All you need to know about material adverse change

Material adverse change (MAC) clauses are a tool for allocating to the seller the risk of something happening before closing that has, or at some time in the future may have, a materially adverse effect on the business.

Typically, there are two types of MAC clause: 

1. closing condition MAC, ie no MAC has occurred between the date of signing and closing; and 
2. seller representation MAC, ie a representation that the target has not suffered a MAC between the date of signing and closing, along with a closing condition that entitles the buyer to walk away if the representation is not true.

The existence of a MAC provides a buyer a right to terminate before completion, but is typically used as a basis for renegotiation. Sellers are willing to renegotiate terms to avoid litigation uncertainty and the associated reputational damage of a claim.

A typical MAC clause includes: 

• the need for a 'material event' (rarely defined) that impacts the business; 
• a timing requirement, ie that the adverse change occurs before closing; 
• an exclusion for industry-wide factors; and 
• carve-outs for events such as acts of God, natural disasters, etc and more recently, pandemics.

MAC jurisprudence

MAC clauses have received limited consideration by English courts, and Asian court jurisprudence is also slim or non-existent. In contrast, Delaware courts have considered MAC on many occasions, finding a MAC only once. Post-COVID, at least seven MAC cases have been filed before the Delaware courts, including the most recent by Tiffany’s against LVMH. The few existing English cases suggest that English courts may adopt the Delaware approach.

Three pre-COVID cases largely shape Delaware’s MAC-landscape: IBP v Tyson Food, Hexion v Huntsman, and Akorn v Fresenius.

The key take-aways from those decisions are as follows:

• MAC cases are generally brought by the seller against the buyer for failure to close. Remedies include specific performance and declaratory relief. The buyer sometimes seeks declaratory relief that its termination was valid.
• The burden of proof lies with the party seeking to exclude performance. This is a 'heavy burden', and not one that is easily satisfied.
• MAC clauses will be interpreted narrowly, and having regard to the context in which the parties were transacting. The court will generally adhere to the express contractual wording.
• Materiality is a different standard to that required for termination at common law, more closely approximating disclosure obligations. It will be met where there is a substantial likelihood that a reasonable investor would view a breach as having 'significantly altered the total mix of information'.
• Before considering any exclusions, the courts will first answer the critical question of whether there has been a MAC at all.
• Different benchmarks are used to determine whether a MAC has occurred. Operational results (ie EBITDA) are generally considered the most appropriate benchmark (compared to earnings per share, which may be more sensitive to capital structure).
• A MAC requires significant business decline not attributable to general economic or industry decline. There is no bright-line test, but in Akorn, the EBITDA dropped by 86 per cent and revenue, operating income and EPS fell by 25 per cent, 105 per cent and 113 per cent.
• The impact on a business must be durationally significant. It is a question of what is commercially reasonable in the context of the transaction when viewed from a longer-term perspective that the court would measure in 'years rather than months'.
• Mere risk of a business decline is not sufficient, and a party must show more than 'unsubstantiated expectation', but the effect need not actually have been felt yet.
• The buyer’s pre-signing knowledge of the risks giving rise to a MAC might not matter. Known but unrealised risks might still give rise to a MAC, but the Delaware court’s jurisprudence is inconsistent.
• Litigation positions taken in support of a MAC are unlikely to gain traction where not backed by contemporaneous evidence and common sense.