This article is written by Abhishek Sharma and Mohammad Khurshid Anwar, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from Lawsikho.com.

Introduction

After nearly 50 days of the lockdown, the utter state of disorientation and perplexity brought by the novel coronavirus (Covid-19) has continued to claim lives of people in India and around the world. Along with the humans, the business operations have eventually affected a broad swathe of the world economy. Stock Market coming to a halt, supply chain disruption and performances of many contracts are in a state of delusion.Even Mergers & Acquisition transactions and other related financing agreements may be swayed.So, the question now arises that whether or not the pandemic caused by COVID-19 would trigger “Material Adverse Effect (MAE) clause.” The term may seem to be straight forward but deep-down carries years of litigation in it. Let’s dive into the heat of the discussion. 

Understanding Material Adverse Effect (MAE)

In Simple layman language, a Material Adverse Effect clause in M&A context would basically permit a buyer to terminate a proposed agreement or transaction, if due to an event or series of events has caused a significant or material downturn in the financial robustness of the target or in the solidity and stoutness of the target business between the party(s) signing the contract. During this hard time, we expect that every party to a M&A agreement or financing agreement will be looking forward to finding out that and determine that whether or not any of the parties or parties to the contract has a right where they can suspend or rescind the contract. In the nucleus, a Material Adverse Effect (MAE) clause shall function as a sort of tool for risk allocation. The clause places the general risk or burden of the MAE on the seller and uses certain exceptions to dispense specific brackets of risk or burden on to the buyer. In other words, exclusions from the bracket of exceptions return risks or burden back to the seller. 

It shall be important to note risks related to contagious disease, such as “epidemics”, “pandemics”, and “public health crises,” have never commonly been included as MAE exceptions in M&A agreements entered into prior to the Novel Coronavirus COVID-19. It generally includes:

1. Economic or Political conditions in any country;
2. Changes generally affecting a target’s industry;
3. Geopolitical conditions such as terrorism, war, sabotage or calamity; and
4. Natural Disaster such as hurricane, tornado, flood, flood, or earthquake.

Use of Material Adverse Change Clause

Large transactions are generally involved in merger and acquisition agreements, venture financing agreement, the project with large concession period and others, with world business environment evolving and geographically spreading MAC can become a part of agreement anywhere required. 

Though generally, large transaction agreement does have Material Adverse Change clause its use is largely dependent on the team involved in finalization of the agreement who is responsible for proper due diligence. For examples in a typical acquisition agreement accountant, lawyer, risk department, human resource, senior executives and buyer’s key person can get involved in due diligence and can achieve a profitable acquisition. Due diligence generally involves buyer going through target’s corporate records; meeting with key employees; understanding the legal, environmental, and risk issues; and gaining an overall comfort of the target operations before agreeing to the purchase.

Importance of Material Adverse Clause

“Material Adverse Change” (MAC) or “Material Adverse Effect” (MAE) are usually used interchangeably which is important for both buyer and seller. In M&A transactions, it shall be noted that the time which is there in signing the contract and closure of the transaction of that particular contract is very important. It is when MAE/MAC comes into operation which basically gives the right to parties to a contract to rescind the agreement between the parties upon occurrence of any such event which affects materially on the potentiality of transaction. 

• Buyer: It shall be important because the seller can meticulously and easily shift much of the risk of unknown pre-closing liabilities to the buyer. However, careful crafting of an effective “Material Adverse Effect” can give the buyer a slight beneficiary or benefiting chance to stand in a solid position. 
• Seller: It is obvious on the part of the seller to sprinkle MAE/MAC everywhere possible to minimize the risk associated with the agreement. Sellers should carefully negotiate the definition to remove any kind of forward-looking language, which could limit the MAE to financial effects, as a change in the ongoing business that doesn’t affect its financial position in any way shouldn’t be considered as a MAE. A busted deal can be a huge problem for the seller as they may thereafter be viewed as broken goods in the market. So, it is vital for the seller to possibly make sure that buyer is obligated to close the deal. 

