“Material adverse change” and “material adverse effect” are often used interchangeably to mean a change for the worse. Typically, they are found in finance documents, commodity sale agreements and sale and purchase agreements for upstream acquisitions (“SPAs”). In finance documents, the term allows the lender to call a default if there is an adverse change in the borrower’s financial position. In commodity sale agreements, the term acts as a hardship provision which recognises that over the course of long-term contracts, market economics may change, making the original contract price inequitable to either the buyer or the seller during the term of the contract. In SPAs, the term acts as a buyer protection measure, allowing the buyer to walk away from the deal if an adverse event occurs which significantly affects the target or asset between the milestones of signing and completion. In all three types of contract, the material adverse change or material adverse effect makes the deal economically unattractive to the party seeking to rely on the provision, although not impossible for the contract to be performed. Importantly, the event which results in a material adverse change or material adverse effect must be outside of the affected party’s control.
This article focuses on how the prospect of a change for the worse can be addressed by buyers and sellers in the context of SPAs, and considers how material adverse change and material adverse effect provisions have been interpreted and applied by the courts.
Upstream acquisition agreements
There is some debate over whether “material adverse change” or “material adverse effect” is the better term. Although material adverse change trumps as being more certain - a change is easier to note than an effect is to measure – material adverse effect is often the preferred choice in SPAs. This is on the basis that it sounds peculiar to refer to an adverse change rather than an adverse effect in the context of valuing the target or asset.
Material adverse effect provisions are only relevant where there is a period of time between signing and completion. In SPAs, there will always be a gap between these two dates in order for the buyer and the seller to obtain the necessary regulatory approvals and other third party consents, and to perform any other conditions precedent. The longer the interim period, the greater the likelihood of a material adverse effect event occurring, at least in the opinion of one of the parties.
In order to protect itself against this pre-completion risk, the buyer can use material adverse effect provisions in two ways. The first is as a condition to completion which entitles the buyer to terminate the deal if there is a material adverse effect which significantly affects the target or asset during the interim period. The second is a representation and/or warranty from the seller that the target or asset has not experienced a material adverse effect between signing and completion, a breach of which may entitle the buyer to damages. These two means of addressing pre-completion material adverse effect risk are explored further below.
As a rule, SPAs include interim period covenants which restrict what the seller can do with the target or asset once a deal has been agreed. One of the usual covenants is that the seller will keep the buyer informed in a timely manner of matters which have, or could have, a material adverse effect on the value of the target or asset. Such matters may include: any physical damage to or destruction of the asset, such as the degeneration of a pipeline or the destruction of a platform; any matters arising which are inconsistent with any of the representations or warranties which are repeated at completion, for instance if a royalty agreement comes to light but the seller has warranted that no encumbrance is in existence and in force over the asset; any significant change in law, for example, one which grants the state an option to acquire the seller’s interest in the target or asset for an amount significantly lower than the market price; or any event which constitutes a breach of any of the seller’s other interim period covenants, such as failing to consult with the buyer prior to an operating committee meeting in relation to a material decision affecting the target or asset. Typically, if any of these types of events occur, and they have a material adverse effect on the value of the target or asset, the buyer may be entitled to terminate the SPA before completion. In situations such as these, and if the buyer is in a strong bargaining position, the buyer should also consider requesting that the seller indemnifies the buyer against all costs and expenses that it has incurred in connection with the SPA up to and including the date of termination.
In a similar vein, the SPA may include a seller’s representation and/or warranty which states that no event has occurred which constitutes a default under any contract under which the asset is governed, being a default which would have a material adverse effect on its ability to perform its obligations under the SPA at completion. In this scenario, the material adverse effect provision is used to qualify the representation and/or warranty. In other situations, the seller’s representation and/or warranty may instead be absolute, stating that since the date of the SPA, there has been no event which will have a material adverse effect on the value of the asset. In both circumstances, the SPA may not grant the buyer a termination right and instead the only remedy available to the buyer, if the qualified or absolute representation and/or warranty is or becomes untrue, would be damages for breach of contract.
