A key purpose of many commercial contracts is to allocate risk between the parties and identify what consequence should arise if any economic or financial risks increase as a result of a change in circumstances or the occurrence of an adverse event after the contract was signed. Often the change in circumstances or the adverse event was not foreseeable by the parties on the date on which the contract was signed. This article examines material adverse changes (MAC) clauses and their legal treatment. It begins by defining a MAC clause and outlining how it works in a contractual sense, and the different contexts in which it may be used. It then examines the various ways in which such clauses have been interpreted in common law jurisdictions, and in China.
What is a MAC clause?
In general terms, a MAC clause allows one party to exercise certain rights in the event that a material adverse change occurs. The right might be the right to terminate a contract (for a discussion about the basis on which a contract may be brought to an end, see China Business Law Journal, volume 2, issue 1, page 58: When a contract comes to an end) or the right of the relevant party to choose not to perform, or continue to perform, its obligations under a contract. MAC clauses are sometimes referred to as material adverse effect clauses. As a result of its potential impact, a MAC clause is often heavily negotiated between the parties and their lawyers.
MAC clauses are common in the context of loan agreements, where a material adverse change that affects the ability of the borrower to perform its obligations allows the lender to refuse to provide funds to the borrower, or to accelerate the loan and demand repayment of all the funds that have already been lent. In the context of a loan agreement, a MAC clause can operate in two different ways, which may apply either concurrently or in the alternative. First, a MAC clause can be included as one of the borrower’s representations, with the effect that if the representation proves to be incorrect on the relevant date – for example, the date on which the borrower requests a drawdown under the loan, or the date on which the borrower pays interest to the lender – the lender can choose not to lend the funds or lend any further funds (for a discussion about representations and warranties, see China Business Law Journal, volume 1, issue 3, page 78: Warranties and misrepresentations). Second, a MAC clause can operate as an event of default, the occurrence of which entitles the lender to accelerate the loan (i.e. declare that the loan is immediately repayable and demand that the borrower make repayment immediately). An example of a MAC clause operating as a representation and as an event of default in a loan agreement appears below:
“Material Adverse Effect” means a material adverse effect on or material adverse change in:
- the financial condition, assets, prospects or business of the Borrower;
- the ability of the Borrower to perform and comply with its obligations under any Finance Document; and
- the validity, legality or enforceability of any Finance Document.
The Borrower represents and warrants as follows:
- Since the date on which the original Financial Statements were prepared, there has been no change in the business condition (financial or otherwise), prospects or operations of the Borrower which might have a Material Adverse Effect…;
Events of Default
- If any event or circumstances occur that have, or might reasonably be expected to have, a Material Adverse Effect…;
MAC clauses are sometimes agreed in acquisition agreements. In the context of an acquisition agreement, the MAC clause can operate in two different ways, which may apply either concurrently or in the alternative. First, a MAC clause can operate as a condition precedent to completion, under which the failure to satisfy the condition by the completion date allows the purchaser to terminate the acquisition agreement and to withdraw from the transaction. Second, a MAC clause can operate as a representation, which allows the purchaser to terminate the acquisition agreement and withdraw from the transaction if the representation proves to be incorrect on the completion date. An example of a MAC clause that takes the form of a condition precedent is set out below:
From the date of this Agreement, there has not occurred any fact, matter, event, circumstance, condition or change that materially and adversely affects, or could reasonably be expected to materially and adversely affect, the business, operations, assets, liabilities, condition (whether financial, trading or otherwise), prospects, or results of operation of the Company, but excluding any of the following arising out of, resulting from, or attributable to:
- changes in stock markets, interest rates, exchange rates, commodity prices or other general economic conditions;
- changes in condition generally affecting the industries in which the Company operates; or
- changes in applicable laws, regulations or accounting standards or practices,
provided that the matters in paragraphs (a) to (c) must be taken into account if and to the extent that they have a materially disproportionate effect on the Company compared to other participants in the industries in which the Company operates.
In a loan agreement, the primary purpose of a MAC clause is to enable the lender to manage the risk of events or circumstances that decrease the ability of the borrower to repay the loan or the ability of the lender to recover the debt (i.e. the credit risk or enforcement risk). In an acquisition agreement, on the other hand, the primary purpose of a MAC clause is to enable the purchaser to withdraw from the transaction on the occurrence of any circumstances that decrease the value of the assets in the period between the date on which the contract was signed and the completion date – a period that can often be quite lengthy.
Because a MAC clause in an acquisition agreement enables the purchaser to avoid all risks and to withdraw from the transaction, it is often interpreted by the courts in common law jurisdictions in a more restrictive manner than in the case of a MAC clause in a loan agreement. In addition, the clause is often more detailed in terms of excluding changes that do not apply specifically to the target company, as illustrated in the above example.
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A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.