Scope for Negotiating 

Whether MAC/MAE could be brought into the picture as a result of COVID-19 pandemic and subsequent economic impacts shall always be dependent upon the capacity of the party or parties which are seeking to rely on this clause will have to prove that COVID-19 has actually caused significant adverse effect to the borrower. For example, a MAE clause which expressly provides that upon the occurrence of “natural disasters”. On comparing the material differences between the MAC clauses in (M&A) context versus a normal lending agreement is that, in the Merger and Acquisition, there are usually most of the times highly or deeply negotiated exceptions and restrictions to the scope of MAE/MAC clauses. Whereas lending agreements contain fewer MAE clauses. The important thing is that, in the light of the evolving situation with respect to the COVID-19 pandemic, parties that have entered into the agreement and are negotiating new contracts in M&A context need to address this issue by specifically addressing the business and economic impact caused by this pandemic. This negotiation is useful because there are Certain industries and businesses, for e.g. tourism and hospitality industries, have suffered a huge loss and are more vulnerable than others caused by COVID-19.

Importance of Due Diligence in Material Adverse Conditions

Application of Material Adverse Clause along with proper due diligence can result in effective mergers & acquisitions agreement, proper handover of projects with large concession period or implementation of the change of management of company or projects. Hereinafter some examples of failed Merger & Acquisition are given where the use of MAC could have been possible along with the case of a project with concession period where MAC was utilized.

Telenor India Joint Venture, Telenor a Norwegian company, at the time of joint venture Telenor was 7th largest with global telecommunications operator in the world with over 190 million subscribers with its subsidiaries and a major presence in Nordic counties. With a view to expanding geographically, Telenor started searching for a partner in India, which was a developing country with 2nd largest population. With Indian growth projection, only next to china it becomes an attractive destination. Unitech then 2nd largest real estate developers looking to expand had earlier obtained a license for telecom operations in India. The two companies came together and formed a joint venture, in 2008 Unitech had the license of a wireless network for 13 regions in India.  With Telenor having cutting edge technology in the telecommunication segment it looked like a win-win situation for both the parties. The joint venture came into existence with a name UNINOR and started operation aggressively.   However, at the same time, India had 3 other major players in the same segment, and all trying to acquire a larger customer base. The market becomes competitive and Telenor management became emotionally driven and started to approach India market aggressively to establish their presence citing their long and strong presence in another market. Further, it became more difficult for UNINOR to operate and Telenor had to back out from the Indian market. Later management informed different legal and political scenarios for different regions were the reason for backing out from India. 

In this case, Telenor had the overarching goal of becoming a global player which led them to enter the Indian market and acquire a relatively new and small player in Indian telecommunication business. On macro parameters, the deal looked okay, but more pragmatic due diligence was required while entering into a large unknown market which could have made Telenor more aware of government regulations and Indian political scenarios and could have saved Telenor from such decisions. 

In another case, of Bank of America purchased Merrill Lynch, Merrill Lynch was an American investing and wealth management company, with the bubble burst of real estate market between the year 2006 to 2008 and world going into the great depression, Merrill Lynch became a most affected company and had to go for a write-off of the total sum of $ 42 billion in subprime mortgage bonds. With Merrill Lynch getting into difficult situation government came in for rescue and supported Bank of America to purchase Merrill Lynch. Bank of America (BOA) then-largest retail bank of America had to absorb Merrill Lynch losses through purchase, it was reported BOA bought Merrill Lynch for $ 50 billion which was negative value to the investment, since Merrill Lynch market capitalization was around $ 26 billion. The deal between BOA and Merrill Lynch was done within one weekend from Friday to Monday morning giving no time of due diligence to BOA. 

Material Adverse Clauses in Different Context

Above two examples emphasize mainly on the due diligence required for the implementation of Material Adverse Clause in merger and acquisition agreements. MAC clauses in agreements look like:

“Material Adverse Change” mean any change that (considered together with all other changes) has or could reasonably be expected to have or result in a material adverse effect on the business, condition (financial or otherwise), cash position, liquidity, working capital, capitalization, assets (tangible or intangible), liabilities (fixed, contingent or otherwise), operations cash flow, financial performance or prospects of the target.

