When economic conditions deteriorate, some parties inevitably find compliance with their contractual commitments more difficult. But can a party avoid its obligations on the basis that performance has become more expensive or onerous as a result of the economic climate? Or can a party get out of a contact on the grounds that economic circumstances have compromised its counterparty's future ability to perform, even though it has not yet actually failed to perform?
The English courts have always been reluctant to let a party avoid the consequences of an imprudent commercial deal and will seek to hold parties to their agreement even where the fulfilment of their obligations has become more expensive or onerous. A recent example is the case of Gold Group Properties Ltd v BDW Trading Ltd [2010] EWHC 323 (TCC). This involved an attempt by BDW to avoid a contract by relying on deterioration of the property market as a frustrating event automatically discharging the contract and releasing the parties from their obligations.
Freehold owner Gold and property developer BDW had agreed that BDW would develop a site by building houses and flats, which would then be sold on long leases with the revenue generated shared by Gold and BDW. A schedule to the development agreement set out minimum prices for the units constructed.
In its defence to Gold's application for summary judgment, BDW argued that they had received advice that the minimum prices would not be achieved, due to a fall in the property market, and the contract was therefore frustrated because the fall was the fault of neither party and so it would be unjust to hold the parties to their literal obligations under the development agreement. Although Mr Justice Coulson allowed the claim to continue to trial on other grounds, he found against BDW on this point, holding that:
- Both Gold and BDW foresaw a fall in the property market, even if such an event was unexpected;
- The development agreement set out a mechanism for a reduction in the minimum prices, either by agreement between the parties or by expert determination;
- There was therefore no injustice to the parties; and
- There was no true frustrating event: there was no evidence that minimum prices would definitely not be achieved, merely a gloomy forecast as to what prices might be achieved on future sales (which would not occur for at least two years).
However, parties can seek to protect themselves from performance difficulties which might result from deteriorating economic conditions by making express provision in their contracts allowing termination for specific events, including events which fall short of actual nonperformance. Probably the most common example of this is a material adverse change clause (a_"MAC_clause"). Forms of MAC clause include:
- A representation that there has been no material adverse change in an entity's financial or business position since a certain date (often the date of the latest accounts);
- A representation in the same form as 1 but deemed to be repeated on later dates, for example on each draw down under a loan; or
- A stand alone event of default if there is a material deterioration in the financial position of one party or a relevant market. Such a clause may also provide that the question whether such a change has occurred is to be determined in the reasonable opinion of the other party.
MAC clauses are commonly used in company acquisitions, to allow a buyer to walk away between signature and completion if unexpected events occur which result in the target losing value, and in loan agreements, to allow a lender to call a default if there is a significant threat to the borrower's ability to repay or to the value of the lender's security, caused for example by a large fall in a company's trading performance or a significant decline in its market. They can also be used in property purchases, to deal with the period between exchange and completion, or in contracts for the supply of goods or services.
MAC clauses may, in principle, appear to provide an easy way out of a contract for a party in times of economic turmoil, but the legal reality is less certain. There have been surprisingly few reported English court decisions about these clauses and those that exist are heavily dependent on their own facts and the precise wording of the MAC clause in question.
What does emerge from the cases is that the English courts will give such clauses their ordinary English language meaning rather than employing special rules of interpretation.
A party who wishes to rely on a MAC clause must ensure not only that the clause is drafted with sufficient precision to enable it to demonstrate when and how it has been breached, but also that it adequately defines the change in circumstances that it wishes to guard against. The court is also likely to consider whether the risk of the stated event has in fact, whether expressly or implicitly, been assumed by one of the parties.
CDV Software Entertainment AG v Gamecock Media Europe Ltd & Ors [2009] All ER (D) 298 (Nov) is a recent example of a case where the court was reluctant to find that a change in circumstances amounted to a materially adverse change. The point was dealt with briefly by Mrs Justice Gloster, in relation to a warranty in a software distribution agreement that CDV was "fiscally capable" of performing its contractual obligations and would notify Gamecock of any material adverse change in such status. She held that CDV was not in breach for non-disclosure despite difficult credit conditions at the relevant time because it still had sufficient funds to meet its obligations as they fell due.
