By Shraddha Ray Menon and Prateek Kumar Singh
The vivacious COVID-19 has tremendous ability to hold the length and breadth of the globe, captive. It is mercilessly holding several legal contracts, hostage. The resilient economy has witnessed numerous crisis till date, albeit not something as this. All bets are off & governments worldwide have offered multiple rescue tools. GOI, Ministry of Finance, microscoped in on Force Majeure declaring COVID-19 a pandemic classified as FM. Act of God[1] as one of the first “go to” remedies for legal documents.
Hostages, bear no blame for re-looking all clauses along with your FM clause. Include a sneak peek into the “Material Adverse Effect/Change” (“MAE”). Very strong, lawyered & deep words there, “Material”, “Adverse” and “Effect”. MAE is a draftsman’s delight!
Unlike the Force Majeure clause, which provides for events which specifically excuse the performance of the contract due to impossibility of performance (FM relies on Contract Act for interpretational value), the MAE looks at metrics of duration of adversity imposing negative impact. It also pools in elements of
– business viability,
– excuse of performance since the intended purpose of the arrangement/ transaction remain unachieved due to certain unknown event.
However, it does not necessarily have to clear the litmus of, impossibility.
MAE, in its altruistic version, rarely hurts the arrangement. Investees/ acquirees/ vendors optimism retains a moderate to high rate of success without the MAE being invoked. But, a long standing, immensely disruptive COVID-19 has started touching businesses in a material way, in a deeply adverse way and with unquantified effects.
Reminds me of a famous catch line of a popular advert “zor ka jhatka, dheerey se lagey.”
COVID-19, MAEs and Tips to navigate your contracts:
1. Successful business & financial deals, investor agreements, M&A, financing arrangements achieve over-arching targets on a delicate possibility of the business dodging MAE, constructively.
Historically, MAE has played a backstop provision for the dominant party in investment / M&A arrangements, cushioning the acquirer/ investor against unknown events negatively impacting the business. The invoker could use MAE to either exit, penalize, stagger, titrate, relax, delay, terminate the arrangement. MAEs’ affecting substantially, the earning capacity of entity over a significant duration, hold better chances of being upheld, once invoked[2]. While short hurdles on runways’ do not empower the invoker to misuse the MAE. It appears, though, a pandemic like COVID -19, is likely to ripple over 2 years/ potentially have re-runs, this is steering towards long term!
Tip: Look at targets with the pessimistic lens. Be reasonable to the extent possible. It may not be a bad option for the investee/ acquiree to consider an exit if the annual targets seem hard to meet, with increase in hardships over 3-4 years’ time frame. If a re- negotiation is not possible, sooner or later protracted litigation, awaits.
2. MAE clause can be invoked when any event “materially and adversely” affects the viability of a transaction/ achievement of a ABP/ frustrates or renders impossibility. To understand “materiality”, a Delaware Chancery Court ruling in Akorn Inc vs. Fresenius Kabi AG[3] laid down a few indicators:
– Substantial decline in business’s value (COVID-19 has got this one).
– Motive of the party invoking MAE (genuineness of intent).
– Language of the clause, specificity & carve-outs (not having that lawyer at the negotiating table is bound to hurt, now).
– Qualitative and quantitative assessment of deviation and shortfall of value (ongoing impact).
International judicial rulings, support MAE when businesses have been adversely impacted in their long-term earning potential over a commercially reasonable period of time.[4] The materiality hinges on the duration for which the event has had an impact.
Broadly, judicial rulings indicate, that invoker of MAE will have to place high reliance on,
– duration of the adversity,
– duration of the adverse impact on the specific,
– exclusions built in the MAE clause.
Tip: If the past 3 months have looked patchy, best to assume, “business as usual” is far. All players in the chain are impacted, just like you are, in varying degrees. Consider the first option possible to call out MAE and start the dialogue.
3. The test on “Materiality” has not favoured termination, in courts. Since Indian courts have had limited opportunities to decide on the subject of materiality, we have inferences of M&A as per the Takeover Code. In case of Open Offer, SC/ SEBI have preferred, withdrawal of an offer can only be on the grounds of impossibility of performance on part of the acquirer/buyer[5]. It appears, the materiality quotient has been made proportionate to the level of impossibility to withdraw an open offer in these cases. Drawing it to the current situation, investor will largely have to evidence that COVID-19 has impaired and rendered the investment, impossible. Eg., this may be a good possibility for some businesses like travel, airline, hospitality etc. as these are likely to face direct, long term, adverse impact. On the investee side, if some targets were linked to MAE impacting EBIDTA, then it calls for an evaluation of impact of COVID-19 on those EBIDTA reliant targets and seek relaxations.
