the economic efficiency of material adverse change clauses

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The economic efficiency of material adverse change clauses in private M&A agreements

subject to English law

Master Thesis

Phillip Becker

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1. Introduction

Contracts related to mergers and acquisitions of companies (“M&A”) often, where the

contract requires a period of delay between the date of the contract and the performance

thereof, contain a clause with which the buyer seeks to protect herself from any unforeseen

deterioration of the business of the target company during such period. These material

adverse change clauses (“MAC clauses”) allow the buyer to terminate the contract where the

target company is subject to a material adverse event (“MAE”) prior to completion.

Due to the dramatic impact which MAC clauses can have on M&A agreements, they have

been described as “the most important contract term of our time”.1

Often, MAC clauses are drafted in a very general way2 and do not make reference to specific

circumstances which trigger their application. This paper focuses on this type of MAC clause

(as opposed to clauses which relate to a small number of clearly defined MAEs) and limits

itself to the use of these clauses in private M&A (i.e. in contracts for the purchase of shares in

a closely held company which is not listed on a stock market).

The following example scenario will be used throughout the paper: a seller and a buyer have

contracted for the sale of the entire issued share capital of a target business. The sale price is

€100 million but the sale can only be completed several months after the date of the contract

as the transfer of the shares is subject to consent from the relevant competition law authority.

Before the merger clearance from the competition authority can be granted (it ultimately is

granted), an accident occurs in the target business which destroys one of its manufacturing

plants and significantly affects the perception of the target business by its customers. The

buyer estimates that the value of the target business has been reduced to €60 million. This

figure is mainly based on the damage to the target’s reputation and projected loss of future

business. The buyer would therefore pay €100 million in return for an asset with a value of

€60 million.

The buyer could proceed with the acquisition and accept that she is overpaying by €40

million or she could breach the contract and face a claim from the seller which, if her

estimates are correct, is likely to result in an award of damages in the sum of €40 million

1 Schwartz, Standard Clause Analysis, UCLA L. Rev. 2009-2010/57, p. 789 2 52% of all MAC clauses in English law acquisition agreements according to Middelkoop & Steer, Themes in

Private M&A, Allen & Overy 2016, p. 9 [online]

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(ignoring any element of legal and/or wasted transaction costs). Damages in this amount

would reflect that, following specific performance of the contract, the seller would no longer

own the company (now worth €60 million) but would have received €100 million from the

buyer. Neither of these options is attractive to the buyer.

Being aware that events may happen between exchange and completion of the contract which

reduce the value of the target company, a rational buyer would seek to address such risks

before entering into the contract.

This paper analyses whether the introduction of a general MAC clause would improve the

position of the buyer in a manner which preserves the economic efficiency of the contract.

The focus of this paper is therefore to understand whether English courts in practice follow

the intentions of the parties when interpreting such clauses and arrive at a more buyer

friendly outcome than they would have if the contract did not contain such a clause. This is

the minimum threshold which a MAC clause must pass to render it an effective ex ante

choice of (self-help) remedy by the parties. Schwartz has argued that this is case under

English law in the case of public M&A transactions3 but no such analysis has been conducted

for private M&A.

The analysis is conducted in the context of English law as private acquisition agreements

subject to English law only contain a MAC clause in a significant minority of cases.4 Their

inclusion therefore appears to be a conscious choice (rather than for example in agreements

subject to US law where they are seen as boilerplate clauses which are included as standard5).

This may indicate a degree of ambivalence as to their effectiveness among practitioners

which would render research into this topic particularly relevant.

The main question posed by this paper is:

Do English judges interpret widely drafted MAC clauses in a way which reflects the

risk allocation negotiated by the parties and therefore preserves the economic

efficiency of the contract?

To arrive at an answer, a number of sub-questions are put forward.

(i) How are MAC clauses linked to economic efficiency?

3 Ibid., p. 829 4 Middelkoop & Steer, Themes in Private M&A, Allen & Overy 2016, p. 12 [online] 5 Ashton (et al), Much Ado about nothing?, D&P 2013/13(4), para 2

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This sub-question conducts a brief descriptive literature review of the classic theory of

efficient breach followed by the introduction of a revised version of this theory which will be

used throughout this paper. The aim is to identify a definition of economic efficiency which

can be used as an evaluation criterion to answer the main question posed by this paper.

(ii) How are MAC clauses used in the context of private M&A subject to English

law?

This chapter conducts a literature review of academic writing on MAC clauses to identify the

key theoretical approaches to this type of clause. It then eliminates the theories which are not

relevant to private M&A under English law. The purpose of this exercise is to establish

whether a MAC clause in principle is capable of fulfilling the criterion of economic

efficiency set out in the answer to sub-question (i). Finally, the chapter provides a sample

MAC clause to illustrate the key issues relevant to the drafting and functions of such a clause.

(iii) How would English law interpret the sample scenario if the contract did not

include a MAC clause?

The doctrine of frustration is introduced to demonstrate how an English court would treat the

sample scenario in the absence of a specific clause dealing with the sample scenario. The aim

of this chapter is to provide a baseline outcome for the parties. It is put forward that the MAC

clause only has an economic effect if it changes the outcomes obtained by the parties

following an MAE from this baseline position.

(iv) Which rules of interpretation would be relevant for the construction of a MAC

clause under English law and how would English law treat a buyer who relies

on a MAC clause in error?

This sub-question provides a descriptive overview of the English law rules of contractual

interpretation. The purpose is to demonstrate the limits to a court’s scope for interpretation of

a MAC clause under English law and to understand whether a court should be able, in the

abstract, to interpret a MAC clause in line with the intention of the parties.

This sub-question also investigates whether the invocation of a MAC clause creates a risk for

the buyer in case a court subsequently holds that no MAE had occurred when the clause was

triggered.

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(v) How have English courts construed MAC clauses in the past?

This chapter reviews the case law in which English courts had to interpret MAC clauses. As

only a very limited number of MAC clauses connected with M&A transactions have been

brought before the English courts, this chapter will not only review decisions taken in an

M&A context but will also review cases related to other areas. The aim is to identify the

arguments and approaches used by judges in construing MAC clauses.

These findings are then used to evaluate whether the decisions reached leave the parties in a

position which differs from the default outcome introduced by sub-question (iii). It is also

examined how closely the court follows the parameters prescribed by the MAC clause in the

individual cases.

The final chapter concludes.

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2. Efficient breach theory

The theory of efficient breach been traced back to ideas first expressed by Birmingham6 in

1970.7 In that time, academics have continued to develop the theory and its current form

differs significantly from its first iteration.8 This chapter provides a brief outline of the

original theory before identifying one specific evolution of the theory which will be used

throughout this paper.

The classic theory of efficient breach

At its heart, the classical theory of efficient breach holds that the law should not in all

circumstances enforce a contract by giving the non-breaching party the ability to sue for the

performance of the contract. Instead, the theory argues that the default remedy should be a

payment of damages by the breaching party. Performance of the contract should only be

available as a remedy where such performance will lead to the creation of economic value.9

The classic theory argues that using the expectation interest10 as starting point for the award

of contract law damages will provide an incentive only to perform a contract where such

performance leads to the creation of economic value. This is commonly illustrated by an

example along the following lines (see for example Posner11).12

Assume that a potential customer (C) approaches a trader (T) to purchase a widget. T

establishes that she can instruct a manufacturer (M) to produce the widget and have it ready

for delivery to C in one month’s time. M has calculated that it will cost €600 to produce the

widget and has quoted a price of €800 to T. On this basis, T has contracted with C to deliver

the widget in one month’s time for a price of €1,000. In this scenario, economic value in the

amount of €400 is being created of which M and T each retain €200. It is therefore reasonable

for both of them to enter into the relevant contracts and the transaction is also sensible from a

macroeconomic perspective.

6 Birmingham, Breach of Contract, Rutgers L. Rev. 1970/24, p. 273 7 Liao, Efficient Breach in the Common European Sales Law, Syracuse J. Int’l L. & Com. 2013-2014/41, p. 336 8 Klass, Efficient Breach, in Philosophical Foundations of Contract Law, 2014, p. 363 9 Ibid, p. 363 10 I.e. allowing the non-breaching party not only to recover its wasted costs (the reliance interest) but also the

profit which it would have subsequently gained had the contract not been breached – see ibid p. 364 11 Posner, Economic Analysis of the Law, Little, Brown and Co. 1992, p. 118 - 121 12 Ibid, p. 364

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While the transaction is reasonable at the outset, events may occur prior to the production of

the widget which affect M’s willingness to perform its obligations under the contract. These

events can take a positive or a negative form. A positive event would be another customer

approaching M with an offer to pay an amount in excess of €800 for the widget. An increase

in the production costs of the widget above €600 would be a negative event. The literature on

efficient breach more commonly discusses scenarios of a positive nature13 but this paper will

limit itself to discussing the negative version as this leads to a more appropriate analogy to

the sample scenario.