In contrast, in one of the few English cases in which reliance on a MAC clause was successful, Levison v Farin [1978] 2 All ER 1149, the purchaser sought to rely on a breach of a warranty in a sale and purchase agreement that, save as disclosed, there would be no material adverse change to the value of the target company's net assets in the period from the date of the latest accounts to the date of completion. The vendor submitted that there was no breach because the illness of the company's proprietor and the company's traded down state had been made known to the purchaser such that the change in the net assets of the company could not be considered 'material'. Mr Justice Gibson held that this was insufficient to avoid a breach: there had been no disclosure of the actual drop in asset value, merely of facts which were a possible cause of loss, the reduction could not be considered 'a normal trade fluctuation' as it was entirely special to the company, and there was no specific disclosure for the purpose of or by reference to the clause. In that case, the term 'material' was not defined, but a reduction in value of around 20 per cent was thought sufficient.
Another example of successful reliance on a MAC clause, this time in a banking context, is Bankgesellschaft Berlin AG v First International Shipping Corporation Limited (unreported, December 2000). The bank had made a $10m loan to the defendant, secured on six tankers which were under charter to Shell. Although the parties were aware that Shell had the option to terminate, the defendant claimed this was very unlikely to happen. In fact, Shell did terminate the charters early, and the bank called an event of default based on a MAC clause and accelerated the debt. Mr Justice Andrew Smith held that the charter termination was a material and adverse change as it prejudiced the defendant's ability to repay the loan principal and ongoing interest payments. It was not necessary to show that the loan would not be repaid as long as it could be shown that the risk of payment default increased. The fact that the termination by Shell was envisaged by the parties as possible at the time of the agreement (a factor which negated the frustration claim in Gold), did not mean that it could not constitute an event of default within the natural meaning of the clause in question, given that neither party had expected Shell to terminate. However, this decision should be treated with some caution, as the defendant decided at the last moment not to appear at trial.
In the context of public company mergers and acquisitions (as governed by the Takeover Code), the Takeover Panel has emphasised the difficulties in relying on MAC clauses in a decision involving advertising group WPP Group Plc (Statement 2001/15). The Takeover Panel held that the events of 11 September 2001, although exceptional and unforeseeable, did not mean that WPP could invoke a MAC clause and withdraw its offer for Tempus Group Plc, a media buying agency. WPP had not shown a material long term decline in Tempus' prospects, and thus failed to demonstrate a material adverse change in the context of their bid.
Some guidance on the possible approach of the courts to the question of materiality may also be found in two US cases involving acquisition agreements. In both Hexion Speciality Chemicals, Inc v Huntsman Corp 965 A.2d 715 (Del. Ch. 2008) and IBP Inc v Tyson Foods, Inc 2001 WL 675330 (Del. Ch. 2001) the US courts held that materiality should be judged by reference to the longterm consequences of the event on the target's position over a commercially reasonable period (which was to be measured in years not months in relation to an acquisition). In IBP the court commented that MAC clauses are "best read as a backstop protecting the acquirer from the occurrence of unknown events that substantially threaten the overall earning potential of the target in a durationally-significant manner". In neither of these cases was the buyer permitted to avoid its obligations based on alleged material adverse change.
The fact that there have not been more cases concerning MAC clauses is perhaps a reflection of the uncertainties around their application. It is not surprising, in the circumstances, that banks for example remain reluctant to rely solely on MAC clauses when calling a default and usually rely on them alongside other more tangible events of default. They clearly do not necessarily represent an easy way out of a contract in troubled economic times. That said, they can confer rights to exit which are not available under general law and may make the other side more amenable to a renegotiation of terms if circumstances change. Taking time to draft a MAC clause carefully, to ensure it is absolutely clear as to when and how it will apply and give a party an exit from an unprofitable contract in difficult economic times, can therefore be worth its weight in gold.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
