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This article is part of our Disputes in M&A: 5 key trends for 2022 and beyond series: a collaboration between our market leading Corporate and Dispute Resolution teams.
The nature of risk in M&A sale agreements
Sale agreements in Australia are governed by statute (particularly where they involve public companies) and are also guided by common law. However, at a fundamental level, they represent a contractual agreement between two parties based on commercial terms negotiated at a given point in time. In almost all transactions there exists an underlying risk that between signing and closing the deal, external events may render the earnings or value of the target company or assets less than what was originally agreed or forecast.
The utility of the MAC clause
As dealmakers are likely well aware, reliance on the doctrine of frustration to terminate a sale agreement is often not possible. This tends to be because in a growing number of circumstances (particularly arising from COVID-19) it is not that the transaction has become impossible to perform or that performance is radically different than that intended, rather, it is that due to no fault of the acquirer, an unforeseen event has arisen which has caused the earnings or value of the target company to materially decrease.
Enter the material adverse change or “MAC” clause; a contractual mechanism developed over time by the acquirer to address the risk of the target’s business materially deteriorating in the time between when the parties sign the deal and when the deal closes.
The MAC clause thus reflects a contractually agreed alternative to the doctrine of frustration; rather than the acquirer having to establish that the agreement has been frustrated, the parties can opt to define a quantitative measure which they deem to “materially” affect the target business to a degree which entitles the acquirer to terminate the transaction.
The utility of the MAC clause in such circumstances is clear: although an acquirer intending to engage in a merger or acquisition will knowingly operate in a volatile and sometimes unpredictable environment, it should have the peace of mind of knowing that it will merge with or acquire a company which materially represents the value originally bargained for.
Dissecting the MAC clause
Dealmakers would be excused for thinking that, considering the utility of the MAC clause, there is an array of judicial guidance readily available. To the contrary, there is a dearth of case law that deals with MAC clauses in Australia – even in foreign jurisdictions, MAC litigation and judicial guidance is sparse.
Considering the risk of MAC litigation, settling MAC disputes (or avoiding them entirely) is strongly preferred. For the target, losing a dispute relating to a MAC clause in a public setting results in a public determination that the company has actually suffered a ‘materially’ adverse blow to its value. This could have a negative flow on effect on its market value as well as possibly raise solvency concerns.
On the flipside, if the acquirer loses a MAC dispute, it is forced to merge with a company that it has determined and publicly declared to be worth ‘less’ than it originally envisioned – raising similar reputational and market price consequences. Furthermore, it is likely that the target or seller’s initial response will be to counter sue for specific performance of the contract as well as seek damages for repudiation of the agreement.
In light of the above, Australian dealmakers will find it useful to look abroad to iron-clad their MAC clauses to reduce the risk of subjective interpretation, and thus litigation.
As stated by Justice Cockerill in the English Wex case1
“While I would agree that the cases [in the United States, Delaware Court of Chancery] are not admissible as factual matrix, this is just the kind of situation where a review of the authorities from a foreign court is called for. Those authorities will obviously not be binding or formally persuasive, but to ignore the thinking of the leading forum for the consideration of these clauses, a forum which is both sophisticated and a common law jurisdiction, would plainly be imprudent – as well as discourteous to that court.”
To this end, the relatively recent matter of Fairstone Financial Holdings Inc. v. Duo Bank of Canada2 (the ‘Fairstone case’) provides a topical discussion of what a party must establish to successfully rely on a MAC clause. In that case, Duo Bank of Canada agreed to purchase Fairstone Financial Holdings Inc. and its subsidiaries. Shortly after entering into the agreement, Duo Bank informed Fairstone that, due to COVID-19, Duo Bank had experienced a MAC event and therefore could not complete the transaction. The subsequent litigation that ensued is a salient reminder to dealmakers that what makes the MAC clause an effective risk mitigation measure is how it is tailored in a way to reflect the risks unique to the industry in which the target business operates.
I. Occurrence of an unknown event
Generally, the “event” on which the acquirer relies to have triggered the MAC must not have been known by the acquirer—at the time of signing the deal—to have or likely to have had the effect of materially affecting the value of the target’s business. This makes sense, if one knows and accepts a potential risk, they should not be able to change their mind at a later date because acceptance of the risk backfired. The knowledge of the acquirer here is therefore relevant.3
In the Fairstone case, although the parties had entered into a share purchase agreemnt after COVID-19 had already become daily news (and therefore was arguably a ‘known event’), as no evidence was tendered to establish the acquirer’s knowledge of the extent to which COVID-19 would affect the target’s business, COVID-19 was determined to be an “unknown event” on which the acquirer could successfully rely.4
II. Threat to overall earnings potential – quantitative versus qualitative approach
The unknown event must have posed a threat to the overall earnings potential of the target. This enlivens the most negotiated (and litigated) aspect of an MAC: has the threshold (in a quantitative approach) been satisfied, or alternatively, has the acquirer discharged their onus that, on the balance of probabilities, the unknown event has had a ‘material’ impact on the target business value (the qualitative approach)?
