The following is a contributed article from Gary Kleinrichert, senior managing director, and Brent Miller, managing director, of FTI Consulting. Opinions expressed are the authors' own.
Agreements typically include some version of a material adverse change (MAC) provision as a condition of closing. The clause may let you terminate an agreement if something causes a material change in your company’s finances or operations.
Against the backdrop of COVID-19, you might wonder if the pandemic gives you grounds to invoke a material adverse change clause or if a company can invoke it against you in an agreement you’re both party to.
At first glance, it might seem so. But courts have noted that MAC claims face a high burden. The fact is, not every negative change in a company’s performance qualifies as a MAC.
The definition of a MAC and the situations in which it may alter a party’s obligations are unique to each agreement, so determining whether a change qualifies will vary from case to case. Historically, courts have commonly sought to answer the following questions:
Is there a material downturn in the performance of the business?
Is it unforeseen or unknown?
Will it have a material impact for a significant length of time?
Is the impact disproportionate to the impact on the company’s industry?
You’ll want to answer these questions if you’re seeking to get out of a contract or responding to an entity invoking the clause against you. If you’re the company seeking to invoke the clause, here’s what you need to consider.
Is the change in performance material?
There is no universal test to determine whether a change in performance is material. In some instances, the parties may include language in the agreement to define materiality. If your agreement doesn’t include that, you’ll want to look at changes in your revenues, earnings, and other financial metrics relative to past and projected financial performance to gauge how much impact the changes have on your prospects, and potentially your company’s value.
Some qualitative factors to look at: whether a lost customer had provided significant reputational benefits for your company or if the affected revenue stream was a higher expected source of growth than your other business lines or products.
To support a claim that the impacts of the pandemic constitute a MAC, you should quantify those impacts (to the extent possible) and identify any other qualitative impacts. As part of this, you should engage a qualified financial expert to help you; in a key case, IBP v. Tyson, the court noted that the lack of expert evidence regarding the subject company’s diminution in earnings potential was significant.
Is the impact unforeseen or unknown?
Whether you knew of the impacts of the pandemic will be a question of fact you'll have to address.
The reports of cases in China began in late 2019, but the magnitude of the problem increased and became more apparent over the subsequent months, with the World Health Organization declaring the outbreak a pandemic in mid-March 2020.
If you're asserting a MAC claim, you’ll likely take the position that both of you — your company and the one with which you have an agreement — didn’t know about the outbreak at the time of the agreement or didn’t anticipate the potential extent of its impact. Courts will have to determine whether the eventual impacts of the pandemic were known risks when you negotiated the agreement.
Is the impact durationally significant?
Courts have historically held that the impact of a MAC must persist for a commercially reasonable period of time. If the agreement involves an acquisition, this typically means the length of the impact must be measured in years rather than months.
In a lending context, a shorter duration may be significant depending on the term of the loan agreement. Proving the duration of the pandemic’s impacts might be challenging, because it’s unclear how long the pandemic will last or how long the more disruptive response efforts such as government shelter-in-place orders will continue.
The federal government has contemplated the possibility of an 18-month timetable for response efforts, but has also suggested that the more disruptive response efforts may be shorter-lived.
Effective treatments could quickly alleviate many of the pandemic’s negative impacts on businesses. Because of that uncertainty, you should evaluate whether your business is likely to be significantly impacted, even after the pandemic ends.
As the court decides whether the change was durationally significant, it will consider whether your company is likely to recover once response efforts end. Impacts extending beyond the duration of the pandemic will more likely convince a court that a MAC has occurred.
Is the impact disproportionate?
In many contracts, general downturns in an industry or the broader economy don’t qualify as a MAC. For that reason, you can expert courts to evaluate whether the event giving rise to the MAC claim had a disproportionate impact on your company (i.e., whether it was affected to a greater degree than others in your industry or in the broader economy).
In these situations, a disproportionate impact may show that the decline in performance was not caused by a general downturn.
Courts also may consider the impact on your company relative to its industry in order to assess whether the change is part of the normal business cycle as opposed to a material change to your business.
In IBP v. Tyson, general industry downturns were not excluded from the definition of a MAC, but the court noted that a significant decline in profitability for the subject company was largely driven by an unusually harsh winter that affected the overall industry.
This formed part of the court’s basis for concluding that Tyson had not demonstrated that the drop in profitability was a MAC as opposed to an unpredictable yet inherent aspect of the subject’s cyclical business.
Given the widespread effects of the pandemic, many companies in hard-hit industries may experience significant declines, making it harder to demonstrate a disproportionate impact on any one company.
For example, the restaurant industry has been severely affected by pandemic response efforts, and could face long-term declines in profitability if the pandemic produces demand-reducing cultural shifts. As a result, a particular restaurant might experience an unprecedented performance drop, but that drop might not be disproportionate if most of the industry experiences the same problems.
It remains to be seen whether courts will view the pandemic as such a unique event that it warrants consideration as a MAC, even without disproportionate impact on the subject company relative to its industry. Nonetheless, you'll be in the best position to assert a MAC claim if you’re able to demonstrate such a disproportionate impact.
When would COVID-19 constitute a MAC?
Assuming the impact is material and unforeseen, the most compelling examples of MACs related to COVID-19 will likely be instances where your company has already experienced a unique loss that will extend beyond the end of the pandemic response efforts.
For example, assume your company’s top customer has gone out of business as a result of the pandemic. Because of that, the duration of the impact is not as significantly affected by the length of the pandemic. That results in less uncertainty about the durational significance of the loss.
Additionally, the loss from a major customer going out of business is less likely to be comparable across the industry, making it more likely that the impact to your company will be disproportionate.
A similar example would be if your company had planned to start a major project expected to provide much of the company’s revenues in subsequent years, but was no longer able to secure financing.
Again, the fact that it was a company-specific project increases the likelihood that the effect on your company would be disproportionate compared to your industry. If your company could not start a comparable project at a later date, the impact would likely be viewed as durationally significant as well.
Other examples might be if the pandemic’s effects caused your company to default on a key loan agreement or lose its lease on a key retail location.
If your company hasn’t yet experienced these types of losses, the pandemic might still have increased the risk of such a loss in the future. While that increased risk may seem like a MAC because it reduces the likelihood that your company will meet pre-pandemic expectations, courts might not agree.
In S.C. Johnson Son v. Dowbrands, the court ruled that a patent infringement lawsuit against the subject company didn’t constitute a material adverse change in the company’s operations or financial condition, because the company might prevail in the lawsuit.
However, in Frontier Oil v. Holly and Channel Medsystems v. Boston Scientific, the court seemed to allow for the possibility that a potential future loss could be a MAC if there is evidence that the loss is highly likely.
Here are a few points to keep in mind if you’re contemplating or facing a MAC claim:
Determining whether a MAC has occurred is highly fact- and agreement-specific, and the COVID-19 pandemic is not an exception to that. You should carefully evaluate the language of the agreement when considering or responding to a MAC claim.
The two most challenging issues for many companies affected by the pandemic will likely be demonstrating durational significance and (if necessary) a disproportionate impact. As a result, the strongest MAC claims will likely involve instances in which a loss has already occurred, will extend beyond the pandemic response efforts, and is unique to your company.
MAC claims don’t always have all-or-nothing results. The ambiguity in many MAC clauses can encourage the parties to renegotiate an agreement when there is a significant change rather than risk litigation. When preparing for those types of negotiations, bring in someone with the relevant expertise to help you evaluate the strength of your positions, and present them in a manner to optimize your bargaining position.