October 30, 2019
It is quite common in both business merger or acquisition and financing agreements to include “material adverse change” clauses, which allows to one of the parties to terminate the agreement when, between the signing of the contract and the closing of the transaction, its context or the conditions agreed change abruptly. However, Argentine jurisprudence is almost inexistent in the matter so it is necessary to resort to North American jurisprudence; which, has recently issued a ruling that provides certain parameters that can serve as a guide when negotiating this type of clause.
It is quite common in both business acquisition and financing processes that the signing of the contract and other transactional documents and the closing of the transaction are performed on a deferred basis. Therefore, it may happen that, in such period of time, the context of the transaction abruptly varies and the previously agreed conditions cease to be those foreseen for one of the parties. It is under such scenario that the material adverse change clauses (better known as "MAC clauses") take on a crucial role.
Is it still convenient for a foreign buyer to acquire a company in Argentina that is not going to be able to access the foreign exchange market to pay dividends to its shareholders? Is an international oil company still interested in buying a line of business in Argentina after the price of fuel was tightened by the government? Should the fact that the currency depreciates 35% in one day be considered an adverse material change?
It is for these reasons that it is essential to understand the scope of MAC clauses and avoid the termination of agreements by finding one of the parties, usually the buyer, a way out thanks to the incorporation of such clauses in contracts.
However, even though it is common to find in the local market contracts that include them, Argentine jurisprudence is almost inexistent in the matter, which generates great uncertainty when applying them. Therefore, it is appropriate to resort to North American jurisprudence; which, while not having too many precedents on this subject either, has recently issued a ruling that provides certain parameters that can serve as a guide when negotiating this type of clause.
Since the beginning of the financial[JMR1] crises, significant importance has been given to materially adverse change clauses that seek to mitigate the risk inherent in an acquisition, merger or investment transaction, where circumstances with a substantial negative effect may affect the transaction and may therefore result in some of the parties no longer being interested in continuing the transaction. As mentioned, these clauses become take on more importance in those operations that have what is known as a closing deferred in time, that is, when the same is instrumented chronologically through two different moments: (i) the signing of the agreement; and (ii) the closing itself.
Within an agreement, a MAC clause may be found as a condition, representation, or both. As a closing condition, this type of clause allows the buyer not to close the transaction if the business to be acquired suffers a MAC between a reference date (such as the signature) and the closing date. As the seller's representation, a MAC clause states that the seller's business has not suffered a MAC between the reference date and closing, plus a closing condition that allows the buyer to withdraw from the transaction if such representation is false on the closing date.
The contractual allocation of pre-closing risk between the parties is a key issue in this type of particularly complex agreements, given that the dynamics of the seller's own business, as well as that of the market in which it operates, could give rise to changes that could affect the economic and legal objective of the parties in executing the agreement. This need for the parties to protect themselves against unexpected and unpredictable circumstances during the intervening period is even more relevant in situations of great economic, political and social insecurity and uncertainty, as is currently the case in Argentina.
But what exactly is an "adverse change"? How is its materiality defined? Unfortunately, neither caselaw nor jurisprudence provide a specific answer to these questions, so the context of each specific operation must be analyzed to try to answer them. With this in mind, special attention must be paid to the wording of the definition agreed upon by the parties, which may be broad or rather specific. In general terms, purchasers will advocate a broad MAC clause allowing them to terminate the agreement when adverse events make the acquisition unattractive. Sellers, on the other hand, will attempt to negotiate a narrow MAC clause to displace the risks of closing the sale of their business.
Many authors consider that MAC clauses have some relation to the theory of frustration of the purpose of the contract, which can be defined as "a specific cause of termination of contracts, operating when a normal event, occurring outside the will of the parties, not caused by any of them and not arising from the risk that the party invoking it has taken charge of, prevents the satisfaction of the purpose of the contract that would have been part of the declaration of intent”.
This theory, unlike the MAC clauses as has been mentioned above, has been developed for many years by caselaw and Argentine jurisprudence and was recently incorporated in the Argentine legislation, specifically in article 1090 of the Argentine Civil and Commercial Code, sanctioned by Law N°26.994, which establishes that "The definitive frustration of the purpose of the contract authorizes the aggrieved party to declare its termination, if it has its cause in an extraordinary alteration of the circumstances existing at the time of its conclusion, alien to the parties and that exceeds the risk assumed by the affected party. The resolution is operative when this party communicates its extinctive declaration to the other party. If the frustration of the purpose is temporary, there is a right to resolution only if the timely fulfillment of an obligation whose execution time is essential is prevented.”