An increase in production costs of no more than €200 will reduce M’s profit margin but will

not impose further costs on M. Even in a hypothetical world where M does not have to fear

legal sanctions from T, the incentive for M to breach the contract would be low as breaching

the contract would mean that M is likely to incur reputational damage. This changes once the

costs of producing the widget increase above €800. M now has to incur costs to avoid

breaching the contract. Allowing T to recover expectation damages from M, means that it is

still reasonable for M to perform the contract as long as the increase in production costs is

lower than the combination of its own profit margin of €200 and T’s profit margin of €200

(i.e. €400 in total). A production cost increase of €350 to €950 would lead to M suffering a

loss of €150 but performance of the contract would still be reasonable both for M who would

avoid a claim in the sum of €200 from T and from a macroeconomic perspective as €50 of

economic value is being created by the overall transaction. A production cost increase to

€1,050 on the other hand renders performance inefficient for M who would rather pay T’s

expectation loss of €200 than incur the loss of €250 that would arise if the contract were

performed. Performance of the contract is also no longer efficient from a macroeconomic

perspective as now an aggregate of €1,050 is invested by M to create €1,000 in value.

This demonstrates the key argument of the classic efficient breach theory. Allowing parties

always to claim for the specific performance of contracts can lead to the performance of

contracts which reduce the wealth of society as a whole. Expectation damages on the other

hand avoid this while still adequately compensating the innocent party.14

13 Ibid, p. 365 14 Ibid, p. 366

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Criticisms of the classic theory

The classic theory of efficient breach has been the subject of much criticism from contract

law theorists. They feel, among other criticisms, that encouraging breach of a contract is a

moral wrong.15 These critics argue that rights, including contractual rights, should not be

subjected to an instrumentalist view which only gives effect to them where they serve an

ulterior motive such as the maximisation of wealth.16 This paper will not discuss this or other

criticisms of the classical theory in any further detail as they do not take into account how the

classical theory has been developed by Klass.17 This is demonstrated by him in his review of

“criticisms from outside the model” in one of his recent papers18 and is also borne out by a

review of current articles engaging with the theory of efficient breach.

Academics such as Harrison19, Isaacs20, Liao21 and Vilaça22 have continued to write about

moral and ethical objections to the theory.

Olson23 has restated a pragmatic criticism of the theory by focussing on the burdens which

courts would have to face when reviewing large quantities of economic evidence.

Epstein24 and Al-Tawil 25 both review whether the theory could be applied in a specific

context (intellectual property law and English law respectively).

The most comprehensive review of the theory was produced by Harrison26 who summarised

three main lines of criticism, these being the question of which default remedy is truly most

efficient, the moral component to contractual promises and an argument based in behavioural

economics which questions whether efficient breach increases overall happiness.

Finally, Niblett27 and Foulds28 both look at the theory in the context of public company

takeovers. Niblett focuses on the relationship between target company staff and management

15 Ibid, p. 363 16 Ameer, Between Scylla and Charybdis, UCL Juris. Rev. 1995/2, p. 204 17 Klass, Efficient Breach, in Philosophical Foundations of Contract Law, 2014, p. 363 18 Ibid, p. 366 – 370 19 Harrison, Influence of Law and Economics Scholarship, N.Y.U. Ann. Surv. Am. L. 2012-2013/68, p. 11 – 12 20 Isaacs, Hypothetical Efficiency, Va. L. Rev. 2013/116, p. 364 21 Liao, Efficient Breach in the Common European Sales Law, Syracuse J. Int’l L. & Com. 2013-2014/41, p. 337 22 Vilaça, Why teach legal theory today?, German L.J. 2015/16, p. 793 23 Olson, Who mourns for specific performance?, Advocate Vancouver 2013/71, p. 859 24 Epstein, Intellectual Property Law and the Law of Contract, E.R.C.L. 2013/9(4), p. 349 25 Al-Tawil, English Contract Law and the Efficient Breach Theory, M.J. 2015/22(3), p. 397 26 Harrison, A nihilistic view of the efficient breach, Mich. St. L. Rev. 2013, p. 168 – 171 27 Niblett, Hostile Takeovers and Overreliance, Seattle U. L. Rev. 2014-2015/38, p. 605

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while Foulds reviews a specific decision of the Delaware courts which considers whether

target company management should be permitted to lock the target into an offer without the

option to walk away in a manner akin to an efficient breach.

All the articles mentioned in the preceding paragraphs engage only with the classic theory.

Klass’ revised theory

The revised theory of efficient breach as presented by Klass is less prescriptive than the

classic theory which seeks to improve default remedies (including self-help remedies) which

are to prevent the performance of economically inefficient contracts. Instead, it merely

demands that contract law respects the wishes of the parties not only in respect of the

obligations under the contract but also in respect of the remedies (including self-help

remedies) which are available.29

The rationale for this demand is that the parties themselves are in a much stronger position to

quantify the relative importance of any individual right than a court would be and are

therefore much better placed to identify the appropriate remedy or self-help remedy which

should apply to a specific breach.30 The aim of the restated theory is thus not to enable an

efficient breach of all contracts but to give the parties the option to allow for an efficient

breach of their specific contract. As the buyer is likely to pay a “price” (presumably in the

form of a concession elsewhere in the agreement31) for the inclusion of such a clause in the

contract,32 the standard ethical criticism that efficient breach rewards immoral behaviour

would also not apply.

This can be seen as a variation of the “standard clause analysis” put forward by Schwartz

which argues that the law creates default terms which are implied into contracts that do not

contain provisions specifically dealing with the subject matter of the relevant default term.

The parties to any given contract can then choose to retain the implied default term or to

include an alternative solution which is more appropriate to their situation.33 Chapter 4 will

discuss the relevant default term which would apply under English law.

28 Foulds, For whom should the corporation be sold?, J. Corp. L. 2012-2013/38, p. 748 29 Klass, Efficient Breach, in Philosophical Foundations of Contract Law, 2014, p. 381 – 384 30 Ibid, p. 385 31 Supreme Court 02-11-2011, Rainy Sky SA v Kookmin Bank, [2011] UKSC 50, para. 19 32 Klass, Efficient Breach, in Philosophical Foundations of Contract Law, 2014, p. 381 33 Schwartz, Standard Clause Analysis, UCLA L. Rev. 2009-2010/57, p. 792

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From the perspective of Klass’ theory, a MAC clause therefore would be economically

efficient if it provided the buyer with enhanced protection following an MAE.

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3. MAC clauses

Having established why a buyer may want to seek protection against a deterioration of the

target’s business between exchange and completion, this chapter sets out how such protection

can be provided by a MAC clause and reviews the surrounding academic discussion.34

A large part of the literature on MAC clauses focuses on acquisitions of companies which are

publicly traded and/or located in the United States (including all of the articles cited in the

preceding paragraph) and it is important to understand how this literature has to be

interpreted in the context of a private acquisition agreement subject to English law.

MAC clauses in English law contracts

Practitioners in England expect MAC clauses to be used in public M&A transactions but state

that they are far less frequently used in private M&A.35 One explanation is that English legal

culture leads to sellers expecting that a buyer will assume the full risk regarding the target

from the date of the contract.36

This argument for the relative scarcity of MAC clauses in English law agreements (which is

also noted by other practitioners37) sits well with the general theme of this paper that parties

will bargain for legal entitlements just like they bargain over the purchase price.38 A cultural

predisposition to assign risk to the buyer39 would increase the “price” which a buyer would

need to pay for the inclusion of a MAC clause.

While MAC clauses are less prevalent in English private M&A agreements than they are in

their US counterparts, practitioners still report that they were included in 33% of

agreements.40 This constitutes a significant minority of all transactions.

34 See for example: Gilson & Schwartz, Understanding MACs, J.L.E.O 2005/21(2), p. 330 – 358; Garrett,

certainty in uncertain times, J.L.S.P. 2010/43(3), p. 333 – 362; Monson, The modern MAC, S.Cal. L. Rev.

2015/88(3), p. 769 – 804; and Elken, Rethinking the Material Adverse Change Clause, S. Cal. L. Rev. 2008-

2009/82, p. 295 35 Ashton (et al), Much Ado about nothing?, D&P 2013/13(4), para 5 36 Ibid, para 4 37 Baker & McKenzie, Global M&A Handbook, 2015, p. 663 38 Klass, Efficient Breach, in Philosophical Foundations of Contract Law, 2014, p. 382 39 see for example Peel, The Law of Contract, 2007, para 9 – 123 40 Middelkoop & Steer, Themes in Private M&A, Allen & Overy 2016, p. 12 [online]

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Public and private acquisitions

Very different rules apply to MAC clauses for public and private M&A transactions under

English law. Private acquisitions are governed by the rules of English contract law. Public

acquisitions on the other hand are subject to the rules set down by the City Panel on

Takeovers and Mergers in The Takeover Code which mainly seeks to create certainty for the

shareholders of the target company and therefore sit outside the scope of this paper.41

MAC clauses in academic theory

A number of, non-mutually exclusive, theories regarding the purpose of a MAC clause have

been provided over time. Elken42 has provided a succinct summary of these theories.

The first function which has been identified is to shift risk from the buyer to the seller by

allowing the buyer to unilaterally terminate the agreement if pre-determined circumstances

occur.43 This is the purpose of a MAC clause on which this paper focuses.

