Podcast: Recent Developments on the Use of MAC Clauses in Secondary Transactions
In this Ropes & Gray podcast, asset management partners Emily Brown, Isabel Dische, Adam Dobson and Vincent Ip, and litigation & enforcement partner Martin Crisp, discuss recent trends in the usage of material adverse change (or MAC) clauses and “ordinary course” operating covenants in secondary transactions, and provide some context on how these provisions may be interpreted in light of recent events in Ukraine.
Adam Dobson: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I’m Adam Dobson, a partner in our asset management group based in Boston. Joining me today are my colleagues Isabel Dische, Martin Crisp, Emily Brown and Vince Ip, from our New York, London and Hong Kong offices respectively. Today, we are going to be talking about material adverse change clauses and “ordinary course” operating covenants and, in particular, providing some context on how these provisions and purchase agreements may be interpreted in light of recent events in Ukraine.
Isabel, would you like to kick off our discussion with a quick overview of what these clauses are and some of the recent trends we’ve observed in their usage in the secondaries market?
Isabel Dische: Gladly. Very briefly, material adverse change (or MAC) clauses arise in secondaries transaction agreements in two typical ways. First, and more common, would be to include a MAC qualifier on certain of the representations within the agreement. For example, a representation about an underlying portfolio company might be read so that the portfolio company is not in default under any of its contractual arrangements, except for such defaults as would not individually, or in the aggregate, cause a MAC.
Less common would be to include a MAC closing condition for a deal, expressly saying that the buyer’s performance obligations are conditioned upon no material adverse change having occurred. The usage of MAC clauses in this context has been fairly uncommon in recent years, but in the past two months, we have seen these clauses creep into a number of letters of intent and term sheets for deals, as buyers try to protect themselves against market uncertainty. And in the past couple of weeks, we’ve seen increasing questions around this. It is worth stressing that we are still seeing MAC clauses in only a small minority of deals, but it is a trend that seems to have been accelerating along with events in Ukraine.
Vince Ip: Yes. Not surprisingly, buyers are including the MAC clauses to hedge against core assumptions behind a deal being eroded by market events. In many ways, the recent uptick in this use of MAC clauses mirrors what we observed in the Asian markets in late 2019 and early 2020 as parties reacted to the emerging COVID-19 pandemic. What we have seen in Asia is that while a COVID-19 MAC is not unusual in M&A transactions nowadays, other details around the scope of a MAC clause can very quite significantly, depending on the industry sector of the relevant underlying assets
Martin, I know there was a fair bit of MAC-related litigation at the outset of the COVID-19 pandemic. Does that provide insight into how parties should think about implementing MAC clauses into their contracts today?
Martin Crisp: It does. Ultimately, MAC clauses are all about the contractual allocation of risk. Typically, MAC clauses apportion general market or industry risks to the buyer, and company-specific risks to the seller. For example, MAC clauses have historically carved out events like war, Acts of God, or global pandemics. Starting in late 2019, however, parties of course focused more extensively on the pandemic language, including intense negotiations on whether such carve-outs should include language stating that a pandemic could constitute a material adverse change only if it impacted the seller in a manner disproportionate to others in its industry.
The key MAC cases arising from the COVID pandemic taught us a few important lessons. First, the DecoPac decision from the Delaware Court of Chancery showed that the law still requires that the seller experience an adverse change that is consequential to the seller’s business and which occurs over a “durationally significant period.” A short-term hiccup in earnings is not a MAC. Given that we are in the earliest days of the Ukraine conflict, it’s important to keep that requirement in mind. Second, there can be multiple applicable exceptions in a MAC clause. For example, sellers often invoked global pandemic exceptions and exceptions concerning changes in applicable local laws, which they successfully argued included COVID-driven local lockdown orders. Maximizing the number of applicable carve-outs of course benefits sellers, while limiting those exceptions will be important for buyers with this concern. Third, MAC language requiring the adverse change to disproportionately impact the seller is critical for sellers, as it provides an additional layer of protection to businesses operating in sectors that are affected by the relevant global event. And lastly, specificity is key. Do not presume that courts will infer contractual rights in agreements negotiated by sophisticated parties. Courts have and will presume that MAC clauses were specifically drafted to allocate risk, and will interpret them accordingly.
Emily Brown: Related, we’ve been fielding a number of questions from clients around “ordinary course operations” covenants, particularly in the past few weeks when nothing in Europe has seemed to be “ordinary course.” For example, we have seen clients want to be much more granular around the relevant time period for assessing what constitutes ordinary course operations and/or setting objective criteria—for example, deeming contracts above a given threshold to by definition not be ordinary course. Secondary buyers are looking at these covenants with a much more rigorous eye in live negotiations than they might have done even six months ago.
Martin Crisp: Ordinary course covenants are critical, as courts have considered them to be separate closing conditions even when underlying events do not constitute a contractual MAC. For example, in the AB Stable decision, which concerned the 2020 sale of a portfolio of luxury hotels, the Court of Chancery in Delaware did not find that the seller had experienced a material adverse change. However, the Court rejected the seller’s argument that the MAC clause had effectively shifted all pandemic risk to the buyer, and independently evaluated the ordinary course covenant, which was not MAC-qualified.
The Court concluded that COVID-induced lockdown orders caused the seller to operate its hotels inconsistently with its historical practices, which violated the ordinary course covenant. This can seem like a harsh outcome, but it shows that courts will focus on plain contractual language and that it is critical for sellers to negotiate for ordinary course language that does not undermine their heavily-negotiated MAC clauses. For example, sellers in COVID-era transactions fought hard for “ordinary course” to be defined in reference to what was ordinary for their industry given the pandemic, or to include specific carve-outs allowing them to act in compliance with government orders. Clients engaging in transactions involving industries likely to be effected by the conflict in Ukraine should negotiate such clauses carefully, with an eye towards how a court will read the plain language of those provisions.
Adam Dobson: Of course, including carefully drafted MAC and “ordinary course operations” clauses in contracts can represent prudent and defensive planning, but as Martin has described, identifying whether a MAC or a breach of an “ordinary course of operations” has occurred remains subjective, and proving either in a court of law remains difficult. We’re likely to see the growth remain focused on single asset transactions where the alleged impairment is more clearly discernable than in portfolio transactions because it is more straightforward to identify a causal link in single asset transactions than in sales where a diverse set of assets is being sold. Moreover, in the relatively small secondary buyer market where many firms are repeat players on both sides, any particular buyer may be wary of calling a MAC lest it risk future deal flow from sellers and brokers who are reluctant to add perceived execution risk to their transactions. In any event, we’re likely to see continued development in this area as technology from the M&A world continues to filter into the secondary market.
Needless to say, there’s a lot to consider. Thank you, Isabel, Vince, Emily and Martin, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed—please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.