By Louis Lehot, business lawyer and partner at Foley & Lardner LLP in Silicon Valley, and formerly the founder of L2 Counsel, P.C.
As someone with extensive experience advising public and emerging growth companies and their investors, along with parties in M&A transactions, I am often asked to advise companies on how they can prevent interruptions to their business priorities, particularly interruptions to customer and supplier relationships. With the advent of COVID-19 and the declaration of a “global pandemic” by the World Health Organization, companies are more concerned than ever about protecting the business contracts they have in place. I am now being asked if companies are able to trigger a “material adverse change” clause that would allow them to terminate a contract they are bound to and how companies can ensure the contracts they have in place are protected.
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What constitutes a “material adverse change”?
A “material adverse change” clause, or MAC clause in short, is a clause outlined in a business agreement that allows a counterparty to exit the agreement if there is a major degradation affecting the fundamentals of the deal between when it is signed and closed. MAC clauses have been prevalent in commercial and investment contracts and are often interpreted in the context of merger agreements with the buyer being able to walk away from the deal.
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When determining if a MAC clause has been breached, there are several things a court needs to assess. The adverse change must be “material” to the deal in whole and occur over a significant period of time. A circumstance that is only temporary and occurs over a short period of time is not enough to necessitate a MAC. Additionally, the MAC must have actually taken place; the threat of a forthcoming MAC will not trigger a MAC. For a MAC to be triggered, the party wanting to trigger the MAC needs to demonstrate the adverse change in terms of time and quantity while being specific to how and why the MAC occurred. If the consequence was foreseeable when the contract was established, but was not spelled out, the courts would be less likely to see the event as a MAC. A MAC clause will be carrying more weight when leveled against an unknown or unforeseeable event.
Triggering a MAC should not be taken lightly, as the party seeking to trigger the MAC must provide evidentiary support to prove that a MAC has actually occurred. A famous example of a MAC was between a buyer and seller of a sugar refinery in Cuba in which the subject refinery became nationalized under Fidel Castro following the Cuban revolution. Legal standards for a MAC do not differ across the states, though Delaware and New York are most persuasive (as to variations across national boundaries, that is another question entirely). Furthermore, there are no specific guidelines that must be followed, so courts interpreting a potential MAC must look at each circumstance individually with all facts presented.
COVID-19 and your contracts: Can this global pandemic trigger a MAC?
As stated above, the party wishing to trigger a MAC clause must provide immense evidentiary support for the clause to be granted. Terminating a contract poses consequences to the viability of commerce and the financial economy as a whole, and the courts will seek to preserve the economic basis of contracts in light of the consequences that may arise.
Questions to consider:
- Was the circumstance, in this case COVID-19, already a known factor or had it been contemplated when the contract was established?
- Has the declaration of COVID-19 as a global pandemic resulted in an adverse change so severe as to render the agreement economically unfeasible?
- How long is the circumstance occurring for in relation to the length of the contract? Will the COVID-19 outbreak occupy a significant time during the performance period of the contract?
- If a MAC clause is not granted, will economic consequences to the other party be so great that they must cease operations in their current capacity?
- Are pandemics specifically called out in the contract?
- If more time passes and the COVID-19 outbreak subsides, will both parties be able to fulfill the terms of the contract?
How can your company protect its contracts now?
As the current COVID-19 situation stands, business should review their most important contracts. To determine:
- whether the contract provides for suspension or termination of performance;
- whether any representations, warranties, covenants, delay rights, termination rights, conditions or force majeure provisions are triggered by COVID-19 and determine next steps;
- look for any notice requirements that have been or may be triggered;
- the extent to which COVID-19 prevented a party asserting an inability to perform;
- consider what, if any, other means exist to deliver or perform on contractual obligations
- are there proactive steps that can be taken now in case the crisis continues for longer than currently anticipated?
- is there any ability to mitigate effects to better perform?
- try and quantify the potential consequences of a breach and/or default;
- communicate, communicate and communicate, and consistently; and
- to check for any governmental or regulatory statements that could impact performance or non-performance.
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Risks and opportunities should be assessed on an individual case-by-case basis.
With the COVID-19 outbreak being categorized as a global pandemic, businesses now have a standard for handling such a situation in the future. In the current state of affairs, businesses should take this as a chance to thoroughly review their standard terms and conditions regarding business activities, including any agreements in place between customers, suppliers, or vendors. These contracts can then be tailored going forward according to experiences and expectations during a global health crisis, including if situations degrade before they get better.
Entrepreneurs and those in management should take a long-term view of relationships and avoid over-reacting to the current COVID-19 pandemic, which could, and most likely will, have only a temporary, albeit large, impact on their business. It is advisable to uphold any commitments that have been made to the fullest extent feasible, while continuing to look for business opportunities that foster trust, confidence, and continued growth in the future.