The second purpose is described by the so called “symmetry theory” which is particular to

the circumstances of a US law merger agreement. Under US law, the shareholders of the

target will need to ratify the merger agreement after it has become binding on the buyer. This

allows the shareholders of the target to reject the contract if this seems advisable in light of

events occurring after the date of the agreement. The buyer has no corresponding safeguard

and will therefore want a MAC clause to level the playing field.44 This theory has been

challenged on the basis of US law considerations45 but is also not relevant to a private M&A

transaction in which no ratification (or acceptance of the offer as in a bid for a target which is

listed on the stock market) from the target’s shareholders is required as they are a party to the

sale agreement. It is therefore not relevant to this paper.

The third function is set out in the “investment theory”.46 Here, one purpose of a MAC clause

is to ensure that, especially in fast moving and research intense industries, the target business

does not invest further funds into product lines which will be discontinued following

41 Cline & Trobman, Comparing the value of US and UK MAC clauses, Int’l Fin. L. Rev. 2002/21, p. 20 42 Elken, Rethinking the Material Adverse Change Clause, S. Cal. L. Rev. 2008-2009/82, p. 295 43 Ibid, p. 29 44 Ibid, p. 296 45 Ibid, p. 297 46 Ibid, p. 298

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completion of the acquisition.47 This function of a MAC clause does not relate to the impact

of an unforeseen external event on the target and will therefore not be discussed further.

Finally, the fourth theory sees the function of a MAC clause as creating “renegotiation

leverage”. Having a credible threat of successfully invoking a MAC clause may focus the

parties’ minds and result in a renegotiation which leaves both parties satisfied after the

occurrence of an MAE.48 It has also been pointed out in the literature that both parties face

considerable risk if the clause is actually litigated. If the buyer is unsuccessful, she will

acquire a business which she has publicly described as no longer feasible. An unsuccessful

seller will be left with a company which a court has just described as the object of a

catastrophic event.49

There is anecdotal evidence of such negotiations happening in practice.50 The question of

whether these bargains reach a result which is economically efficient or merely more

favourable to the buyer than performance of the original contract would have been is beyond

the scope of this paper. The fact that such bargains are struck does imply though that they

reduce the buyer’s loss as they would otherwise not occur.

For the purpose of this paper, this function sets out a second way in which a buyer may end

up with a better result than she could hope for if purely relying on the doctrine of frustration.

Chapter 6 will review English cases dealing with MAC clauses to understand the degree to

which MAC clauses transfer risk from the buyer to the seller (as per the first function of a

MAC clause discussed in this chapter). This is an important test to establish whether MAC

clauses in fact provide additional renegotiation leverage. Unless risk is transferred back to the

seller, her willingness to renegotiate the sale terms following the occurrence of a pre-

completion MAE should not be influenced by the inclusion of a MAC clause in the contract.

It is now time to turn to the practical form of MAC clauses.

Specific and general MAC clauses

A MAC clause can either deal with specific and pre-defined MAEs51 or with a general and

much more widely defined MAE. This can be illustrated using the sample scenario. Two

47 Monson, The modern MAC, S.Cal. L. Rev. 2015/88(3), p. 337 48 Elken, Rethinking the Material Adverse Change Clause, S. Cal. L. Rev. 2008-2009/82, p. 300 49 Schwartz, Standard Clause Analysis, UCLA L. Rev. 2009-2010/57, p. 824 50 Elken, Rethinking the Material Adverse Change Clause, S. Cal. L. Rev. 2008-2009/82, p. 300 51 Woolrich, MAC clauses, J.I.B.L.R. 2014/29(6), p. 377

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parties have contracted for the sale of a company. Between exchange and completion, a

crucial manufacturing plant of the target burns down and the resulting delay in performing

existing orders and damage to the company’s market reputation lead to a significant

deterioration of its prospects.

In this situation, a MAC clause could allow the buyer to escape from the transaction in one of

two ways. A specific MAC clause would function akin to a condition to completion52 and

would identify the factory (either specifically or as part of a class of factories of strategic

importance) and prescribe that the factory must continue to exist undamaged and functioning

at completion. Subject to it being drafted in a competent manner, such a MAC clause leaves

very little room to the seller to argue that the relevant MAE has not occurred.

A general MAC clause on the other hand would not refer to the factory at all. Instead it would

aim to cover off much wider range of risks by using less specific language (e.g. identifying

damage to the target’s prospects as the trigger).

It will be easier for the buyer to demonstrate that a specific MAC clause has been triggered as

the triggering event will be more clearly defined therein. A general MAC clause might afford

the seller more scope to argue that the relevant event was not an MAE but theoretically

protects the buyer against a wider range of events.

The two types of clause are therefore appropriate for buyers with different appetites for risk.

Typology of risks

Miller has provided a typology of the four main types of risk which are capable of being

covered by a MAC clause which can be summarised as follows: firstly, there is “systematic

risk” which is macroeconomic risk outside the control of either party.53 Secondly, there is

“indicator risk” which refers to the potential failure by the target to meet key financial goals.

In itself this may not constitute an MAE but it may indicate an impending MAE.54 Thirdly,

there is what Miller calls “agreement risk”. This is risk created by the deal itself becoming

public knowledge. Employees may decide to leave and customers may decide to switch to a

52 I.e. an obligation which one of the parties, often the seller, has to fulfil before completion can occur.

Examples of such an obligation are obtaining a competition law clearance for the acquisition, performing a re-

organisation of the target or obtaining third-party consent to the assignment or novation of key contracts – see

Denicolo, Acquisitions, CLP 2016, p. 110 53 Miller, The Economics of Deal Risk, Wm. & Mary L. Rev. 2008-2009, p. 2071 54 Ibid, p. 2071 – 2072

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competitor if they feel the impact of the deal will be negative for them.55 This is naturally far

less of a problem in private M&A than in public M&A as there is no requirement to

announce the deal publicly upon its signing. 56 Fourthly, there is all other risk which is

described as “business risk” and is defined as “arising from the ordinary operations of the

[target’s] business”.57

Sample MAC clause

A MAC clause addressing these risks could take the following general form:

The buyer is entitled to terminate this agreement without any further obligation to the seller

where any event occurs between the date of this agreement and the date of completion which

has or is reasonably expected to have a material adverse effect on the target, its assets, its

business and/or its financial condition save where such event has a comparable effect on all

competitors of the target.

The above clause is a loosely drafted example but contains the four elements which are to be

expected in any general MAC clause. These are (1) a definition of the time frame during

which the MAE has to have occurred; (2) the required likelihood that the trigger event will

amount to an MAE; (3) a definition of which aspects of the target business need to be

affected by the MAE; and (4) a list of exceptions noting events which would constitute

MAEs but are expressly for the risk of the buyer.58

Each of these four elements can take a number of forms (and in general the seller will aim to

limit the scope of the clause while the buyer will aim to widen it59).

The time period in which the MAE has to occur to trigger the MAC clause normally runs

from the contract date to completion but could also start earlier.60

Regarding the nature of the relevant event, a buyer would ideally want the ability to trigger

the MAC clause as soon as an event has occurred which has the mere potential of turning into

an MAE while a seller would ideally allow this only where the event has actually amounted

55 Ibid, p. 2072 56 contrast Rule 2.7, The Takeover Code [online] 57 Miller, The Economics of Deal Risk, Wm. & Mary L. Rev. 2008-2009, p. 2073 58 Quintin, M&A contracts in the American financial maelstrom, I.B.L.J. 2008/3, p. 280 – 281 59 Hall, How big is the MAC?, U. Cin. L. Rev. 2002-2003/71, p. 1064 60 Ibid, p. 281

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to an MAE. In practice, the parties are likely to agree on some form of “reasonable

foreseeability” as a compromise.61

Defining the way in which the target needs to be affected is also likely to be contentious.

While the inclusion of the target itself, its assets and its financial position is uncontroversial,

a buyer will also want to include the prospects of the target in this list while a seller will resist

this as too subjective.62

Returning to the example, the seller would argue that the destruction of the factory will only

lead to a temporary reduction in customer orders while the buyer would, for the purposes of

being able to trigger the MAC clause, treat these customers as irretrievably lost.

Finally, each clause will include exclusions which assign some or all of the risk for external

MAEs to the buyer.63 These exceptions tend to be more detailed in US transactions than in

acquisitions which are subject to English law64 which may be owed to the fact that claims

related to MAC clauses have been prominent in the US in recent times65 while the English

courts have seen fewer cases involving MAC clauses66 resulting in fewer opportunities to

understand the manner in which such clauses will be interpreted by the courts and a more

limited need to refine the drafting of existing standard clauses.

MAC clauses and economic efficiency

The theories developed to describe the functions of a MAC clause are consistent with finding

of the last chapter that MAC clauses may be an economically efficient tool to allocate risk

between the parties. While much will depend on the drafting of the individual clause, the case

law review in Chapter 6 analyses whether this is also borne out by court decisions in practice.