It is evident above definition is very general in nature and covers wide area, if the party of an agreement could not go into specifics through due diligence it is very difficult to prove material adverse change.  We will further see a case where the MAC clause was used.

A case between M/S NATIONAL HIGHWAYS AUTHORITY OF INDIA (NHAI) V. M/S ORIENTAL PATHWAYS (NAGPUR) PVT LTD (OPPL). Where the parties entered the agreement for “Improvement, Operation and Maintenance including Strengthening and Widening of existing 2 lane road to 4 lane Road dual carriageway from Km 50.000 to Km 100.00 of NH 6 (Kondhaii -Talegaon Section) in the State of Maharashtra on BOT basis”.

M/s NHAI were supposed to obtain financial clearance on 6th September 2006 but there was a delay in environmental clearances and could obtain it on 27th December 2006 i.e. a delay of 112 days. On the other hand, the construction period of the contract was 30 month, but M/s OPPL could complete it within 18 months. Later the matter went on for arbitration, where M/s OPPL claimed delay in environmental clearance gave rise to material change and affected concession period and requested to increase project concession period. The material change clauses of the contract read as: 

“Material Breach” means a breach by either party of any of its obligations in this Agreement which shall be deemed to have a Material Adverse Effect on the Project and which it shall have failed to cure within the Cure Period. 

“Material Adverse Effect” means the material adverse effect of any act or event on the ability of either Party to perform any of its obligations under and in accordance with the provisions of this Agreement.”

The arbitration award stated:

“the delay in obtaining environmental clearances could not be characterized as “material breach” having a “material adverse effect” for this reason. It is also the submission of Mr.Ravi Gupta that no costs enured to the respondent as it completed the project in 18 months instead of permissible 30 months. It is submitted that consequently, there was no loss at all which was liable to be compensated. It is further submitted that Clause 31.2 spelt out that even if it could be held that there was “material breach” of the agreement, in such eventuality the concessionaire was only required to pay monetary compensation and that the Arbitral Tribunal could not have granted an extension of concession period by three months. It is submitted that extension of the concession period under the Agreement is contemplated only under ………………………….which is relatable only to the occurrence of a Force Majeure Event which was not so in the present case.”

In the above example, the concessionaire requested to invoke “Material Adverse Effect” clause but was not accepted by Arbitration Tribunal, as the then situation of the project was governing the implementation of MAC.

Commercial Transactions 

It is very much common in the commercial transactions; MAE clauses are sometimes used in longer-term especially in the manufacture and supply contracts and outsourcing contracts. The occurrence of Material Adverse Effect in the commercial contract varies, but shall typically allow 1 party or both parties in some cases to either seek to renegotiate aspects of the deal especially the pricing and volume commitments. Where the contract allows for termination of the agreement, the parties need to give careful consideration to the consequences of termination. Where the customer and or the buyer has the right to terminate the agreement upon the occurrence of MAE/MAC, what the parties are required to do is how any stranded or amortized supplier costs are to be dealt with. Courts have been historically stringent in applying MAE clauses in commercial transactions. 

Voluntary and Mandatory Prepayment 

It is seen as a common practice for the lenders to stipulate for a fee transaction which is always or usually paid earlier than its contractual date. This fee is paid to compensate the lender for the loss of any anticipated loss from the deal and it is expressed as a percentage of the principal amount prepaid. 

Representation and Warranties 

It shall be important to note that buyers may also seek additional representations and warranties about the target’s business relating to the impact of COVID-19, and we can surely anticipate typical negotiations over the materiality and knowledge qualifiers. On the other hand, sellers may attempt to ringfence representations and warranties to the effects of Covid-19 so as to minimize a buyer’s post-closing claim that the outbreak has resulted in a breach of more general representations and warranties. 

