A recent Ontario decision of Fairstone Financial Holdings Inc. v. Duo Bank of Canada ("Fairstone") became the first Canadian case to consider material adverse change ("MAC") or material adverse effect ("MAE") clauses in the context of COVID-19. In Fairstone, Duo Bank of Canada sought to invoke the MAC/MAE clause to exit the transaction but the court did not allow it to do so. This blog explains the reasoning of the court and takes a broad look at the law of MAC/MAE clauses within the context of COVID-19.
MAC/MAE is generally defined as "the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner". MAC/MAE clauses typically serve as a closing condition to provide the purchaser a legal avenue to exit a transaction in the event that a material change with adverse effects has occurred in the interim period between signing and closing.
Successful Invocation of MAC/MAE Clauses
There are certain features that can be distilled from the case law for a successful invocation of MAC/MAE clause to terminate an agreement. These are: (1) the unknown event(s) that (2) threaten the overall earnings potential of the target for (3) some durational significance. Since this clause is for the benefit of the purchaser, it is interpreted from a purchaser's reasonable view.
The first feature of an MAC/MAE is that the unknown event(s) must be captured by the language of the provision. There are two parts for this: (1) the event(s) must be unknown, and (2) the event must not be excluded from the definition of MAC/MAE in the agreement. This means that the change cannot be excluded by the MAC/MAE provision through means of a carve-out (as discussed below). For the first part, events that were known to the buyer before signing the agreement are deemed to have been factored in the purchase price. There is case law, such as Consumers Glass Co. v. D'Aragon, where buyers have been unsuccessful on invoking the MAC/MAE clause because all material information was disclosed or known to the buyer.
In the case of COVID-19, the court in Fairstone acknowledged that the parties were aware of COVID-19 when the agreement was signed (February 18, 2020), but the court found that neither party could have appreciated the effects of COVID-19 and therefore, it constituted as an unknown event. Today, COVID-19 and its effects are well known and therefore, it may not qualify as an unknown event and parties may have difficulty invoking the MAC/MAE clauses for COVID-19-related events/effects.
This issue may be overcome by a well-drafted agreement that explicitly lists specific events, such as a new lockdown, that will qualify as a MAC/MAE event. For example, in Marathon Canada Ltd. v. Enron Canada Corp., the agreement clearly identified a drop in creditworthiness rating to below BBB- from Standard & Poor as a material adverse change. When this occurred, Marathon Canada Ltd. availed itself the MAC-out clause to exit the transaction. Enron Canada Corp. argued that the provision should be understood in light of commercial context which would entitle it to re-negotiate following the downgrade in rating; however, the Alberta Court of Appeal rejected this argument and stated unanimously, "[W]e are unable to see how either of these arguments is more than an attempt to re-write the plain terms of the Agreement." As a result, a well-drafted MAC/MAE provision can provide the certainty both parties desire when arranging the terms of their affairs.
Threat to Overall Earnings Potential of Target
The second feature of an MAC/MAE that should generally be established is the threat to the overall earnings potential of the target. Canadian courts consider all the surrounding circumstances when determining the materiality threshold of the event(s). In some cases, a significant decline in external market factors would not qualify even if it affected the business of the target. In Stetson Oil & Gas Ltd. v. Stifel Nicolaus Canada Inc., the court rejected a 27% drop in oil prices as a valid material adverse change citing that such changes are expected in a volatile industry. On the other hand, in Fairstone, the court accepted that there was a threat to the overall earnings potential of the target by comparing the financial statements of the same period from the previous year and finding 56%, 36.6% and 21% decline in new loan originations (target is a financial consumer corporation with a consumer base of borrowers) for three consecutive months.
The third feature of an MAC/MAE is that the event(s) should be durationally significant. Usually, a short-term change is not sufficient to invoke this exit clause but may be sufficient for short term investors. As a result, this requirement is contextual. In Fairstone, the court found that the COVID-19 effects were durationally significant since the projections showed that the target would suffer for two years.
Carve-outs from MAC/MAE Clauses
An important step when determining the success of invoking MAC/MAE clauses is to determine if the event(s) are captured by carve-outs. Carve-outs are express exceptions to events that may meet the definition of an MAC/MAE; some common examples of a carve-out are: acts of war/terrorism, natural disasters, and changes in economic conditions affecting the industry. If the event(s) are captured by the carve-outs, then the party cannot rely on the MAC/MAE clause to exit the transaction unless there is a further exception to the carve-out that expressly excludes certain events from the definition of a carve-out despite being captured by the language of the carve-out. In Fairstone, the MAC/MAE clause had a carve-out that the court interpreted would apply to pandemics. The carve-out stated, "worldwide, national, provincial or local conditions or circumstances ... including ... emergencies, crises ...". Although the language does not explicitly state "pandemic" or "epidemic", it does employ broad language through the use of the word "including". The court relied on the fact that the government has referred to COVID-19 pandemic as an "emergency" to conclude that a worldwide/national emergency includes a pandemic. The court then found there to be no materially disproportionate adverse impact due to the pandemic, an exception to the carve-out, to finally conclude that the pandemic is captured by the carve-out. As a result, courts will look at surrounding circumstances when facing unclear terms and broadly worded MAC/MAE clauses with terms like "emergencies" would likely be interpreted to capture a pandemic.
Insight for COVID-19
The above provides a lay of the land when it comes to MAC/MAE clauses within the context of COVID-19. It is clear that the factual matrix greatly determines a court's decisions since courts look at surrounding circumstances as well as the language of the agreements. Uncertainties in this area can be avoided by a well-drafted agreement. With COVID-19 being prevalent in today's world, it is likely that courts may not allow invocation of MAC/MAE clauses on the basis of COVID-19 for future agreements. However, this can be circumvented by clear language in the agreements that lists such events as a qualifier for MAC/MAE events. If the criteria is met, the buyer may be able to invoke the clause to terminate the transaction and courts will likely not intervene to interfere with the plain language of the contract. In the alternative, COVID-19 could also be expressly carved out from the definition of material adverse change; this also provides certainty to both parties if this is the path they prefer. As a result, despite COVID-19 being a known event, negotiations over the MAC/MAE clause between parties can still be expected in light of the case law outlined above.
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