This article is a contributed piece by Gary Kleinrichert, Senior Managing Director at FTI Consulting, and Brent Miller, Managing Director. The views expressed are solely those of the authors.

Gary Kleinrichert (Image source: FTI Consulting)

Contracts often include Material Adverse Change (MAC) clauses as a condition to closing. These clauses allow a party to terminate an agreement if there is a significant change in a company's financial or operational condition.

In light of the COVID-19 pandemic, you may wonder whether the outbreak constitutes grounds for invoking a MAC clause, or whether the other party could invoke it against you under a mutually signed agreement.

At first glance, it may seem feasible, but courts have noted that MAC claims face a high evidentiary burden. In fact, not every negative change in a company's performance constitutes a MAC.

Unique Obligations

The definition of a MAC and the circumstances that might alter a party's obligations vary from agreement to agreement, so determining whether a change constitutes a MAC requires a case-by-case analysis. Historically, courts have typically sought to answer the following questions:

  • Has there been a material decline in business performance?
  • Was the change unforeseeable or unknown?
  • Will it have a material impact over a significant period of time?
  • Is the impact disproportionate to the overall impact on the industry in which the company operates?

If you are seeking to terminate a contract or responding to the other party invoking the clause, you will need to address these questions. If you are the party asserting the clause, the following factors are important to consider.

Is the change in performance material?

There is no uniform standard for determining whether a change in performance is material. Some agreements may include language defining materiality. If the agreement does not specify, you will need to examine changes in revenue, earnings, and other financial metrics relative to historical and projected performance to assess the potential impact on prospects and company value.

Brent Miller (Image source: FTI Consulting)

Qualitative factors that may be considered include: whether the lost customer brought significant reputational benefits to the company, or whether the affected revenue stream had higher growth expectations compared to other business lines or products.

To support a claim that the pandemic constitutes a MAC, you should quantify the impact as much as possible and identify other qualitative effects. Additionally, you should engage qualified financial experts to assist; in the key case IBP v. Tyson, the court noted that the lack of expert evidence on the decline in the target company's earnings potential was a significant deficiency.

Was the impact unforeseeable or unknown?

Whether you were aware of the pandemic's impact is a factual question that must be addressed. Reports of the outbreak in China began in late 2019, but the severity of the issue became apparent over the following months, with the World Health Organization declaring it a pandemic in mid-March 2020.

If asserting a MAC, you might argue that both parties were unaware of the outbreak at the time of signing, or did not foresee its potential scope. The court will need to determine whether the eventual impact of the pandemic was a known risk at the time of negotiation.

Is the impact duration?

Courts have historically held that a MAC impact must persist for a commercially reasonable period. In acquisitions, the duration is typically measured in years rather than months. In lending contexts, a shorter duration may be significant due to the term of the loan agreement. Proving the duration of the pandemic's impact may be challenging due to uncertainty about how long the pandemic will last and the duration of disruptive measures such as government stay-at-home orders.

The federal government has considered an 18-month response timeline, but has also suggested that stricter measures may be shorter. Effective treatments could quickly mitigate the negative impact of the pandemic on businesses. Given the uncertainty, you should assess whether the business may still be materially affected even after the pandemic ends.

When assessing the duration of the impact, courts will consider whether the company is likely to recover after the response measures end. If the impact extends beyond the duration of the pandemic, it is more likely to persuade a court that a MAC has occurred.

Is the impact disproportionate?

Many contracts exclude general downturns in the industry or the overall economy from MACs. Therefore, courts will assess whether the event triggering the MAC claim has a disproportionate impact on the company (i.e., whether it is more affected than other businesses in the same industry or the broader economy). A disproportionate impact may indicate that the decline in performance is not due to a general downturn.

Courts may also compare the company's impact to the industry to determine whether the change is part of the normal business cycle or a material change. In IBP v. Tyson, a general industry downturn was not excluded from the MAC definition, but the court noted that the target company's significant earnings decline was primarily due to an unusually harsh winter affecting the entire industry, which was one of the reasons the court found that Tyson had not proven the earnings decline constituted a MAC (rather than inherent unpredictability in a cyclical business).

Given the widespread impact of the pandemic, many companies in hard-hit industries may experience significant declines, making it more difficult to prove a disproportionate impact on a single company. For example, the restaurant industry has been severely affected by pandemic response measures, and if the pandemic triggers a cultural shift reducing demand, the industry may face long-term earnings declines. Therefore, a particular restaurant may experience unprecedented declines, but if most businesses in the industry face the same issues, the decline may not constitute a disproportionate impact.

Whether courts will view the pandemic as a unique event and find a MAC even without a disproportionate impact remains to be seen. However, proving a disproportionate impact would be most favorable to asserting a MAC.

When Does the Pandemic Constitute a MAC?

Assuming the impact is material and unforeseeable, the strongest pandemic-related MAC cases may involve companies that have already suffered unique losses that will extend beyond the end of pandemic response measures. For example, if a company's largest customer goes out of business due to the pandemic, the duration of the impact is less affected by the length of the pandemic, reducing disputes over duration uncertainty. Additionally, the loss of a major customer may not be comparable within the industry, making a disproportionate impact more likely.

A similar example: a company planned to launch a major project expected to contribute a significant portion of revenue over the next several years, but can no longer obtain financing. The uniqueness of the project increases the likelihood of a disproportionate impact. If the company cannot launch a similar project later, the impact may also be considered durational.

Other examples include the pandemic causing a company to default on key loan agreements or lose a lease for a critical retail location. If a company has not yet experienced such losses, the pandemic may increase the risk of future losses. Although an increased risk may seem like a MAC (as it reduces the likelihood of the company meeting pre-pandemic expectations), courts may not agree. In S.C. Johnson & Son v. Dowbrands, the court ruled that a patent infringement lawsuit against the target company did not constitute a material adverse change in operations or financial condition because the company might prevail in the litigation. However, in Frontier Oil v. Holly and Channel Medsystems v. Boston Scientific, courts seemed to allow that potential future losses could constitute a MAC if there was evidence that the loss was highly likely to occur.

Key Takeaways

If you are considering or facing a MAC claim, the following points are worth noting:

  • Whether a MAC has occurred is highly fact-specific and dependent on the specific wording of the agreement, and the pandemic is no exception. When considering or responding to a MAC claim, carefully evaluate the language of the agreement.
  • The two most challenging issues for companies affected by the pandemic may be proving durational impact and, if necessary, disproportionate impact. Therefore, the strongest MAC claims typically involve losses that have already occurred, will extend beyond the pandemic response measures, and are unique to the company.
  • MAC claims are not always black and white. The ambiguity in many MAC clauses may prompt parties to renegotiate rather than resort to litigation when significant changes occur. To prepare for negotiations, you should bring in relevant experts to assess the strength of your position and present it in a way that optimizes your negotiating stance.