Covenants of Parties

In Mergers and Acquisitions, covenants shall work in protecting and safeguarding buyer’s interest prior to completion, as well as its commercial deal after the completion in an active sense. The seller shall be required to take proper care of the transaction or to disentangle the acquired business. In a passive sense, the seller is required to refrain from using its knowledge or business-related relationships in order to compete with the business it is selling to. From the date of signing till the date of completion of the transaction, anticipated investments may or may not continue as per the plan. 

A decline in the business could seriously affect the upcoming performance of the parties. While financial covenants are the most likely to be challenged while considering the impact of COVID-19 and the buyer may also be subject to financial covenants due to operational continuation of the business. If the buyer would have suspended the agreement for a specified period of time, then an event of default would arise.

Investors/Acquires Right to walk away

Usually, most of the transactions include non-occurrence of MAC/MAE. Therefore MAE/MAE will depend upon the factual matrix. It shall be very difficult for the investors/acquirers to claim that COVID-19 will result in MAE. However, if the contract includes general or specific language with an adverse effect on financial conditions, investors/acquirers can try to prove that COVID-19 has inimically affected the company’s targets. There is no doubt about the fact that this pandemic has caused a temporary suspension of the businesses as well as stress on costs. Accordingly, investors/acquirers, while trying to provoke MAEclause, circumstances in each case will have to be closely examined to determine the impact on COVID-19 in specific industries. 

What Should Business Do 

It is recommended to review transaction documentation and relevant commercial contracts to confirm whether there are MAC clauses which you may invoke to benefit your business or which other parties may invoke against your business. Further, the investors/acquirers may even negotiate commercial terms, such that they will be able to withstand the possible implication arising from such instruction. 

What are the Other Options for Acquirer and Investor?

Parties may mutually agree to shelve or defer the agreement relating to M&E and suspend the agreement till the situation is brought under control. The best thing which can be done is to amend or renew the contract by analyzing the COVID-19 situation and financial condition of the targeted investment. It shall also be a viable option if the parties could see for securing a debt to complete the transaction. However, it could only be done when parties are financially sound. 

References

1. Mae Engineering Ltd v Dragages Singapore Pte Ltd (fka Dragages et Travaux Publics (S) Pte Ltd) [2002] SGHC 86
2. India: Coronavirus (COVID-19): Impact Of MAE/MAC Clauses On M&A And Investments, by Suneeth Katarki , Akhoury Winnie Shekhar , Rahul Tiwari and Jaidrath Zaveri, published on 26 March 2020 available at https://www.natlawreview.com/article/coronavirus-covid-19-and-material-adverse-effect-clause
3. Material Adverse Effect, Thomson Reuters Practical Law, available at https://uk.practicallaw.thomsonreuters.com/8-382-3618?transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp=1
4. Material Adverse Effect/Material Adverse Change Clauses, Eric. D. Dufee, Published on 25 May 2018, available at https://www.keglerbrown.com/publications/material-adverse-effectmaterial-adverse-change-clauses/
5. COVID-19 as a Material Adverse Effect (MAC) Under M&A and Financing Agreements, Gail Weinstein, Warren de Wied, Steward Kagan, Fried, Frank, Harris, Shriver & Jacobson LLP, Published on 4 April 2020, available at https://corpgov.law.harvard.edu/2020/04/04/covid-19-as-a-material-adverse-effect-mac-under-ma-and-financing-agreements/
6. Does the COVID-19 Outbreak Constitute a Material Adverse Effect? Plus Other Impacts on M&A Transactions, Vinson and Elkins, available at https://www.lexology.com/library/detail.aspx?g=42f1c16f-a788-4e2b-84ba-6a252b163a32
7. India: COVID-19: A Pandemic, A Force Majeure And A Material Adverse Change, Rajesh Sivaswamy and Mohana Roy, published on 24 March 2020, available at https://www.mondaq.com/india/maprivate-equity/907230/covid-19-a-pandemic-a-force-majeure-and-a-material-adverse-change
8.  Material Adverse Change: Lessons from Failed M&As by ROBERT V. STEFANOWSKI
9. https://indiankanoon.org/doc/61844547/
10. https://indiankanoon.org/docfragment/61844547/?formInput=material % 20adv ers e% 20effect

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