61 Ibid, p. 280 – 281 62 Ibid, p. 281 63 Gilson & Schwartz, Understanding MACs, J.L.E.O 2005/21(2), p. 339 64 Ashton (et al), Much Ado about nothing?, D&P 2013/13(4), para 8 65 Gilson & Schwartz, Understanding MACs, J.L.E.O 2005/21(2), p. 331 66 Woolrich, MAC clauses, J.I.B.L.R. 2014/29(6), p. 373

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4. Change of circumstance

Having explained how MAC clauses are meant to improve the buyer’s position in the

previous chapter, this chapter analyses how English law would deal with the sample scenario

in the absence of a MAC clause. Would English law treat the destruction of a factory owned

by the target as a change of circumstance which would allow the buyer to claim relief under

common law?

Historically, the answer would have been no as English law views contractual obligations as

absolute 67 and initially only deviated from this view where the contract was for the

performance of personal services and the individual who was to provide such services had

died68.

Over time, this absolute contract theory has been tempered by the doctrine of frustration.

Bingham LJ, as he then was, set out five general propositions regarding this doctrine in the

case of The Super Servant Two.69 These state that (1) its purpose is to “mitigate the rigour …

of absolute promise”; (2) it discharges the contract in full and therefore cannot be “lightly

invoked”; (3) it results in the contract being brought to an end “forthwith, without more and

automatically”; (4) it has to be triggered by an “outside event or extraneous change of

situation”; and (5) such event must occur “without blame or fault on the side of the party

seeking to rely on it”.70

The doctrine of frustration only can be applied in specific scenarios, three of which are

relevant to the question investigated by this paper. These are impossibility of performance,

frustration of the contract’s purpose and subsequent illegality of the contract. Each of these

scenarios will be investigated in turn but first three general points regarding the doctrine need

to be discussed.

General observations

Firstly, frustration is different from the doctrine of mistake in that it can only be triggered by

an event or circumstance which had not yet occurred at the time the contract was signed.71

The doctrine of mistake could only provide relief if both parties had entered into the

67 Peel, The Law of Contract, 2007, para. 19-002 68 Ibid, para. 19-003 69 Court of Appeal 12-10-1989, The Super Servant Two, [1990] 1 Lloyd’s Rep 1, Question 2 70 Beale, Chitty on Contracts, 2015, para. 23-007 71 Smith, Mistake, frustration and implied terms, L.Q.R. 1994/110 (Jul), p. 401

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agreement under the same mistaken assumption with regard to a fact which was fundamental

to the agreement.72 As the example scenario supposes that the factory is destroyed after the

contract is entered into and not that the factory had already been destroyed on the contract

date without either party being aware of this fact, it is therefore frustration which may offer

relief and not mistake.

Secondly, the event referred to in Bingham LJ’s fourth proposition needs to constitute a

liability which has crystallised and may not merely be contingent on a future event.73 The

MAE in the example scenario of this paper does constitute an event which has caused actual

damage and therefore fulfils this requirement.

Thirdly, English law has in the past deemed contracts to be frustrated where conditions had

changed. These cases though do not focus on the change in condition itself but instead infer

that conditions must have changed on account of an external event which prevented the

parties from performing the contract for a long period of time. This is illustrated, for example,

by Acetylene Co of GB v Canada Carbide Co74 where a contract for carriage was suspended

for three years as the intended vessel had been requisitioned for wartime service.75

This form of frustration will not be discussed in further detail as an M&A acquisition

agreement is very likely to contain a long-stop date by which completion must have

occurred.76 If completion has not occurred by this date the parties are free to walk away from

the contract without further obligations.77 A delay of several years before completion of the

contract is therefore prevented by contractual means. As a result, the parties would not have

to rely on the doctrine of frustration to avoid the contract in a comparable scenario rendering

any further discussion of the issue moot.

Impossibility

Here the contract is discharged because an intervening event has rendered its performance

impossible. This is often illustrated by the case of Taylor v Caldwell78 in which the lease of a

music hall was discharged after the venue burned to the ground before the start of the lease

72 Beale, Chitty on Contracts, 2015, para. 6-002 73 Thomas, Frustration and force majeure, C.L.Int. 2001/6(2), p. 22 74 Court of Appeal 18-07-1921, Acetylene Co of GB v Canada Carbide Co, [1921] 8 Ll.L.Rep, p. 456 75 Peel, The Law of Contract, 2007, para. 19-019 76 Modrall, Antitrust-approval risks, NRF November 2013, p. 10 [online] 77 Denicolo, Acquisitions, CLP 2016, p. 110 78 King’s Bench Division 06-05-1863, Taylor v Caldwell, [1863] 122 E.R., p. 309

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term. 79 It has been argued that this case in fact demonstrates a situation of severe

impracticability rather than impossibility as the venue could, at great expense, have

conceivably been rebuilt in time.80 This discussion is moot as it has since been determined,

for example in the case of Davis v Fareham,81 that physical impossibility is required and that

“it is not hardship or inconvenience or material loss itself which calls the principle of

frustration into play”.82

This application of the principle of frustration would therefore not provide relief in the case

of the destroyed factory as the seller’s obligation is to transfer the shares in the company

which owns the defunct factory. This remains perfectly possible. Further, this application of

frustration is much more relevant to the position of a seller than that of a buyer. The buyer

would therefore need to consider her other options.

Frustration of purpose

One of these other options takes its origin from maritime law and deals with situations in

which performance remains possible but where the commercial objective of the contract can

no longer be achieved.83

Two cases linked to the coronation of Edward VII in 1902 help to understand this form of

frustration. Krell v Henry84 demonstrates how the concept is applied while Herne Bay v

Hutton85 shows its limitations.86

The dispute in Krell concerned a lease of a room overlooking the route of the coronation

procession for the intended day of the procession. When the king fell ill and the procession

had to be postponed, the tenant argued that the contract had been frustrated as its purpose had

not been to rent the room but to see the procession. The court found in favour of the tenant

and discharged the contract.87

Hutton concerned the hire of boat for the day of the coronation with the intention to sell

tickets to spectators who wanted to see the review of the fleet which was to be held later that

79 Peel, The Law of Contract, 2007, para. 19-009 80 Ibid, para. 19-032 81 House of Lords 19-04-1956, Davis Contractors Ltd v Fareham UDC, [1956] A.C., p. 696 82 Parker & Chapman, Escaping from a bad bargain, I.E.L.R. 2010/7, p. 244 83 Kotzur, Frustrated parties, J.I.B.L. 1998/13(11), p. 345 84 Court of Appeal 11-08-1902, Paul Krell v CS Henry, [1903] 2 K.B., p. 740 85 Court of Appeal 06-08-1903, Herne Bay Steamboat Co v Hutton, [1903] 2 K.B., p. 683 86 Peel, The Law of Contract, 2007, para. 19-042 87 Ibid, para. 19-042

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day. Here, the court refused to discharge the contract and argued that it was still possible to

take visitors out on a boat ride even if at a lower ticket price than if the review had been held

that day.88

The two judgements contradict each other but in practice Hutton has been followed while

Krell has been described as “the exceptional case” which “has been subject of much

criticism”.89

For the purpose of the example scenario, it appears that a buyer would be unable to claim

relief under this heading as long as the target business is still able to engage in some form of

its business at all. Arguably, even the destruction of all factories operated by the target would

still leave its intellectual property, know-how and customer relationships intact and allow it to

continue its business after its manufacturing capabilities have been restored.

While arguing that the doctrine of frustration would not provide relief in even such an

extreme scenario involves some speculation, the case of Denny, Mott & Dickson v James B

Fraser90 shows how high the hurdle for a successful claim for frustration of purpose is.

In this case, the court had to decide whether the lease of a timber yard had been frustrated

when wartime regulations rendered a separate contract under which the tenant was to provide

a third party with wooden beams illegal. Both parties to the dispute were in agreement that

the tenant had leased the timber yard solely for the purpose of fulfilling this contract and the

contract was discharged by the court.91

The tenant in this case was in a very specific situation for two reasons. Firstly, the linked

contract to supply wooden beams and secondly the wartime context. The buyer in the

example scenario on the other hand seeks to acquire the target for its ability to generate future

income. The reason for this construction of the example is that a buyer with a very specific

reason for acquiring the target knows where the main risks from its perspective lie and is

likely to seek protections in the contract which are tailored towards these specific risks

instead of the inclusion of a general MAC clause.

Commentators have also warned against putting too much reliance on cases in which the

courts had to deal with wartime measures as the policy considerations around such measures

88 Ibid, para. 19-042 89 Beale, Chitty on Contracts, 2015, para. 23-034 90 House of Lords 19-05-1944, Denny, Mott & Dickson Ltd v James B Fraser & Co Ltd, [1944] A.C., p. 265 91 Peel, The Law of Contract, 2007, para. 19-043

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tend to be particularly strong and can lead to judgments which would not have been given

had only commercial considerations been at stake.92

The buyer from the example case is therefore still unlikely to obtain relief while relying on

the doctrine of frustration.