In the Fairstone case, a threshold in the share purchase agreement was not defined and therefore a qualitative assessment of whether a MAC occurred was required. In this situation, where the target’s year-on-year loan origination (a material factor to the target’s ability to generate revenue) had decreased by 56% in May 2020, 36.6% in June 2020 and 21% in July 2020, the qualitative test was easily established.
However, in the majority of situations (unlike the Fairstone case), the materiality of the unknown event on the target’s potential earnings will not be as clear cut, and a qualitative approach poses an unacceptable risk to the acquirer. To this end, the MAC threshold should be defined in the contract to avoid protracted arguments as to what each party subjectively deems “material”. This is essential because sale agreements are inherently built on a degree of information asymmetry in favour of the target; that is, despite conducting appropriate due diligence, the target will invariably know its own business better than the acquirer. As stated by Vice Chancellor Travis Laster in his memorandum opinion on the recent Akorn case5
“[the seller] … is better placed to prevent such risk and has superior knowledge about the likelihood of the materializations of such risk [in the target company] that cannot be prevented”.
To mitigate this risk in an acquirer-friendly deal, defining the threshold ‘trigger’ to a MAC clause is critical. This may be, for example, that the target’s EBITDA decreases by 30% (with durational significance). The counterfactual being that the acquirer is faced with the heavy burden of establishing that a reasonable investor would, in its shoes, be deterred from entering into the transaction.6 For reasons outlined above, this onus is perhaps easier to rebut by the target than to establish by the acquirer, placing the acquirer in a precarious position.
III. Durational significance
Establishing that the “event” has “materially” affected the target’s overall earning potential is not the last step. The acquirer must then establish that such effect is “durationally significant”. Notably:
In essence, the effect should substantially threaten the overall earnings potential of the target in a durationally-significant manner.10 The assessment for the company’s performance is best undertaken against its results during the same quarter of the prior year, which reduces the effect of seasonal fluctuations.11 However, it is worth noting that this assessment is highly industry-specific; what may be “durationally significant” for a beef supplier in central Queensland will unlikely be the same for an energy, resources and mining company in Western Australia.
The battle of carve-outs and exclusions – Acquirer-friendly versus target-friendly MAC clauses
The MAC clause serves to limit risk to the acquirer. Naturally, therefore, whereas the acquirer looks to broaden the scope of the MAC, the target is looking to limit the scope to the greatest extent possible. With this in mind, it is best to visualise the MAC clause as having three layers: the definition of the MAC clause (and its constituent elements discussed above), the carve-outs and the carve-out exceptions.
Carve-outs and Carve-out Exceptions
The principal purpose of a “carve-out” to a defined material adverse change definition is to remove reliance by the acquirer on systemic or industry risk, as well as risks that are known by both parties at the time of the agreement. If these carve-outs arise and cause the target to suffer a reduction in earnings or value, the MAC clause will not enliven and therefore cannot be relied upon by the acquirer to terminate the agreement. Common carve-outs include force-majeure events, industry or economic wide impacts and relevantly, pestilence. In response, the acquirer will look to build-in “carve-out exceptions”. The most common being that the defined carve-out cannot have disproportionally affected the target’s business in comparison to other companies in the industry.
A final note
MAC clauses attracted a lot of attention during the heat of COVID-19. And rightly so. However, as Australia’s economy recovers, it is critical that acquirers consider MAC clauses with heightened focus given their application in an increasingly volatile world.
About Hamilton Locke
Hamilton Locke is a corporate law firm specialising in complex corporate finance transactions, including mergers and acquisitions, private equity, finance and restructuring, litigation, property and fund establishment.
1 Travelport Ltd & 12 Ors V Wex Inc : Adam Rhys Olding & 112 Ors V Wex Inc  EWHC 2670 (Comm) at .
2 2020 ONSC 7397.
3 Inmet Mining Corp. v. Homestake Canada Inc 2002 BCSC 61 at 128.
4 2020 ONSC 7397 at  – .
5 Akorn v Fresenius – memorandum opinion – page 128 - https://courts.delaware.gov/Opinions/Download.aspx?id=279250.
6 Fairstone Financial Holdings Inc. v. Duo Bank of Canada, 2020 ONSC 7397 at .
7 Re IBP, Inc. S’holders Litig., 2001 Del. Ch. LEXIS 81, 789 A.2d 14 (2001).
8 Re Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del.
Ch. 2008) at 738.
9 Re Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del.
Ch. 2008) at 738.
10 Re IBP Inc. v Tyson Foods Inc 789 A.2d (2001) at 68.
11Akorn case, per Laster, V.C. referring to Hexion, 965 A.2d at 742. https://courts.delaware.gov/Opinions/Download.aspx?id=279250