In the examples provided above, the seller will want to build in a wide grace period in which it can remedy any event which has or will have a material adverse effect before completion and before the buyer is entitled to terminate the SPA, if relevant. Conversely, the buyer will want to limit the time-frame in which the seller has to remedy any default or inconsistency and to preserve its right to claim for breach of contract and/or breach of representation or warranty if it elects not to terminate the SPA.
In addition to appearing in material adverse effect provisions, the concept of materiality is often introduced into the SPA by means of a simple materiality threshold. In some cases, the SPA will specify what is meant by “material” - for example, the value of the asset will only be deemed to be materially affected if it is reduced by an amount equal to or greater than a certain percentage of the consideration payable by the buyer to the seller for the asset under the SPA, or a material adverse effect will only occur if a target’s revenues fall by over a certain amount. In others cases, the SPA may be silent on what constitutes “material” and this is problematic as there are no set boundaries as to whether or not an event or effect will be construed by the courts as being material. Without a specified definition or test, the materiality threshold under a SPA is traditionally very high and is unlikely to cover de minimisamounts; it is treated as an objective test and the burden of proof is likely to lie with the buyer to discharge.
Reliance on material adverse effect provisions as a deal protection measure for the buyer needs to be balanced against the seller’s requirement for deal certainty. Ultimately, the extent to which the buyer and seller agree to allocate risk in the SPA through the inclusion of material adverse effect provisions will largely depend on the negotiating power of the parties. The buyer is unlikely to negotiate a favourable material adverse effect provision in an auction situation but may have more ability to do so as part of a package sale or a preferred bidder bilateral negotiation.
Application of material adverse effect provisions
Few jurisdictions have considered how material adverse effect provisions in contracts will be applied in practice. One possible explanation is that buyers may be reluctant to litigate; given that there is a limited body of case law on this subject, it is difficult to gauge how the courts will react to claims that there has been a material adverse effect event. If a buyer chooses to exercise its rights under the material adverse effect provisions in the SPA, the seller can either accept that a material adverse effect has occurred or choose to defend against it. If the seller elects the latter option, and the court or arbiters conclude that the event did not constitute a material adverse effect, there may be an award of damages to the seller for the buyer’s breach of contract or for specific performance under the SPA. This outcome, coupled with the fact that dispute resolution can be an expensive and time consuming option, may make this an unappealing choice for the buyer who is faced with an unattractive deal. Instead, the buyer may seek to re-negotiate the purchase price of the target or asset with the seller before completion, outside of the dispute resolution process.
Another related explanation is that contracts may direct the parties to resolve any disputes thereunder through arbitration rather than court process. Consequently, the outcome of how material adverse effect provisions are applied is determined in private, behind closed doors, rather than documented in the public forum.
As the concept of material adverse effect is largely a product of American and English draftsmen in certain jurisdictions, for example in Japan and Singapore, the material adverse effect provision is traditionally uncommon in contracts. This therefore limits the pool in which disputes around material adverse effect provisions may arise and may be a further explanation as to why there are few cases on this subject matter.
One most recent case on the interpretation and application of material adverse effect that has come before the English courts is Grupo Hotelero Urvasco SA v. Carey Value Added SL1. Although this case looked at a material adverse change in the in the context of finance documents, it provides useful guidance on how the courts might interpret material adverse effect provisions in SPAs.
In summary, Grupo was involved in developing a hotel and apartments in London and had entered into a loan agreement with Carey as it was experiencing difficulties increasing its bank finance. The loan agreement contained a material adverse change provision which stated that, “There has been no material adverse change in its financial condition (consolidated if applicable) since the date of this Loan Agreement [21 December 2007].”, and this representation was deemed to have been repeated at drawdown. Although the material adverse change clause was plain vanilla, material adverse change was not defined in the agreement. Carey ceased lending under the loan agreement after it became concerned that a material adverse change in the financial condition of Grupo had occurred. The main factual issues were whether there had been a material adverse change in the financial condition of Grupo and, if so, whether it falsified a representation it had repeated at drawdown so as to amount to a default under the loan agreement.