Illegality

The previously introduced notion of wartime restrictions is the most obvious example for a

contract which is subsequently rendered illegal. This can be illustrated by the Fibrosa93 case

in which a contract under which an English company was to ship machinery to Poland was

frustrated by the German invasion of that country in September of 1939. Again, this is a very

specific example in which the policy considerations are extremely strong.94

In other cases, it has been held that the prohibition needs to address the subject matter of the

contract very specifically, e.g. a prohibition on export will affect only contracts for the sale of

goods which have been designated for export and not contracts where the buyer merely

intends to use them for export even if the seller is aware of this intention.95

While of no use to the buyer in the example scenario, it is at least conceivable that this

iteration of the frustration doctrine might be of use to other buyers who are unable to rely on

a MAC clause. For example, a buyer who has contracted to purchase a company which

manufactures so called “legal highs” might be able to rely on the doctrine of frustration if the

manufacturing of such products is outlawed prior to completion of the sale. The buyer would

still need to be able to demonstrate though that this legislative change was neither foreseen

nor foreseeable.96

In summary, the doctrine of frustration does not provide relief for the buyer in the example

scenario. There is also only a very limited range of situations in which the purchaser of a

company would be able to rely on the doctrine of frustration in general. It remains to be seen

whether a general MAC clause improves on this position in practice.

92 Ibid, para. 19-072 93 House of Lords 15-06-1942, Fibrosa v Fairbairn, [1943] A.C., p. 32 94 Peel, The Law of Contract, 2007, para. 19-045 95 Ibid, para. 19-046 96 Ibid, para. 19-047

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5. The interpretative context and the risk of repudiation

Having established how an MAE would affect a contract without a MAC clause in the

previous chapter, this chapter briefly examines the rules of construction which an English

court will have to apply when interpreting a MAC clause. This is followed by a brief

discussion of whether a general MAC clause risks being too wide to be enforceable. Finally,

this chapter will look at the consequences faced by a buyer who refuses performance of a

contract in reliance on a MAC clause which is subsequently found not to have been triggered

at the relevant time.

The rules of interpretation under English law

The starting point for the construction of a contract under English law is that the court has to

take an objective approach.97 This means that the contract is to be interpreted from the

perspective of “a reasonable person […] who has all the background knowledge which would

reasonably have been available to the parties in the situation in which they were at the time of

the contract”.98

To this end, the courts have developed various rules of construction. Today, these are no

longer applied in a strict way but serve as guidelines instead.99 This chapter outlines the

following areas which it sees as most relevant in the context of this paper: (1) words and their

ordinary meaning; (2) commercial common sense; (3) evidence taken from pre-contractual

negotiations and (4) contract terms which appear one-sided.

Firstly, words should be interpreted according to their ordinary meaning. This rule is seen as

a mere starting point in contemporary jurisprudence though. It mainly prevents a court from

interpreting a provision in a manner which runs contrary to its natural meaning in the absence

of strong evidence in favour of such interpretation.100 Legal commentators continue to stress

that “literal meaning isn’t decisive of legally correct outcomes”.101 This view has also been

endorsed by the Supreme Court with Lord Clarke stating “it is not in my judgment necessary

97 Beale, Chitty on Contracts, 2015, para. 13-043 98 Supreme Court 02-11-2011, Rainy Sky SA v Kookmin Bank, [2011] UKSC 50, para. 14 99 Beale, Chitty on Contracts, 2015, para. 13-045 100 Ibid, para 13-051 101 Flanagan, Literal Meaning, O.J.L.S. 2010/30(2), p. 270 – 271

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to conclude that, unless the most natural meaning of the words produces a result so extreme

as to suggest that it was unintended, the court must give effect to that meaning”.102

Reverting to the sample MAC clause introduced in Chapter 3,103 a court would therefore have

discretion to interpret, for instance, the term “competitor” in a narrower or wider manner

depending on how it expects that a reasonable person would construe the term.

Secondly, a court may not alter the terminology used in the contract to arrive at an outcome

which it considers to make more commercial sense than the outcome under the contract.104

Nevertheless, the Supreme Court has clarified that “where a term of a contract is open to

more than one interpretation, it is generally appropriate to adopt the interpretation which is

most consistent with business common sense”.105

Applying this to the proviso in the sample MAC clause that an event is no MAE “where such

event has a comparable effect on all competitors of the target”, a court will therefore be able

to take into account business common sense when construing “comparable effect” and

“competitor” but may not use this as a justification for removing the “all”.

Thirdly, English law knows a rule, often referred to as the “parol evidence rule”, which

prevents court from relying on pre-contractual negotiations when interpreting the contract.106

Judges and academic commentators have called for this rule to be relaxed where the sole

reason for relying on extrinsic evidence is to identify a consensus reached by the parties prior

to entry into the contract but not documented therein.107

This approach was subsequently endorsed by the House of Lords in the case of Chartbrook v

Persimmon Homes. Lord Hoffmann also noted that in this context “there are no conceptual

limits to what can properly regarded as background” and is therefore admissible.108

102 Supreme Court 02-11-2011, Rainy Sky SA v Kookmin Bank, [2011] UKSC 50, para. 20 103 The sample MAC clause allows the buyer to terminate the purchase agreement where any event occurs

between the date of the contract and the date of completion which “has or is reasonably expected to have a

material adverse effect on the target, its assets, its business and/or its financial condition save where such event

has a comparable effect on all competitors of the target”. 104 Beale, Chitty on Contracts, 2015, para. 13-074 105 Supreme Court 02-11-2011, Rainy Sky SA v Kookmin Bank, [2011] UKSC 50, para. 30 106 Beale, Chitty on Contracts, 2015, para. 13-099 107 McMeel, Prior negotiations, L.Q.R. 2003/119(Apr), p. 296 108 House of Lords 01-07-2009, Chartbrook Ltd v Persimmon Homes Ltd, [2009] UKHL 38, para. 33

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For the purpose of construing the example MAC clause, if the court were aware of a

consensus between the parties on who is to be counted as a “competitor” and this consensus

is not in dispute, it could rely on this information when interpreting the clause.

Fourthly, the case of Chartbrook v Persimmon Homes also notes that a court must not

disregard a provision simply because it seems “to be unduly favourable to one of the parties”.

The reason for this is that the court cannot know whether the inclusion of this clause “was not

in exchange for some concession elsewhere or simply a bad bargain”.109

This means that a court might find that the reference to “all competitors” in the proviso of the

sample MAC clause does constitute a very high hurdle but that this view must not sway the

court to construe the clause differently than the parties appear to have intended.

Is a general MAC clause too wide for enforcement?

One way to question the usefulness of a general MAC clause is to argue that the more general

its nature the greater its ambiguity will be, ultimately jeopardising its enforceability. There

are two arguments why this is not a substantive risk.

Firstly, an ambiguous contract will still need to be interpreted through the objective bystander

test.110 Arguably, the vaguer the terms of the MAC clause are the greater is the range of

events which could conceivable constitute an adverse change.

Secondly, the court might argue that the clause is so vague that its vagueness actually

constitutes bad drafting. In this case, the courts are generally expected to be less likely to

depart from business common sense than had the drafting been clear.111 It seems unlikely that

a court which is looking at the clause from such a perspective would decide that the parties

chose to include the clause without the intention of it having some effect.

Repudiatory breach

Imagine that all conditions precedent to the contract’s completion have been fulfilled and that

the completion date has arrived. Now, the buyer alleges that the MAC clause has been

109 Ibid, para. 20 110 Beale, Chitty on Contracts, 2015, para. 13-057 111 Ibid, para. 13-058

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triggered 112 and refuses to proceed to completion. The seller argues that no MAE has

occurred and that the buyer will be in default if she refuses to complete the contract.

If on the facts no MAE has occurred, English law would hold that the buyer has renounced

the contract113 as the breach affects a fundamental term114. English law then requires that the

seller formally “accepts” the breach. Acceptance here means an acknowledgement that the

buyer is now in breach and must not be confused with a waiver of the buyer’s breach by the

seller.115 The seller is immediately relived of its obligations under the contract116 and, much

more importantly in this situation, is entitled to bring a claim against the buyer117.

So while English law employs rules of construction which ensure that a court remains as

close as possible to the agreement reached by the parties, much will depend on the terms of

the individual MAC clause and the decision to invoke it is not without risk for the buyer.

112 This paper assumes that the buyer has notified the alleged MAE to the seller in a way which complies with

all procedural requirements under the contract. 113 Beale, Chitty on Contracts, 2015, para. 24-018 114 Thomson, The effect of a repudiatory breach, Mod.L.Rev. 1978/41, p. 138 115 Beale, Chitty on Contracts, 2015, para. 24-023 116 Ibid, para. 24-024 117 Dawson, Metaphors and anticipatory breach of contract, Cambridge L.J. 1981/40, p. 104

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6. Judicial interpretations

There has been only very limited litigation of MAC clauses in English courts. Judges have

speculated that this is because “the interpretation of such provisions may be uncertain, proof

of breach difficult and the consequences of wrongful invocation […] severe, both in terms of

reputation and legal liability”.118

There are only five decisions of English courts regarding MAC clauses: (1) Grupo Hotelero

Urvasco v Carey Value Added119; (2) BNP Paribas v Yukos Oil Company120; (3) Attrill v

Dresdner Kleinwort121; (4) Thomas Witter v TBP Industries122; and (5) Levison v Farin123. All

of these are decisions of the High Court and therefore do not constitute binding precedents.

