Given the unprecedented scale of disruption across supply chains and businesses which has severely affected the performance of commercial contracts, it is not surprising that the COVID-19 pandemic has been declared a Force Majeure event in many jurisdictions. While the Force Majeure clause is a staple of all commercial contracts, another oft-forgotten boilerplate of agreements which substantially deal with security transactions is the 'Material Adverse Effect/Change' Clause (hereinafter referred to as 'MAE clause') which permits exiting a transaction before closure due to considerable change in the commercial environment surrounding the envisioned transaction.
DIFFERENCE BETWEEN FORCE MAJEURE AND MATERIAL ADVERSE EFFECT
MAE clauses can be located within the agreements concerned with M&As, securities issuances, investment or financing transactions. While interpretation of Force Majeure and MAE clauses can be subjected to the rule of ejusdem generis, in that, they both activate upon the occurrence of an event 'beyond the control' of the parties which makes it difficult to realize the objective of the contract – the invocation of the clauses differs with respect to the nature of events that might qualify as either.
Force Majeure events usually manifest as physical events that affect the performance of a contract – they can occur any time after the parties have entered into a contract and affect either of the parties' obligations under the contract. On the contrary, MAE events entitle the purchaser of securities or an investor to walk away from a transaction before closing it. MAE clauses might be drafted to be as open-ended (catch-all events) as a generic Force Majeure clause, but they never list an exhaustive set of events. Events that qualify as MAE are those that affect the economy and market conditions at large and can substantially alter the financial status of the target company – something that is not envisioned by the acquirer while agreeing to enter into a deal.
INVOCATION OF MAE CLAUSE
The corollary for MAE clauses in the Indian context, can be found in Regulation 23(1)(c) of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011. The said regulation provides that an open offer can be withdrawn if:
"(c) any condition stipulated in the agreement for acquisition attracting the obligation to make the open offer is not met for reasons outside the reasonable control of the acquirer, and such agreement is rescinded, subject to such conditions having been specifically disclosed in the detailed public statement and the letter of offer."
It is interesting to note that the said regulation does not merely permit withdrawal of the offer but also mandates the rescission of the agreement which triggered the open offer. Due to the difficulty of categorizing any event as a MAE, the 'materiality' threshold of an 'affecting' event is kept ambiguous in agreements. It is left to the courts to interpret and determine whether an event is MAE. Given that courts have held strict standards1 while interpreting 'loosely' drafted clauses, they may rely on ascribing 'business efficacy' to the agreement and prevent the party to terminate a contract by deeming the cited event as MAE. However, if a MAE affects the market health, the risk is allocated to the buyer but if it affects the target's financial viability, the risk is borne by the seller.
Claiming an event to be 'material' should convey that the change is of such a nature that it would have altered a person's decision to enter into the agreement, had it occurred prior to entering into the agreement. Courts have held that this MAE should affect the buyer's long term perspective of expecting a reasonable return from the transaction2 . While some quarters of poor performance may not qualify as MAE, the inability to exhibit project turnovers/revenues by a large margin or drastic cost-cutting measures have the potential to qualify as MAE3 . It would not help to solely rely on continuous poor performance by a company as the very nature of business carries with itself the possibility of fluctuation – the affected party has to attribute it to some exceptional and unpredictable extreme event. 4 In the case of Nirma Industries Ltd. and anr v. Securities Exchange Board of India5 , although an MAE clause was absent from the agreement wherein the seller pledged equity shares to the buyer (the Appellant), the latter moved the SEBI for withdrawal of the open offer on the basis of the emergence of extraordinary facts that merit withdrawal. The hon'ble Supreme Court rejected this proposition on the ground that the circumstances6 stated by the buyer did not render it impossible7 to proceed forth with the transaction. Thus, the Supreme Court also confirmed that only where the impossibility of performance can be, stricto sensu, framed within the criteria specified in the relevant statutory provisions, can the withdrawal of an open offer be permitted by SEBI.
Keeping in mind the above judgment as well as the more lenient stance promoted by Regulation 23(1)(c) of the 2011 Takeover Regulations, MAE clauses might forego the need to establish that an event has to render a transaction 'impossible' in order to qualify as an MAE. Yet, the drafters have found it wise to err within the statutory compliances lest arbitrary withdrawals of offers become the norm.
DOES THE COVID-19 PANDEMIC QUALIFY AS A MAE EVENT?
Given the unavailability of guidelines on determining 'materiality' of events affecting securities transactions and the unique circumstances propagated by the COVID-19 outbreak, the courts will have a novel duty - of examining disputes concerning invocation of MAE clauses citing the pandemic, on a case-to-case basis.
The main factor on which the cases shall be examined will be the degree to which the market and various industries have taken a hit, in turn considerably affecting the businesses of the target companies. While the travel and hospitality sector has been suffering the most, stocks of pharmaceutical and healthcare companies have been on the rise. For example, a buyer cannot take coverage under a MAE clause citing COVID-19 as a cause of poor performance by a company, which is a part of the essential services sector, in order to rescind its investment offer in the company.
The buyer shall have no recourse to the MAE clause if the contract excludes events caused due to natural calamities, since the COVID-19 pandemic shall fall squarely within such exclusion. But if the clause provides no exceptions and has an open-ended definition as to what might constitute an MAE, the buyer may prove that the pandemic has altered the target company's financial condition, operations, assets, liabilities or business, to the detriment of the buyer's proposed investment. The current spate of business closures, lay-offs, shuttered operations combined with orders to mandatorily disburse wages has compromised the economic status of many target companies, especially the start-ups. The buyers/ investors can rely on such an unforeseen upheaval to invoke the MAE clause.
Footnotes
1. Nabha Power Ltd. v Punjab State Power Corporation Ltd. (PSPCL) (2018) 11 SCC 508.
2. Mrs. Fields Brand, Inc. v. Interbake Foods, LLC, Court of Chancery of State of Delaware, 2017
3. Akorn, Inc. v. Fresenius Kabi A C.A. No. 2018-0300-JT
4. In Re IBP, Inc. Shareholders Litigation v. Tyson Foods, Inc., No. 18373, 2001 Del. Ch. LEXIS 81 (June 15, 2001).
5. AIR 2013 SC 2360
6. The promoters of Seller had perpetrated fraudulent transactions resulting in embezzlement of funds in excess of Rs. 350 Crores
7. Regulation 27(1)(d) of the 1997 Takeover Regulations
Originally published on April 2020
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