The court considered what information should be taken into account when considering a borrower’s financial condition. It stated that, “the assessment of the financial condition of the borrower should normally begin with its financial information at the relevant times, and a lender seeking to demonstrate a material adverse change should show an adverse change over the period in question by reference to that information”. Next, the court considered how to assess the materiality of any change in financial conditions and held that the adverse change would be material if it significantly affected the borrower’s ability to repay the loan in question. Furthermore, the court considered to what extent a lender’s knowledge of pre-existing circumstances should be considered when assessing whether a material adverse change has occurred. The court concluded that a party seeking to trigger a material adverse change clause could not do so on the basis of circumstances of which it was aware at the time of entering into the agreement. Finally, the court held that it is up to the lender to prove the breach.
In giving his judgment, Mr. Justice Blair acknowledged that in the United States there are no appellate decisions interpreting material adverse change provisions, and that the few trial court opinions that exist have failed to establish a consistent interpretation. Admittedly, this lack of consistency limits how beneficial it may be for buyers and sellers negotiating English law governed SPAs to take heed of such decisions. However, as courts in the United States are more familiar with interpreting material adverse effect provisions than their English counterparts, their analysis of such provisions may provide useful guidance on the approach that could be taken by English courts in similar situations, especially in the absence of domestic case law to the contrary.
An important case in the United States which deals with the application of material adverse effect is IBP, Inc. v. Tyson Foods, Inc.2 This case was heard before Vice Chancellor Strine in the Court of Chancery of Delaware. Briefly, the facts were as follows: Tyson had entered into a merger agreement with IBP and pursuant to this agreement, IBP made certain representations and warranties in respect of its financial statements. IBP was forced to admit that it would have to restate its warranted financial statements to address issues raised by the Securities and Exchange Commission and to record the additional losses of its subsidiary. Tyson decided to terminate the merger agreement on the basis that IBP’s restatement of its warranted financial statements constituted a breach of the warranty that the warranted financial statements were accurate in all material respects. Tyson also argued that it was permitted to terminate the merger agreement because IBP had breached the representation and warranty that IBP had not suffered a material adverse effect since the “Balance Sheet Date”, except as set out in the warranted financial statements or a schedule of the merger agreement which qualified the scope of the warranty. Under the merger agreement, a material adverse effect was defined as, “any event, occurrence or development of a state of circumstances or facts which has had or reasonably could be expected to have a Material Adverse Effect….on the condition (financial or otherwise), business, assets, liabilities or results of operations of [IBP] and [its] Subsidiaries taken as whole….”. Tyson argued that a combination of factors had resulted in IBP suffering a material adverse effect.
The court held that IBP had not suffered a material adverse effect within the meaning of the merger agreement that excused Tyson’s failure to close the merger. It concluded that Tyson had improperly terminated the merger agreement because “it was having buyer’s regret” and the court granted IBP specific performance of the merger agreement.
This leading case is particularly significant in three respects. The court held that:
- “a buyer ought to have to make a strong showing to invoke a material adverse effect exception to its obligation to close”;
- a broadly written material effect condition, “is best read as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earnings potential of the target”; and
- the determination of materiality should be, “viewed from the longer-term perspective of a reasonable acquirer”, rather than a, “short-term hiccup in earnings”.
Whilst IBP, Inc. v. Tyson Foods, Inc. provides a very valuable analysis of the application of a material adverse effect provision in the context of an acquisition agreement, as Vice Chancellor Strine admitted, his conclusion was reached, “with less than the optimal amount of confidence”. It is therefore likely that the outcome of each case on material adverse effect will inevitably turn on its facts.
Given potentially what is at stake, it is important for the buyer to ensure that any material adverse effect provisions that are included in the SPA are well defined and clearly documented, including a careful definition of the test for materiality. This will give the buyer a stronger chance of successfully extricating itself from the deal if the value of the target or asset is significantly reduced due to an event outside of the buyer’s control. Conversely, the seller should try to resist the inclusion of material adverse effect provisions in the SPA and instead argue that any financial risk should be allocated to the buyer during the interim period between signing and completion. Both parties should be aware of the structure and content of the SPA as a whole and the effect that a materially adverse event will have on the wider agreement. English courts will not interpret material adverse effect provisions in isolation and will instead consider the SPA in its entirety in order to determine the intention of the parties if the deal becomes economically unattractive to the buyer. Ultimately, the buyer may have little appetite for litigating on this point, but a well crafted material adverse effect provision may stand the buyer in good stead when using it as leverage for re-negotiating the price of the deal with the seller.