The first two cases deal with MAC clauses in a financing context, Attrill concerns the use of a

MAC clause in an employment dispute and the last two cases look at the concept of material

adverse change in agreements for the acquisition of companies.

These cases may therefore seem most relevant but are also the oldest, provide only limited

input on the interpretation of MAC clauses and deal with warranties regarding the absence of

MAEs, not MAC clauses outright. These cases will be reviewed first.

The financing cases will be reviewed next. Grupo Hotelero is the most recent case and

discusses MAC clauses in great detail while Yukos is a very short case regarding an interim

application and relies on facts which are rather extraordinary.

Finally, Attrill has some lessons to offer on construction but uses a form of MAC clause

which differs to quite some extent from what is to be expected in an M&A transaction.

As previously noted, decisions of the Takeover Panel, including WPP Group/Tempus

Group124 and the related Practice Statement No. 5125, sit outside the scope of this paper as

they primarily apply the rules of the Takeover Code and not those of English contract law.126

118 Queen’s Bench Division 26-04-2013, Grupo Hotelero Urvasco SA v Carey Value Added SL, [2013] EWHC

1039 (Comm), para. 334 119 Ibid 120 Chancery Division 24-06-2005, BNP Paribas SA v Yukos Oil Company, [2005] EWHC 1321 (Ch) 121 Queen’s Bench Division 09-05-2012, Attrill v Dresdner Kleinwort Limited, [2012] EWHC 1189 (QB) 122 Chancery Division 15-06-1994, Thomas Witter Ltd v TBP Industries Ltd, [1996] 2 All ER, p. 573 – 608 123 Queen’s Bench Division 04-11-1977, Levison v Farin, [1978] All ER, p. 1149 124 Takeover Panel, WPP/Tempus, 2001/15 [online] 125 Takeover Panel, Practice Statement No. 5, 2004 [online] 126 Cline & Trobman, Comparing the value of US and UK MAC clauses, Int’l Fin. L. Rev. 2002/21, p. 20

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Thomas Witter v TBP Industries

The underlying transaction in this case was the sale of a carpet manufacturing business.127

The main dispute before the court related to the alleged misrepresentation of a one-off item of

expenditure for the production of pattern books in the management accounts of the target.

This item was included with an amount of £120,000 when in reality it should have been only

£50,000 (i.e. £70,000 of recurring expenditure were disguised as one-off expenditure).128

Aside from this misrepresentation claim, the case also dealt with breaches of warranties

including a warranty stating that there had been no material adverse change in respect of the

target.129

This warranty was worded as follows: “Since the 31st December 1988 (but disregarding the

sale hereby agreed) … there has been no materially adverse change in the financial or trading

position of the Business”.130

This aspect of the case turned on whether “financial and trading position” was wide enough

to include the current profitability of the business or whether it was limited to the balance

sheet position of the business. The court held that “material” must be interpreted from the

purchaser’s perspective and, opting for the wider interpretation, held that there had been a

material adverse change as “what is “material” to [the buyer] is what matters”.131

Unfortunately, the court does not discuss what level of breach would be required to satisfy

the materiality requirement. The court merely holds that the discrepancy constituted “a

substantial amount” but does elaborate on this.132

It has to be noted that the breach of this warranty had little importance within the wider

context of the case as the claim and the award of damages were in respect of

misrepresentation133 and related to the preparation of the accounts under a separate provision

of the sale contract134.

127 Chancery Division 15-06-1994, Thomas Witter Ltd v TBP Industries Ltd, [1996] 2 All ER, p. 573 (d-g) 128 Ibid, p. 598 (g-h) 129 Ibid, p. 586 (c) 130 Ibid, p. 585 (g) 131 Ibid, p. 605 (c) 132 Ibid, p. 605 (d) 133 Ibid, p. 606 (a) 134 Ibid, p. 602 (a-b)

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This case therefore is not one in which the occurrence of an MAE could have afforded the

buyer a more advantageous right of termination than the doctrine of frustration. Regardless of

this, it finds that a MAC clause has to be interpreted from the perspective of the buyer even

though it fails to provide further guidance by simply stating that a “substantial” change will

be “material”.

Levison v Farin

The second claim in an M&A context regarded a warranty which stated that “there will have

been no material adverse change in the overall net assets of the company”.135 The target

business was a fashion company which was already loss making prior to the sale contract

being signed. It had also lost its chief designer to a long term illness and had therefore been

unable to design a new collection for the spring/summer season.

Both of these facts had been disclosed against the relevant warranty but the court held that

this disclosure was insufficient as it merely identified circumstances which were likely to

cause an MAE as defined by the warranty but did not quantify the expected impact.136

The issue of the buyer’s awareness of the circumstances causing the MAE will be discussed

in greater detail in the section on the Grupo Hotelero case. As far as Levison is concerned, it

suffices to note that the parties had identified a very specific criterion (a deterioration of the

target’s net asset value) which meant that the only question for the judge to answer was

whether any such decrease was on the facts material. This question was answered in the

affirmative, as the decrease went beyond “normal trade fluctuations”.137

While it seems plain that the judge preserved the intention of the parties, the adoption of a

very clearly defined evaluation criterion by the parties means that the clause in question is

much more akin to a specific MAC clause than to a general one.

The question that cannot be answered by this case is whether the same deterioration of one

key metric, the target’s net asset value, would have been sufficient to constitute an MAE had

it not been expressly identified and had the clause instead referred to a wider metric, such as

the financial position of the target.

135 Queen’s Bench Division 04-11-1977, Levison v Farin, [1978] 2 All ER, p. 1156 136 Woolrich, MAC clauses, J.I.B.L.R. 2014/29(6), p. 375 137 Queen’s Bench Division 04-11-1977, Levison v Farin, [1978] 2 All ER, p. 1156

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BNP v Yukos

In September 2003, a syndicate of banks led by BNP had made a loan available to Yukos.138

The case before Mr. Justice Evans-Lombe was an interim application by Yukos against the

main action brought by BNP in which it sought to recover the outstanding sum under the loan

agreement, amounting to $472,787,663.10, as a debt.139

The burden of proof was therefore not on BNP to demonstrate that an MAE had occurred but

on Yukos to demonstrate that it “would be able to deploy a defence to the claim which had a

real prospect of success”. If Yukos were successful, BNP would have to prove that an MAE

had occurred and that the outstanding debt was indeed due to BNP.140

BNP argued that an event of default had occurred under the loan agreement because the

MAC clause in the agreement had been triggered by events occurring at the end of 2003 and

in the beginning of 2004.141

The agreement set out that an MAE was any event which “in the opinion of [BNP]” could

have a material adverse effect on:

“(a) the business, condition or production or export capacity of the Group taken as a

whole;

(b) the ability of any of the Offtakers, the Borrowers (including in its capacity as the

Exporter), Energotrade, the Trader and the Trader’s Agent to perform its obligations

under any of the Finance Documents; or

(c) the legality, validity or enforceability of any of the finance documents or the rights

or remedies of any of the Finance Parties under the Finance Documents.”142

Limb (a) of this clause is similar to the general MAC clause introduced in Chapter 3 while

limbs (b) and (c) are considerably more specific and relate directly to the loan agreement in

which they are contained.

At the time when BNP had determined that an MAE had occurred, Yukos was facing

considerable difficulties. Its CEO had been imprisoned, the Russian Ministry of Natural

138 Chancery Division 24-06-2005, BNP Paribas SA v Yukos Oil Company, [2005] EWHC 1321 (Ch), para. 3 139 Ibid, para. 1 140 Ibid, para. 2 141 Ibid, para. 12 142 Ibid, para. 7

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Resources was considering the revocation of Yukos’ licence for operations within Russia, it

had been served with a claim for US$3.3bn in taxes for the year 2000 alone and its credit

ranking with Standard & Poor’s had been downgraded twice. Yukos had in fact issued a press

release in which it noted that further claims for historic tax were anticipated by Yukos and

that these claims could lead to its insolvency.143

Unfavourable as the situation may have seemed, Yukos argued that no MAE had occurred.

There were two strands to this argument. Firstly, that limb (a) of the MAE definition referred

to the Yukos group as a whole which was arguably in a better position than the Russian

business alone and, secondly, that Yukos’ ability to perform its obligations under the

agreement was only endangered by the tax claim against which Yukos expected to bring a

successful appeal.144

The court failed to agree with this argument145 as limb (b) of the MAE definition specifically

referred to individual members of the wider Yukos group146. The judge also placed particular

emphasis on the press release in which Yukos had warned investors of its possible

insolvency.147

As in Levison, the court held that an MAE had occurred but again relied on a relatively

specific evaluation criterion in the MAC clause. While the ability to comply with its

obligations under the finance documents leaves more room for interpretation than the

reference to net asset value in Levison, the facts in Yukos are so overwhelming that it seems

reasonable for the court to have held that there was no prospect for Yukos to defend the claim.

