The global disruption due to COVID-19 has affected businesses in all spheres. The M&A segment in particular is walking a tight rope. Buyers are trying to exit or renegotiate transactions already entered into. The recent row between Sycamore Partners and L Brands over the invocation of the Material Adverse Change clause shows the same.
Buyers are wary of overpaying for assets whose future earning potential may have been further damaged. Lenders may seek to invoke the MAC clause to stop loss and safeguard their interests. Thus, MAC clauses are likely to be invoked due to COVID in acquisition and financing agreements.
What is a MAC Clause?
A MAC clause seeks to protect buyers from unforeseen risks, which may affect the following:
- business,
- assets,
- financials, or
- operations of the target company.
MAC clauses divide risk between the buyer and seller for the time of intervening between the signing and closure of the agreement. Usually, the buyer undertakes market and industry-specific risks, whereas the seller undertakes company-specific risks. MACs provide buyers a window for walking out of deals without having to pay termination fees.
Standard MAC Clause
A standard MAC clause has the following components:
Firstly, the author provides for the meaning of the MAC in a three-fold manner:
- It is an event, circumstance, change, occurrence or effect that, individually or in the aggregate,
- which has or is reasonably expected to have a material adverse effect
- on the business, operations, or financials of the company.
Secondly, it has certain exceptions such as- natural disasters, epidemics, war, or warlike situations, terrorism, general economic downturns, industry-specific conditions, and other broad categories of market or credit conditions. Some MAC clauses exclude “pandemics,” “epidemics”, “diseases”, and “health emergencies” as well. Recently, entities have excluded “COVID-19 pandemic” from the definition of a MAC. This can be seen in the Morgan Stanley-E*TRADE merger agreement, as well as, the agreement between Assertio Therapeutics and Zyla Life Sciences.
Thirdly, parties may carve an exception to the above exclusion as well. It may be provided that an adverse impact on the acquiree, disproportionate in comparison to other entities of the same industry would amount to a MAC ( “disproportionate adverse impact”). The clause may either be specific or general with catch-all phrases.
Difference Between MAC Clause and Force Majeure Clause
A fundamental difference between the two clauses is the impact of invocation on the agreement. A MAC clause allows the buyer to walk away from the transaction. Whereas, a Force Majeure clause provides a temporary reprieve from the obligations of the parties under the contract while the event lasts. Further, a Force Majeure clause can be invoked by either party, depending on the nature of the contract and the event triggering the clause. But, a MAC is an option that is vested only with the buyer.
The burden of proof for a MAC clause is higher than the one set for interpreting a Force Majeure clause. In the case of Energy Watchdog vs. CERC, the Apex Court laid down criteria required for establishing a Force Majeure event. The ones relevant to our discussion are-
- the specific language included in the contract;
- whether the risk of non-performance is predictable and whether mitigation of such risk is possible;
- whether performance is actually unfeasible or would need more resources.
In contradistinction, while interpreting MAC clauses, the Courts additionally examine whether:
- a long-term investor will experience a loss of value; and
- the loss is greater than that of other firms in the respective industry. (See Akorn Inc v Fresenius Kabi)
Moreover, a MAC clause generally excludes events listed as Force Majeure from its ambit.
Interpretation of a ‘Materially Adverse Effect’
The Courts have set a high bar for interpreting MAC clauses. The contextual nature of MAC clauses requires a fact-specific inquiry.
Strict Interpretation
To dissuade the creation of market volatility, the Courts use strict interpretation. Thus, the wording of a MAC clause is of significant importance. It is easier to read pandemics, such as COVID-19 in MAC clauses, which ideally use general terms and catch-all phrases. Parties may have provided for the exclusion of the term pandemics from the MAC clause. In such cases, only the exception of ‘disproportionate adverse effect’ can trigger the MAC clause.
“Materiality” of the change
There is no straitjacket definition of Materiality. Further, due to the lack of opinion by the Indian judiciary, one needs to refer the precedents set by other jurisdictions. The landmark cases relating to MAC in the Delaware Courts are – IBP Inc v Tyson Foods Inc, Hexion v Huntsman, and Akorn Inc v Fresenius Kabi (hereinafter referred to as “Akorn Case”). They establish the following criteria for invocation of a MAC clause-
- exceptional and unforeseeable circumstances affecting the target must have arisen;
- the occurrence of an “adverse change of very considerable significance”. In other words, the change should strike at the root of the transaction in question;
- there must be large adverse changes to the long-term earning capacity of the target. (and not the short-term profitability).
Qualitative and Quantitative Factors
It was further held that the long-term impact must be adjudged by both quantitative as well as qualitative factors. A lasting effect on the long-term acquisition strategies, such as the multi-year horizon needed to integrate complex businesses should occur. While such determination is factual, the Courts have relied on the identity of the buyer and its investment horizon.
In the Akorn Case, the Court found a year-long business decline, based on business-specific problems enough to constitute a MAC. These problems included unexpected new market entrants competing with the target’s top products and the unexpected loss of a key customer with no signs of abating. While there is no bright-line quantitative test, the Court while allowing a MAC clause in the Akorn Case noted that a 20% change in value is material. (See also Channel Medsystems Inc v Bostin Scientific Development)
Buyer’s Remorse Insufficient for Invocation of MAC clause
The jurisdiction of the UK also reflects these criteria. In the WPP Tempus Case, it was held that a change that undermines the bidder’s rationale for making the acquisition at the specified price is insufficient to fulfill the high threshold.
The Court, in the Channel Medsystems Inc v Bostin Scientific Development case, further criticized parties who did not raise their concerns before filing a suit with their counterparties and appeared to have manufactured issues for purposes of litigation. Hence, “buyer’s remorse” cannot be the reason for the invocation of the MAC clause.
MAC and Indian Legal Framework
Regulation 23(1)(c) of the SEBI (Substantial Acquisition of Shares and Takeover) Code, 2011 (“the Code”) provides for the Indian corollary of MAC clauses. As per the provisions of the Code, it is mandatory to make an open offer. This offer is to the public shareholding of the acquiree company on surpassing certain threshold limits.
Regulation 23(1)(c) permits the withdrawal of an open offer in cases where conditions to the underlying acquisition agreement are not fulfilled due to exogenous factors. Such non-fulfillment must result in a rescission of the agreement. Prior notice of such conditions is also essential. These regulations are applicable only to public listed companies.
The Apex Court, in the case of Nirma Industries v SEBI, while interpreting the 1997 Takeover Code, held that a common genus of ‘impossibility’ exists in the exceptions, permitting withdrawal of an open offer. It further held that SEBI must exercise its discretionary powers, to permit such withdrawals. This stand was further reiterated in the case of Pramod Jain v SEBI. However, this interpretation was before the introduction of the current Regulation 23(1)(c). A plain reading of Regulation 23(1)(c) shows that impossibility is not a need under the clause.
But, in Re Jyoti Limited and Ors., the decision of SEBI was upheld. It held that the rationale from Nirma Industries continued to apply, to the analogous provisions of the Code. A conundrum, thus, lies about whether the ‘impossibility threshold’ will also be applicable to Regulation 23(1)(c).
Conclusion
The Courts have set a high threshold for the invocation of MAC clauses. Currently, there is no formula for determining the invocation of a MAC clause due to COVID-19. Such an inquiry is fact-intensive and depends on several factors. The Courts undertake a strict interpretation of the clause. Thus, the parties will have to prove a material impact over the long term earning capacity of the acquiree.
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