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COVID-19 - Force Majeure and Material Adverse Change Clauses

Client Updates

The global outbreak of the COVID-19 virus is disrupting daily life across the world, and our first thoughts continue to be for those who are most vulnerable in our communities.  Alongside this human impact, businesses are also being drastically affected by the pandemic as demand weakens and governments introduce emergency measures.  In these circumstances, all businesses should be mindful of the contractual clauses in their commercial agreements that may come into effect following an unexpected event such as the COVID-19 outbreak.  Below we look at two types of clauses – material adverse change (MAC) and force majeure clauses – that are often found in English law commercial contracts and that may be triggered in these circumstances.

A MAC clause will be relevant for a business that has signed, but not completed, an agreement to purchase a target entity and the COVID-19 outbreak has now had a material adverse impact on the target.  A force majeure clause will be relevant for a business that has entered into a commercial contract with a counterparty (for instance a supply or construction contract) and the COVID-19 outbreak has now impeded either party’s ability to carry out their contractual obligations.  So in the context of M&A activities, MAC clauses apply before the closing of a deal while force majeure clauses apply in relation to the businesses’ commercial contracts after completion of an acquisition.

Material Adverse Change clauses

What are MAC clauses?

In the context of private M&A transactions, material adverse change (MAC) clauses are provisions which aim to entitle a purchaser to walk away from a transaction between signing and closing if events arise which are materially detrimental to the target.  MAC clauses are one of the contractual mechanisms to allocate risk between the parties prior to closing and typically receive greater attention following events which affect the economy at large.  The aftermath of September 11, 2001 and the 2008 financial crisis saw an increase in parties seeking to invoke MAC clauses.  We expect to see a similar trend during and following the COVID-19 outbreak.

How are MAC clauses interpreted?

When interpreting MAC clauses, the English courts will seek to reflect the intention of the parties in the context of the agreement as a whole and are more likely to enforce a provision which is expressed to be triggered upon specific events occurring.  For example, a specified reduction in orders or loss of customers over a particular period of time.

Notwithstanding the foregoing, MAC clauses can be drafted to encompass broader external economic or market changes (“market MACs”), albeit these should be expressly covered in the clause.  For a purchaser to rely on a market MAC, it would typically need to demonstrate that:

  1. there is an impact on the target’s earning capacity viewed in the long term which will persist for a significant period of time.This time period is typically considered in years and therefore a temporary disruption, lasting a few weeks or months, is unlikely to be sufficient; and

  2. there is a significant change in the types of financial and economic challenges the target faces which has arisen since signing.

In addition to (a) and (b) above, a purchaser is also likely to have to demonstrate a disproportionate effect on the target as compared to other industry participants. 

Although the COVID-19 outbreak is causing significant global disruption, the market MAC test sets a high bar and may be challenging for purchasers to demonstrate, particularly the durational limb and the comparison against other industry participants.

Impact of COVID-19 on future transactions

Going forward, parties will be more conscious of the potential impact of global business disruptions (health related or otherwise) on transactions and purchasers are likely to seek to offset these risks where possible.  With this in mind, it seems likely that we will see the following transaction trends in the next 18 – 24 months:

  1. a greater prevalence of MAC clauses in transaction documents, including in lower value transactions; and

  2. more prescriptive MAC clauses attempting to address the risk of disruptions similar to COVID-19.

Practical Tips

For parties considering incorporating MAC provisions, the following pointers may prove useful:

  1. MAC clauses are generally only applicable in respect of changes/ events which arise between signing and completion.Therefore, unless there is a specific formulation, a purchaser is likely to have been deemed to have “bought-into” any matters which existed prior to signing;

  2. a broadly drafted MAC clause is less likely to be effective and therefore the purchaser should ensure that the relevant risks are specifically addressed.The more prescriptive the provision, the more likely it is to be enforceable; and

  3. parties should consider whether a MAC can be triggered by an aggregation of events or by a single event only.

Force Majeure clauses

What is force majeure?

Force majeure arises when an event that is outside the reasonable control of the parties to a contract disrupts performance of that contract.  If established, force majeure will usually excuse the affected party from failing (in whole or in part) to perform its contractual obligations as a result of the force majeure event.  A party seeking to rely on force majeure will only be able to do so if the contract includes a force majeure clause.

Is COVID-19 a force majeure event?

It depends.  There is no definition of a force majeure event in English law.  Sometimes the parties will set out a full a list of force majeure events in the clause, which may explicitly include “pandemics”.  More typically, contracts will include ‘sweeper’ wording (for example “…or any similar event”).  A pandemic will only be a force majeure event by way of sweeper wording if it is clear from the rest of the clause that this is the sort of event that was contemplated by the parties. 