Yukos therefore does not provide a conclusive answer to the main question posed by this

paper but demonstrates that, at least in extreme circumstances, English judges are willing to

declare that MAC clauses have been triggered even if an element of discretion148 is involved.

Considering how extreme Yukos’ position was, it also seems reasonable to assume that the

court would have accepted that, if it had applied to the same individual entities as limb (b) did

instead of to the group as a whole, limb (a), the general MAC clause, would have been

triggered together with limb (b).

143 Ibid, para. 11 144 Ibid, para. 13.6 145 Ibid, para. 19 146 Ibid, para. 18 147 Ibid, para. 19 148 Consider that the court could have insisted on a closer investigation of Yukos chances of receiving a

favourable response to its appeal against the tax ruling.

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An invocation of the frustration doctrine on the other hand would not have been possible in

this case as no positive obligations, which could have been frustrated, remained for the lender

to perform.

Grupo Hotelero

The most recent of the cases reviewed in this paper is also the most factually complex.

For the purpose of this paper, the facts can be summarised as follows though: Grupo Hotelero

Urvasco (“GHU”) borrowed money from Carey to build a hotel and a block of flats in central

London.149 GHU undertook the London development through a wholly owned subsidiary,

Urvasco Ltd (“Urvasco”),150 and arranged for its own parent company, Grupo Urvasco SA

(“GU”), to provide a guarantee in respect of its obligations under the loan to Carey151.

Shortly after the start of the project, a banking crisis, known in the UK as the credit crunch,

began152 which severely affected GHU as a company which was both highly geared153 and

extremely exposed to the bursting of the property bubble in Spain which occurred at the same

time154.

On 6 June 2008 and following various concerns about the position of GHU having been

raised between the parties155156 and in the Spanish press157, Carey decided not to provide

GHU with the next funding tranche which was due under the loan agreement on that day158.

On 9 June 2008, Carey sent a letter to GHU in which the suspension of payment was justified

by reference to unspecified breaches of the loan agreement and a concern as to whether it

would be possible to complete the project on time.159 In response to this decision, GHU

149 Queen’s Bench Division 26-04-2013, Grupo Hotelero Urvasco SA v Carey Value Added SL, [2013] EWHC

1039 (Comm), para. 2 150 Ibid, para. 98 151 Ibid, para. 37 152 Ibid, para. 72 153 Ibid, para. 35 154 Ibid, para. 73 155 Ibid, para. 154 – 157 156 Ibid, para. 194 157 Ibid, para. 215 158 Ibid, para. 230 159 Ibid, para. 240

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subsequently suspended its work on the development.160 Finally, Carey terminated the loan

agreement.161

In the court proceedings that followed, Carey argued that its decision not to pay the tranche

due on 6 June 2008 was justified because the MAC clause of the agreement had been

triggered at this point. Carey cited “a substantial deterioration in the financial condition and

prospects of GHU, [Urvasco] and GU … based on a comparison of [their financial] position

as at 31 December 2006 with that as at 31 December 2007”.162

The clause required that in respect of GHU and Urvasco “there has been no material adverse

change in its financial condition (consolidated if applicable) since the date of this Loan

Agreement”.163

Carey also sought to rely on the MAC clause in a loan agreement between GHU and a third

party lender which gave the same representation as made in the Carey MAC clause in respect

of GU. Carey’s reliance on this second MAC clause was possible because of a cross-default

clause in its own loan agreement which meant that any default under the second loan

agreement automatically constituted a default under the Carey loan agreement as well.164

Unlike a MAC clause in an M&A agreement, the MAC clauses under the loan agreements

were not triggered by the mere occurrence of an MAE. Instead, GHU had to make a

representation that no MAE had occurred each time a drawdown was made under the relevant

loan agreement. The MAC clause would be triggered if GHU was unable to make the

representation.165

In construing the MAC clauses, Mr Justice Blair had to answer three questions of

construction before examining the facts. It was necessary to define: (1) what was meant by

“financial condition”; (2) to establish the threshold which would render an adverse change

“material”; and (3) to consider how to deal with pre-existing circumstances.

As to the first question, the addition of “(consolidated if applicable)” led the court to interpret

is as referring primarily to financial information such as accounts. While it was held that the

160 Ibid, para. 268 161 Ibid, para. 277 162 Ibid, para. 238 163 Ibid, para. 326 164 Ibid, para. 327 165 Ibid, paras. 322 & 344

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investigation should start there, it was also conceded that it does not have to stop there if

“compelling evidence” exists outside of the accounts. On the facts, the court held that this

was indeed the case and was willing to include GU’s decision to stop paying its third party

debts within the scope of its financial condition.166 The result of this decision was that the

expert evidence in the trial was given by accountants focusing on the accounts of the

borrower and not by bankers discussing market perceptions of what would amount to an

MAE.167

Regarding the second question, the court held that a change will be material if it

“significantly increases the risks assumed by the lender” with particular emphasis being put

on the word significant.168

On the third question, Mr Justice Blair had to decide whether Carey would be prevented from

relying on the clause in respect of any downturn affecting the Spanish property market as it

was aware that GHU was exposed to particular risks in this market.169 While Carey may have

been aware of the risk in general, the judge held that neither party would have been expected

to anticipate the extent which the crash would ultimately have and that therefore Carey did

not assume the risk of such an event happening.170

Following a review of the evidence, it was held that at the time when Carey refused to pay

the next tranche due under the loan no MAE had occurred in respect of GHU and Urvasco. It

was expressly held that there was no need to consider the companies’ ability “to pay future

prospective liabilities which it has not yet incurred”.171 This related in particular to any

liabilities which might arise under a number of derivative and foreign exchange contracts that

these companies had entered into.172 The key point from the judge’s perspective was that

“they did not result in a cash outflow”.173

GU on the other hand was held to have been affected by an MAE even though Mr Justice

Blair did not think that “the balance sheet position [was] decisive” and instead focussed on

166 Ibid, para. 350 – 352 167 Ibid, para. 393 168 Ibid, para. 356 – 357 169 Ibid, para. 358 170 Woolrich, MAC clauses, J.I.B.L.R. 2014/29(6), p. 376 171 Queen’s Bench Division 26-04-2013, Grupo Hotelero Urvasco SA v Carey Value Added SL, [2013] EWHC

1039 (Comm), para. 556 – 557 172 Ibid, paras. 503 – 505 173 Ibid, para. 497

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GU’s decision not to repay its other bank debts and the wider economic climate. 174 In

weighing the evidence, the court assigned very little weight to the press reports about GU’s

financial problems even though it was conceded that they played a role as the lender would

have been aware of and influenced by them.175 Much greater weight was attributed to reports

from GU’s directors as “these reports are contemporaneous, are made by the directors who

were in a position to know the facts and are made in a formal context”.176

The frustration doctrine could have applied to this case in principle as, unlike in Yukos, Carey

still had obligations to perform under the loan agreement. There were no circumstances

preventing Carey from performing its obligations in a way which would have been

recognised by the frustration doctrine though. The inclusion of the MAC clause (which only

failed to be triggered on a technicality177) therefore could have provided Carey with a more

advantageous position than would have been available without it.

Attrill

This is the case which is furthest removed from the scenario under discussion in this paper

and has only been included on account of the limited range of cases available. Attrill is an

employment case which deals with the question whether an investment bank was entitled to

make an already announced overall bonus subject to a subsequently imposed MAC clause.

Stefan Jentzsch, the CEO of Dresdner Kleinwort’s investment banking division, had

announced in August 2008 that a bonus pool of €400m would be available for members of his

division.178 In December of that year, employees received their bonus letters informing them

of their individual bonus entitlements. These letters now made payment of the bonus subject

to a MAC clause which had not been mentioned as part of the announcement in August.179

The precise wording of the MAC clause was as follows: “The provisional bonus award stated

above is subject to review in the event that additional material deviations in Dresdner

Kleinwort’s revenue and earnings, as against the forecast for the months of November and

December 2008, are identified during preparation of the annual financial statement for 2008

174 Ibid, para. 487 175 Ibid, para. 475 176 Ibid, para. 483 177 GHU did not have to make a representation under the second loan agreement when sending its drawdown

request to Carey and therefore had made no representation in respect of GU. See ibid, para. 558 178 Queen’s Bench Division 09-05-2012, Attrill v Dresdner Kleinwort, [2012] EWHC 1189 (QB), para. 6 179 Ibid, para. 8

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i.e. that Dresdner Kleinwort’s earnings position does not deteriorate materially in this period.

This will be reviewed in January 2009 by Stefan Jentzsch. […] the Company reserves the

right […] if necessary, to reduce the provisional award”.180

Much of the case turned on the question of whether Dresdner Kleinwort had been entitled to

include this clause at all181 which is of no importance to this paper. The main question is

whether a unilaterally imposed MAC clause can contribute to an answer to the main question

of this paper at all.

As Mr Justice Owen expressly relies on the rules for the construction of commercial contracts

as summarised in Rainy Sky v Kookmin, it seems that this case may be able to be of use

despite its context. Great care is necessary though as the court decided to apply the

construction most favourable to the employees as the MAC clause had been imposed

unilaterally.182 This may have led to a different outcome than if the exact same clause had

been the result of commercial negotiations between parties of equal strength but the issues in

contention are going to be the same and may prove instructive.

