Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Litigation, April 2008
As noted recently in the Financial Post, both Wall Street and Bay Street are closely watching the next court ruling that may assist in providing parameters of how and when a party may lawfully terminate a contract based upon a material adverse change clause (MAC). Given the high stakes that are often involved, few of these cases go to trial, but there may be more litigation arising as a result of the current credit crisis.
A MAC (also called a material adverse event/effect or MAE) clause is a way for parties to allocate risk. MAC clauses are frequently used in the context of mergers and acquisitions to allocate risk between buyers and sellers. MAC clauses are also prevalent in other commercial agreements, such as those used in the derivatives industry. This article discusses MAC clauses in the context of derivatives contracts. For a discussion of MAC clauses in the context of M&A transactions, please see "Recent Developments in Market Practice and the Law Governing Material Adverse Change Clauses" in Blakes Bulletin on Mergers & Acquisitions, April 2008.
A MAC clause generally refers to a defined term in an agreement delineating what constitutes a material adverse change or a material adverse event/effect. The exact wording of a MAC clause varies from transaction to transaction and is often subject to much negotiation. In general, in commodity contracts, a MAC is a defined set of financial parameters beyond which a collateral event occurs that typically permits the unaffected party to call for performance assurance in the form of security. A MAC is generally not a basis for immediate termination of a contract unless expressly provided. Generally, only where the affected party has failed to provide adequate performance assurance after receiving a written notice and sufficient opportunity to preserve the integrity of a transaction does a MAC become a terminating event that entitles the unaffected party to terminate the contract.
Whenever a credit event is of concern, most industry practices require that the unaffected party give notification of that concern — affected parties cannot speculate or attempt to anticipate what those credit concerns, if any, may be. Again, most industry practices do not impose a requirement on an affected party to voluntarily provide performance assurance. Once that need has been identified, it is typical for a dialogue between the parties to ensue to work out, among other things, the details of the credit support needed and the circumstances under which it will be provided.
In CP&L v. Dynegy, the U.S. District Court for the Eastern District of North Carolina considered a coal supply agreement that was terminated by the plaintiff as a result of an alleged MAC caused by Dynegy's credit rating being downgraded. Although CP&L gave Dynegy notice of the alleged MAC and received back a written reply declining to provide any credit enhancement, CP&L ignored Dynegy's reply and then purported to terminate the contract. The court held that Dynegy's written response was commercially reasonable and appropriate and thus CP&L's termination of the agreement constituted a breach of contract.
The concept of providing a reasonable opportunity to comply with a demand for payment in the context of a demand obligation is well settled in Canada. The application of that principle and the amount of time to be given to a counterparty will depend upon all the facts and circumstances in each case. Whether those well-settled principles will be regarded by the courts as applicable to demand obligations under MAC clauses remains to be seen, although absent contractual provisions to the contrary, it appears there are strong reasons to impose such requirements depending on the facts of each case.
The requirements of notice requesting performance assurance vary by contract. However, safe and effective practice requires that such a notice should: (i) be sent to the contracting party in writing to ensure the request is properly given, particularly if termination of the contract is contemplated; (ii) reference the proper contract to confirm what transaction is in issue; (iii) provide the reason or credit event prompting the demand to ensure the affected party is notified of the precise credit issue; (iv) set out the amount of the performance assurance being requested so the affected party can understand specifically what is being requested to cure and preserve the contract; (v) set out what type of performance assurance is being requested to allow the counterparty to arrange for such security; and (vi) set a deadline for response to set a time by which the affected party must act to preserve the transaction.
Some agreements provide that, even in the event proper notice requesting and opportunity to provide performance assurance is provided, the right of termination remains discretionary in nature. As a result, such provisions invariably involve a consideration of the requirements of good faith and fair dealing. Where a contract grants one party a right to exercise a discretion, that right must always be exercised honestly, fairly and in good faith.
There has been a paucity of court decisions directly concerning MAC clauses outside of the M&A context. However, that trend now appears to be changing with the increased uncertainties surrounding the credit market and the associated economic downturn. There have been no leading cases in Canada interpreting MAC clauses, although some limited U.S. cases provide some insight into how MAC clauses will be interpreted. A recent Canadian trial that considered these and a number of other issues, which is currently awaiting judgment, involves the termination of a long-term natural gas derivative contract that Marathon Canada terminated with Enron Canada arising from a purported MAC caused by the credit rating downgrade of its indirect parent, Enron Corp.
Given the high stakes of many contracts that contain MAC clauses and the plethora of issues that arise in exercising MAC-related termination rights, it is critical to carefully draft these clauses and closely examine the rights and obligations they create and impose to avoid being faced with litigation alleging the wrongful termination of a contract.
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.