An affected party may also be able to claim force majeure if the force majeure clause in the contract includes government or other legal measures (or such measures are included by way of sweeper language used in the clause) and the measures currently being introduced by various countries, such as the closure of borders or restrictions on the movement of people, are preventing or impeding performance of the contract.

In what circumstances can a party rely on a force majeure clause?

This will depend on the wording used in the force majeure clause.  A party seeking to rely on force majeure in connection to the COVID-19 outbreak should consider the following:

  1. the event relied on (for example, the COVID-19 outbreak or government measures introduced to address the crisis) must be within the scope of the force majeure clause;

     

  2. the force majeure event must have impeded performance of the contract – the specific wording of the clause will determine if this means that performance must be impossible or hindered;

     

  3. the event must be beyond the reasonable control of the affected party.For example, a force majeure clause cannot be relied on if the contract simply becomes more expensive or onerous to perform;

     

  4. the event must be the sole cause of the impediment – if the affected party would have failed to fulfill its contractual obligations in the ordinary course of events (for instance, if it was already in significant financial or operational difficulties) then it will not be able to rely on the force majeure clause;

     

  5. the force majeure clause may require an affected party to have taken steps to overcome the impact of the force majeure event – the specific wording used in the contract will determine the level of mitigation required (for example, whether the affected party must take “all” or “reasonable” measures); and

     

  6. force majeure clauses typically require the affected party to promptly notify the other party if a force majeure event exists – the affected party must adhere to the notification requirements specified in the force majeure clause.

Will force majeure apply to contracts entered into after COVID-19 was first reported?

A force majeure event does not have to be unforeseeable, unless the force majeure clause expressly excludes foreseeable events.  The relevant time for determining whether an event was foreseeable is the time the parties entered into the contract.  For contracts entered into before 2020 it is likely that COVID-19 would satisfy any unforeseeability requirement.

For contracts entered into after the outbreak of COVID-19, the situation is less clear.  The affected party would have to argue that at the time of signing of the contract, the event that prevented or hindered performance was not foreseeable.  The likelihood of success of this argument will depend on the facts that were known at the time the contract was signed and the context in which the contract was entered into.

What is the effect of force majeure on the contract?

The force majeure clause should specify the effect of the existence of force majeure on the contract.  Generally, force majeure will suspend (but not cancel) the performance of the affected contractual obligations and exempt a party from liability for non-performance.  In other words, the affected party would be excused from failing to perform its obligations only for as long as the force majeure event in question continues to exist.  Once the force majeure event ends, the affected party will be required to resume performance in full, otherwise it will be in breach of contract.  This can be problematic because either or both parties may want to terminate the contract if the force majeure event continues for several months.  Many force majeure clauses will expressly provide for termination if the force majeure event continues for example a period of time (6 months, for example).

If the contract does not provide for termination, the affected party may have to rely on general principles of frustration of contracts under English law. 

Could the contract be ‘frustrated’?

Even if COVID-19 does not trigger force majeure in a contract, the contract may nevertheless be frustrated.  Under the doctrine of contractual frustration, the parties can be discharged from their future contractual obligations if performance of the contract is rendered impossible by an unforeseen event outside their control.

In the context of COVID-19, most contracts would not satisfy the test of frustration because it would be difficult to establish that the fundamental purpose of the contract was frustrated.  Ultimately, the issue will depend on the particular contract and relevant facts in question.  For example, if it was fundamental to the contract that it had to be performed in Italy in March 2020 and it was not reasonable or practical to delay performance, then the affected party may be able to argue that the contract has been frustrated if the national lockdown measures would render performance illegal.

Practical Tips

Businesses will be more aware of force majeure in contracts following the COVID-19 outbreak, and so parties should keep in mind the key issues when negotiating a force majeure clause:

  1. consider the categories of events that will trigger the force majeure clause and list these clearly in the contract;

     

  2. consider the level of mitigating action that should be taken before force majeure can be relied on;

     

  3. an unforeseeability requirement should be included in the force majeure clause if it is desirable to exclude currently known events (such as the COVID-19 outbreak); and

     

  4. describe clearly the consequences of force majeure, and in particular whether the parties will have a right to terminate the contract if the force majeure event persists for an extended period of time.

 
For further information on MAC clauses, force majeure clauses, or on contractual frustration, please contact Dorine Farah, Daniel Green, or Derek Jones.

 

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Baker Botts is an international law firm of approximately 725 lawyers practicing throughout a network of 14 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy and technology sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.

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