As in Levison, concrete financial metrics are identified in the MAC clause in the form of

revenue and earnings for the months of November and December. On the facts, the

interpretation of the clause did not turn on the question materiality (“material” was construed

as to mean “not de minimis”183) but on two benchmarking and three process questions.

The first benchmarking question concerned whether the relevant forecast against which

further deteriorations of the two metrics had to be shown was contained in a management

forecast for November or in a projection of results which had been circulated throughout the

firm earlier in December.184 Including a reference to a forecast without clear identification

thereof is much more an issue of sloppy drafting than a matter which is capable of clarifying

whether MAC clauses in themselves are capable of effectively documenting the intention of

the parties. In this case, using the most up to date forecast made both commercial sense and

complied with the requirement of interpreting the clause in favour of the employees which

avoided any conflict between these two principles.185

180 Ibid, para. 64 181 Ibid, para. 192 182 Ibid, para. 245 183 Ibid, para. 242 184 Ibid, para. 234 185 Ibid, para. 246

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The second benchmarking question contained the “if necessary” in the MAC clause. This was

construed as precluding the bank from making any adjustments to the bonuses, even if the

required deterioration of revenue and profit had occurred, unless it was practically incapable

of paying the bonuses.186 This again appears to be an example of bad drafting in which the

bank imposed much stricter conditions on itself than intended.

The first process question was also one of contractual interpretation. Was the bank entitled to

reduce the overall bonus pool of €400m or only to reallocate the individual bonuses if the

MAC clause had been triggered? The court rightly held that the language of the MAC clause

did not allow for it to be read in a way that permitted the bank to reduce the overall bonus

pool.187 The “this” at the beginning of the second sentence of the clause as quoted clearly

refers to the individual bonuses.188 Should a different meaning have been intended when the

letters were drafted, this would constitute the third example of poor drafting in this clause.

The second and the third process point are best reviewed in conjunction. Contrary to the

provisions of the bonus letter, the individual rewards were not reviewed by Stefan Jentzsch

and the review took place in February instead of January 2009.189 The former was seen as

another fatal breach of the terms of the MAC clause190 as his involvement had been seen as

an important safeguard to ensure procedural fairness191. The latter in itself expressly would

not have been able to defeat the application of the MAC clause.192

In summary, Dresdner Kleinwort attempted to impose a badly drafted MAC clause on its

employees in an unlawful manner. It subsequently breached the terms of the MAC clause

when attempting to rely on it. The most meaningful lesson from this case seems to be that a

court is willing to accept minor procedural breaches, such as the delay of the bonus

assessment, if these do not unduly prejudice the other party.

By including “if necessary” in the MAC clause, Dresdner Kleinwort put itself in a position

which was no more advantageous than had it merely been able to rely on the doctrine of

frustration.

186 Ibid, para. 247 187 Ibid, para. 251 188 Ibid, para. 253 189 Ibid, para. 280 190 Ibid, para. 278 191 Ibid, para. 256 192 Ibid, para. 283

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Analysis

Chapter 4 has already identified the problems faced by a buyer seeking to rely on the doctrine

of frustration to escape a private M&A contract following a change of circumstance. The

review in this chapter of the limited case law which is available regarding MAC clauses

demonstrates that judges construe these clauses in light of the general rules of contract

interpretation applying under English law.

This includes a tacit acknowledgement of one of the assumptions of the revised theory of

efficient breach which is that parties will bargain for contractual provisions just as they

bargain about the sale price.193 If a clause identifies only one criterion against which any

event is measured to establish whether it triggers the MAC clause, then this is what the courts

will do, as they did in Levison. If a wider metric is chosen, as in Hotelero, the courts will use

this metric but attribute more weight to the elements which the parties saw as the core issues

if these can be identified.

In either case, the courts, as was noted in Thomas Witter and Hotelero, will review the event

from the perspective of a reasonable bystander but will ask the question whether the relevant

event is material to the buyer.

But it is the question of materiality which introduces the key element of uncertainty and only

truly extraordinary circumstances, as in Yukos, will allow a party to be reasonably certain that

a successful claim is possible.

These cases nevertheless demonstrate that a buyer who has been able to introduce a MAC

clause into an English law agreement for a private acquisition will be in a considerably

stronger position compared to a case where the only “exit route” is the doctrine of frustration.

The one exception is the case of Attrill which can be discounted considering that poor design

and drafting will be fatal to any clause. The clause in Attrill is indeed so flawed and the

circumstances are so particular that its inclusion in this paper is owed purely to the paucity of

available case law.

The decided cases also demonstrate that the courts do pay attention to the various ways in

which MAC clauses can be drafted in a tighter or narrower way which were identified in

193 Klass, Efficient Breach, in Philosophical Foundations of Contract Law, 2014, p. 380

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Chapter 3. While the parties will not know the absolute chances of success for a claim, they

will be aware of the relative strength of the MAC clause in question.

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7. Conclusion

The findings of this paper suggest that the inclusion of a MAC clause in an English law

M&A contract is an effective choice of an ex ante self-help remedy by the buyer.

Without such a clause, the buyer could only rely on the doctrine of frustration where the

target is subject to a catastrophic event between exchange and completion of the contract.

This doctrine is unlikely to allow the buyer to walk away from the contract in this scenario.

A MAC clause on the other hand does offer the buyer this option as long as the relevant event

constitutes an MAE under the clause. Considering the rules of interpretation of English

contract law, even a MAC clause in a general form without any specifically identified MAEs

will be certain enough to be capable of enforcement in principle.

The buyer therefore can either walk away from the contract and rely on the clause to protect

herself from any attempt by the seller to sue for performance of the contract or she can use

this theoretical course of action to re-negotiate the purchase price in light of the MAE.

Only a very small number of cases involving MAC clauses have been brought before the

English courts. It is not clear though whether this is an indication of such re-negotiations

happening or whether it reflects the presumably very low number of cases in which a target is

subject to an MAE between exchange and completion. Further research into this question, for

example through a questionnaire aimed at professional advisers and serial deal-doers such as

private equity houses, would be needed to fully understand the value of MAC clauses in

English M&A transactions.

While such research into the precise practical value of MAC clauses would be useful, it

appears that these clauses improve the position of a buyer compared to her position at

common law. This is supported at first glance by their inclusion in one third of all relevant

contracts and the absence of any academic contributions arguing that they are not effective.

This is also consistent with the case law reviewed in this paper. While the courts did not

always find that the MAC clause in question had been triggered, no judge found that the

MAC clause before them was incapable of being triggered at all.194

194 Even though the clause in Attrill was drafted so badly that it would only have applied in a situation in which

relief under the doctrine of frustration would arguably also have been available.

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Using Klass’ restated theory of efficient breach as the evaluation criterion, a MAC clause in

an English law M&A contract is therefore economically efficient as it allows the parties to

include a (self-help) remedy in the contract which is capable of being honoured by the courts.

In addition to research into the prevalence of (alleged) MAEs in practice, further research

into the “price”195 paid by buyers for the inclusion of such a clause in a contract would be of

interest.

195 Presumably in the form of concessions on other contract terms.

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Table of Cases

Chancery Division 24-06-2005, BNP Paribas SA v Yukos Oil Company, [2005] High Court of

Justice 1321 (Chancery Division)

Chancery Division 15-06-1994, Thomas Witter Ltd v TBP Industries Ltd, [1996] 2 All

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2 King’s Bench Law Reports, p. 683

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Servant Two), [1990] 1 Lloyd’s Reports 1,

Court of Appeal (Civil Division) 11-08-1902, Paul Krell v CS Henry, [1903] 2 King’s Bench

Law Reports, p. 740

House of Lords 01-07-2009, Chartbrook Ltd and another v Persimmon Homes Ltd and

another, [2009] United Kingdom House of Lords 38

House of Lords 19-04-1956, Davis Contractors Ltd v Fareham Urban District Counsel,

[1956] Appeal Cases, p. 696

House of Lords 19-05-1944, Denny, Mott & Dickson Ltd v James B Fraser & Co Ltd, [1944]

Appeal Cases, p. 265

House of Lords 15-06-1942, Fibrosa Spolka Akcyjna v Fairbairn Lawson Combe Barbour

Ltd, [1943] Appeal Cases, p. 32

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Supreme Court 02-11-2011, Rainy Sky SA v Kookmin Bank, [2011] UK Supreme Court 50

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Queen’s Bench Division 09-05-2012, Attrill & Others, Anar & Others v Dresdner Kleinwort

Limited, Commerzbank AG, [2012] High Court of Justice 1189 (Queen’s Bench

Division)

Queen’s Bench Division 26-04-2013, Grupo Hotelero Urvasco SA v Carey Value Added SL

(Formerly Losan Hotels World Value Added I SL) & London Value Added I Limited,

[2013] High Court of Justice 1039 (Commercial Division)

Queen’s Bench Division 04-11-1977, Levison v Farin, [1978 ] 2 All England Law Reports, p.

1149