Podcast: Recent developments on the use of MAC clauses in secondary transactions
Click here to listen to the audio.
In this Ropes & Gray podcast, asset management partners Joel Wattenbarger and Jason Brown discuss the regulatory implications of recent enforcement actions involving management fee calculation and netting issues, as well as their respective regulatory requirements. keeping records of electronic communications. The Private Funds Regulation Update is a series of podcasts covering key topics of interest and updates in the area of regulation and compliance, with a particular focus on private fund managers.
In this Ropes & Gray podcast, asset management partners Emily Brown, Isabel Dische, Adam Dobson and Vincent Ip, and litigation and enforcement partner Martin Crisp, discuss recent trends in the use of change clauses material adverse (or MAC) and “ordinary price”. operating covenants in secondary transactions, and provides 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 to asset managers and institutional investors. I’m Adam Dobson, a partner in our Boston-based asset management group. With me today are my colleagues Isabel Dische, Martin Crisp, Emily Brown and Vince Ip, from our offices in New York, London and Hong Kong respectively. Today we are going to talk about material adverse change clauses and “in the ordinary course of business” operating clauses and, in particular, provide some context on how these provisions and purchase agreements can be interpreted. in the light of recent events in Ukraine.
Isabel, would you like to kick off our discussion with a brief overview of these clauses and some of the recent trends we have seen in their use in the secondary market?
Isabelle Dische: Gladly. Very briefly, material adverse change (or MAC) clauses appear in secondary transaction agreements in two typical ways. The first, and most common, would be to include a MAC qualifier on some of the representations in the agreement. For example, a statement about an underlying holding company may be read so that the holding company is not in default under any of its contractual arrangements, except for defaults that would not individually cause or overall a MAC.
It would be less common to include a MAC closing condition for a transaction, expressly stating that the performance obligations of the buyer are conditioned on the absence of a material adverse change. The use of MAC clauses in this context has been quite rare in recent years, but over the past couple of months we have seen these clauses creep into a number of letters of intent and term sheets for transactions, as buyers try to hedge against the market. uncertainty. And over the past two weeks, we’ve seen more and more questions about it. It’s worth pointing out that we still only see MAC clauses in a small minority of transactions, but it’s a trend that seems to be accelerating with events in Ukraine.
Vince IP: Yes. Unsurprisingly, buyers are including MAC clauses to hedge against fundamental assumptions behind a deal eroded by market events. In many ways, the recent increase in this use of MAC clauses mirrors what we observed in Asian markets in late 2019 and early 2020 as parties responded 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 these days, other details regarding the scope of a MAC clause can be very important. , depending on the industry sector of the underlying assets concerned.
Martin, I know there was quite a bit of MAC-related litigation at the start of the COVID-19 pandemic. Does this give any insight into how parties should think about implementing MAC clauses in their contracts today?
Martin Crisp: It does. Ultimately, MAC clauses are only about the contractual allocation of risk. Typically, MAC clauses allocate general market or industry risks to the buyer and company-specific risks to the seller. For example, MAC clauses have historically cut out events like war, natural disasters, or global pandemics. From late 2019, however, the parties have of course focused more broadly on pandemic language, including intense negotiations over whether these exceptions should include language indicating that a pandemic could not constitute a material adverse change only if it had a disproportionate impact on the seller. to others in his industry.
The major MAC cases stemming from the COVID pandemic have taught us some important lessons. Firstthe DecoPac The Delaware Court of Chancery decision showed that the law still requires the seller to experience an adverse change that is consequential to the seller’s business and occurs over a “significant period of time.” A short-term hiccup in earnings is not a MAC. As we are only in the early days of the conflict in Ukraine, it is important to keep this requirement in mind. Second, there can be more than one applicable exception in a MAC clause. For example, sellers have often invoked global pandemic exceptions and exceptions regarding changes to applicable local laws, which they successfully argued included COVID-motivated local lockdown orders. Maximizing the number of applicable exclusions of course benefits sellers, while limiting these exceptions will be important for buyers with this concern. The thirdthe MAC language requiring the adverse change to have a disproportionate impact on the seller is essential for sellers, as it provides an additional layer of protection for companies operating in industries that are impacted by the relevant global event. And finally, specificity is essential. Do not assume that courts will infer contractual rights in agreements negotiated by sophisticated parties. Courts assume and will assume that MAC clauses were specifically drafted to allocate risk and will interpret them accordingly.
Emily Brown: In a similar vein, we’ve been answering a number of customer questions regarding “normal operations” covenants, particularly over the past few weeks when nothing in Europe seemed to be “normal”. For example, we have seen clients wanting to be much more specific about the relevant period to assess what constitutes normal operations and/or define objective criteria, for example, considering that contracts above a given threshold are not not, by definition, in the ordinary course. Secondary buyers are looking at these clauses with a much more rigorous eye in live negotiations than they might have done even six months ago.
Martin Crisp: Normal course clauses are critical because courts have treated them as separate closing terms, even when the underlying events do not constitute a contractual MAC. For example, in the AB stable decision, which concerned the sale in 2020 of a portfolio of luxury hotels, the Court of Chancery of Delaware do not finding that the seller had suffered a material adverse change. However, the Court rejected the seller’s argument that the MAC clause had effectively transferred all pandemic risk to the buyer and independently assessed the normal course undertaking, which was not MAC qualified.
The Court found that the COVID-induced lockdown orders caused the vendor to operate its hotels inconsistently with its historical practices, which violated the normal course undertaking. This may seem like a difficult outcome, but it shows that courts will focus on clear contractual language and that it is essential that sellers negotiate plain language that does not undermine their heavily negotiated MAC clauses. For example, sellers in COVID-era transactions fought to have “ordinary course” defined by reference to what was ordinary for their industry given the pandemic, or to include specific exclusions allowing them to act in accordance with government orders. Clients engaging in transactions involving industries that may be affected by the conflict in Ukraine should negotiate these clauses carefully, keeping in mind how a court will interpret the plain language of these provisions.
Adam Dobson: Of course, including carefully crafted MAC and “normal course of business” clauses in contracts may represent careful and defensive planning, but as Martin described it, determining whether a MAC or breach of a “normal course of operations” has occurred remains subjective, and proving either in court remains difficult. We are likely to see growth remain focused on single asset transactions where alleged impairment is more clearly discernible than in portfolio transactions, as it is easier to identify a causal link in single asset transactions than in sales where a diverse set of assets is to be sold. Additionally, in the relatively small secondary buyer market where many companies are recurring players on both sides, any individual buyer may be hesitant to call a MAC for fear of risking future deal flow from sellers and brokers who are reluctant to add perceived execution risk to their trades. . Either way, we’ll likely see continued development in this area as technology from the M&A world continues to seep into the secondary market.
Needless to say there is 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 we have 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 all the topics we’ve discussed – please don’t hesitate to contact us. 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.