions (if they have been defined broadly or narrowly); the gravity of impact on the target company compared to similar companies in the same industry; and impact on the overall industry. Due to multiple scenarios, courts will need to interpret the facts of each case differently while considering if a contract can be terminated due to the coronavirus pandemic becoming a MAC.

(Authors Iqbal Tahir, Partner ([email protected]) and Gaurav Kapur, Principal Associate ([email protected]) at Dua Associates, Advocates and Solicitors. The content of this article is intended to only provide a general guide to the subject matter and should not be construed as a legal opinion)