Tip: Try to discuss and arrive at achievable, targets- fitting the requirements of the “re-shaped” world. Whatever, you do, the new world does business, differently.
4. Does this severe disruption to business due to Covid-19 legitimize invoking of MAE clause? Each to its’ unique case of contract & factual impact. In some, contracts- affirmative. The evidentiary burden will be on the invoker. To “show & tell” that the harm or loss caused is persisting for a significant period of time with substantial effect on the financial condition, value of business, value of assets, operations/ fulfillment of the business etc.
o significance of the period could be based on time taken between signing & closing for M&A transaction/ the period of investment in finance transactions, MSMEs may have to trade off exorbitant aspirations for frugal pursuits.
o Significant duration indicators, could be matrixed on-:
– substantial decline in EBITDA,
– drop in share price from $32 to $5-$12 over a period of one year[6], or
– 50% decline in earnings over two consecutive quarters[7] etc.
Covid-19, in it’s full glory is unlikely to fail the ‘significant duration’, indicator. Imperative for the investees with signed contracts to look the MAE definition & count how many times it appears in the document + review the exclusions, if any. Some MAEs are known to be vague, if you are stuck with one such, the opportunity has presented itself to rectify the error.
Tip: Do not underestimate the impact this is going to have on work force stability on all accounts. Be prepared for sudden regulatory changes, which may entail costs with low/no returns. Eg., Unavailable workforce with obligations to pay comp & benefits, added surveillance & Contact tracing requirements.
5. Standard MAE definition could exclude certain events like Act of God, Economic downturn, Pandemics, Natural Disasters, change in law and Terrorism etc., keep a loss % threshold (15% to 25%) with a link to negative effects on earning potential, EBITDA, operations and supply stability, business/ share valuation, impact on immovable property, to name a few. The reality is, investee aspire for something loosely drafted & investor will look at a tightly worded definition. The thing is, no one looked at these with the lens we have today, perhaps, it’s time to.
6. Some businesses are bound to be disproportionately impacted. These will be particularly hit hard. Disproportionate impact is possible due to factors specific to a particular business/ entity, making it more vulnerable in current circumstances. For instance, supply-chain disruption / factory location, a virus hotspot and is shut due to lockdown, leverage on the company and adequacy of reserves as high leverage with low return on assets will diminish the profit of the company, companies with choppy distribution network/ low scale of production might face transportation and labour restrictions, everyday guidelines issued by the government may make it hard for MSMEs to adhere effectively. The investor/ acquiror, may be lured into invoking the MAE in this case.
Tip: This is where you should be deploying your risk assessment and mitigation strategies to understand position vis-à-vis peers. The idea is to stay away from the ‘disproportionate’ bracket, if for some reason it is unavoidable, start the conversation with the investor to avoid being at the not so good end of the MAE clause being invoked. Also, each jurisdiction is likely to implement the new guidelines, differently.
7. Typically, investors favour exclusions and cultivate a narrow, tightly knit MAE. Also, typically, at this point the investees do not push back on these exclusions because most often parties believe, there is no war on! These are accepted as systematic risks as per industry norm. Justifications for reducing these systematic risks include,
– industry norm phenomenon; and
– their materialization is beyond the control of the contracting parties.
8. In current context, classifying pandemics as exclusion in defining MAE would make Covid-19 a systematic risk affecting the industry at large and risk associated would stand assumed by the parties.
Rarely, MAEs are meant to facilitate exits. They are lamp posts in an arrangement to bring, contractings to recalibrate. In instances where an MAE event is invoked and litigated, courts have maintained a high Materiality threshold-Nirma Industries[8]
9. Remaining flexible in uncertain times is hard but will be the key for businesses to recover, hold ground & hopefully thrive. Recalibration can include, extending repayment dates, changing events of defaults, change in representations, deferring closing date for acquisitions, change in structure of transactions/investments and other adjustment, relaxing delivery timelines, extending financial support etc., while monitoring the regulatory implications. Additionally, it will help businesses, to cultivate a compliance plan to stay in synch with the government changes.
Tip: Identify the exact hurdles likely to hold his business to a ransom. Best to err on full disclosure to avoid any potential breach of any other covenant or representations of the agreement. Buffer up all vendor contracts. If your business is multi-jurisdictional reliant for anything, you may want to reconsider- the shipping industry is heavily impacted.
10. Investee, may consider a well thought approach for each of its’ contractual obligations. Contracts supporting invoking of FM should be approached under contract law implications. In real life instances, FM clause invocation have been useful in supply/ leasing contracts. Similarly, if the EBITDA target is unlikely to be met due to impossibility caused by COVID-19, a deliberate discussion for a re-set could be the way.
· Morgan Stanley’s acquisition of E*Trade Financial Corp which specifically excluded Covid-19 from the scope of MAE[9], it is a precedent for transactions yet to be consummated / still undergoing negotiation. COVID 19 is here to stay with potential 2nd and 3rd waves, build in carve-outs, right to suspend contracts, excuse delays without penal provisions, include reliefs apart from termination of contract.
Tip: For ongoing M&As, a ‘reverse breaking fee’ can be cultivated. This can discourage investor/ acquirer exit.
Conclusion
Hardships do not come devoid of “learnings”.
Companies, stakeholders and the court of law need to expand the tolerance threshold and be ready to face difficulty in navigating contractual/ business aftermath of this pandemic with the mitigated risks of the MAE clause.
Uncertainty loom and will linger. We can only hope that since all is “still”, ripples will run their full course without a 2nd and 3rd retributions. What can we do in the “stillness”? Try to mitigate “adverse effect” in the newly interpreted “materiallity”.
Disclaimer: This Note is for general information only and not intended for solicitation. Please do not treat this as a legal advice of any sort. Views contained in this, are personal with interpretive value of the author and teams assisting the author.
Readers are encouraged not to rely solely on these contents before making any decision.
[1] Ministry of Finance, Department of Expenditure, Office Memorandum on Force Majeure Clause, ( Feb 19, 2020), https://doe.gov.in/sites/default/files/Force%20Majeure%20Clause%20-FMC.pdf
[2] IBP Inc v Tyson Foods Inc 789 A2d 14 (Del Ch 2001) 65IBP.
Tyson signed an acquisition agreement with IBP (beef producer) to acquire it. However, Tyson later on contended that revised projections of IBP deviated materially from previous year. The Delware chancery court ruled that any short hiccup in earnings would not suffice to invoke Material Adverse Effect. Court ruled that Material Adverse Effect should be viewed from longer term perspective.
[3] Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018).
Akorn, a pharmaceutical company was confronted with allegations like pervasive breach of data integrity in the middle of the merger with Fresenius. Two days after the shareholders of Akorn sanctioned the merger, its business “fell off the cliff”. After missing the revenue target by 25%, Akorn’s business declined sustainably leading to material adverse effect and regulatory breaches. In addition to non-compliance of covenants, the court ruled that sudden and sustained drop in the business lead to general Material Adverse Effect.
[4] Hexion Specialty Chemicals v. Huntsman, 965 A.2d 715, 738 (Del. Ch. 2008)
In a merger agreement, Hexion asserted that it is not obligated to close the transaction. Courts looked into EBITDA of huntsman from long term years rather than monthly to determine whether business has changed adversely. The Delaware chancery found that Hexion had intentionally breached the merger and therefore in the event the acquirer fails to close the merger, it would be liable to pay reverse termination fees and damages.
[5] Nirma Industries and anr. v. SEBI AIR 2360 (SC 2013);
Nirma Industries invoked the pledged securities which entitled them to acquire 24.5% shares of Shri Ram Murti Tech Limited (SRMTL) by making an open offer. Meanwhile during an audit, it was found that SRMTL was involved in fraudulent transactions. Nirma filed with SEBI for withdrawal of application on the basis of emergence of such extraordinary facts. On appeal the Supreme Court ruled that Regulation 27 of SEBI (SAST) Regulations, 1997 only suggests for impossibility of performance on the part of buyer as the sole ground for withdrawal.
M/S Jyoti Limited WTM/SR/CFD/39/08/2016 (SEBI 2016)
The new SEBI (SAST) Regulations, 2011 provided under Regulation 23(c) a scope for invocation for MAE clause. In this case Jyoti limited was supposed to be acquired by Lavjibhai Daliya and Anjani Pvt ltd, Meanwhile Jyoti limited registered itself with BIFR and BIFR provided for no change in the status quo of target entity. The acquirer filed an application in SEBI for withdrawal under regulation 23(c). However, the SEBI ruled on the lines of Nirma Industries case and held that withdrawal can only be done in the scenario of impossibility on the part of buyer.
[6] Supra Note 4
[7] Raskin v. Birmingham Steel Corp., No. 11365, 1990 WL. 193326 (Del. Ch. Dec. 4, 1990)
Due to a failed merger, the shareholders of the company were involved in litigation for approval of settlement agreement. The court observed in the litigation that material adverse effect had likely occurred when the earnings of the company had declined 50% over two consecutive quarters or 66% and 50% respectively over previous years.
[8] Supra Note 2
[9] Analysis: Morgan Stanley and E*Trade Merger Excludes Coronavirus (Feb. 29, 2020 2:55 AM), https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-morgan-stanley-e-trade-merger-excludes-coronavirus