The law establishes that the following requirements must necessarily be met for the legal business to be considered frustrated and therefore resolved: (i) the alteration that gives rise to it must be extraordinary, foreign to the parties and must overcome the risk assumed by the affected party, (ii) its extinctive declaration must be communicated by the affected party to the other, and (iii) the frustration must be definitive and not temporary, unless such frustration prevents the timely performance of an obligation with essential execution time.
The legislative reception of this theory is considered a great advance for the market, which allows the parties of a purchase agreement to have a viable alternative to resolve the agreement when the negotiated conditions are considerably modified by external factors. However, the law omits mentioning, for example, which is the scope of application of such theory or which is the purpose that must necessarily be violated for the contract to be considered frustrated and give the right to its termination.
The significance of this case lies in the fact that, for the first time, the Delaware Court of Chancery, one of the most sophisticated courts in the United States and a landmark in commercial matters for other courts in that country, considered that an adverse material change had occurred in an M&A transaction which, in combination with other violations of the merger agreement, allowed the buyer to resolve the same and withdraw from the transaction.
The dispute arose from the proposed sale of Akorn Inc., a U.S. manufacturer of generic drugs, to the German pharmaceutical Fresenius Kabi for USD 4.75 billion, which occurred in April 2017 in the signing of a merger agreement between the parties. Fresenius' obligation to close the transaction was subject to certain conditions, including that Akorn did not suffer a material adverse change between the date the agreement was signed and the closing.
In addition to the closing conditions, the merger agreement provided, among other things, Fresenius' right to terminate the contract if Akorn's representations and warranties included in the merger agreement were not true and correct, except when non-compliance with such representations and warranties could reasonably be expected to result in the occurrence of a MAC. In addition, Fresenius could also terminate the agreement if Akorn failed to meet its commitments under the agreement, including its obligation to operate the business in its ordinary course in all material respects. To exercise its right to terminate the agreement, Fresenius could not be in material non-compliance with its own assumed obligations.
However, as a consequence of a precipitated and sustained decline in Akorn's financial performance following the signing of the agreement, of a severe non-compliance by Akorn with the representations and assurances of regulatory compliance provided therein (which were reported to Fresenius through two anonymous letters received) and of Akorn's failure to take the reasonable necessary steps to rectify this regulatory deficiency, Fresenius invoked the MAC clause under the merger agreement on April 22, 2018, deciding to terminate the contract, arguing that Akorn had suffered an adverse material change that relieved Fresenius of its obligation to close the transaction. Akorn, for its part, initiated legal actions against Fresenius with the aim of being forced to continue with the merger agreement entered into.
The Court, in its judgment of October 1, 2018, held that an adverse material change, as defined by what the parties had agreed to in the merger agreement, had occurred, and that Fresenius was therefore fully entitled to decide to terminate the agreement. This decision was later upheld by Delaware Supreme Court on December 7, 2018.
Undoubtedly, the importance of the case lies in that it provides certain guidance as to how the provisions of an adverse material change should be construed and interpreted and what types of facts and circumstances must be presented to constitute a default such that an M&A agreement is terminated.
For example, among other issues, the importance of making a literal interpretation of the language specifically used by the parties in drafting the MAC clause and not relying on general interpretations of what those provisions usually mean or how they are typically operated is highlighted. It also provides that for a MAC assumption to be perfected, there must be a sustained and severe decline in the seller's business not attributed to the general economy or industrial factors and that a simple "misstep" in financial performance would not be sufficient, which is consistent with the opinion in other similar rulings under Delaware law. Namely, the magnitude of the adverse change must be viewed from the standpoint of a reasonable purchaser, both quantitatively and qualitatively.
In a similar way, the Court determined that Fresenius even had the power to terminate the merger agreement, even if the MAC case had not been finalized, since Akorn failed to conduct its operations between the signing and closing of the transaction in the "ordinary course of business," establishing that companies in a merger or acquisition process must operate as a company in the same industry would reasonably do under similar circumstances. In other words, operating in the "ordinary course of business" does not only imply maintaining the status quo but that companies must react reasonably and appropriately to new circumstances, regardless of the fact that a merger agreement has been entered into.
In addition, the Court concluded that under Delaware law, there is no hierarchy among the commonly referred to as "best effort clauses," which are those clauses that are usually included in contracts to force the parties to make their best attempt to meet a particular objective, especially when there is some uncertainty as to the possibility of achieving that objective. Accordingly, all provisions requiring "best efforts", "reasonable best efforts" or "commercially reasonable efforts" demand that the party involved takes all reasonable steps to comply with that obligation. If the parties want a higher or lower standard or simply want greater certainty as to what is considered "reasonable steps," they should consider elaborating a commitment in the agreement that details the specific actions that the parties are obliged to take.
Finally, the Court considered that after the signing of the merger agreement, and despite its growing concerns as to the economic viability of the transaction, Fresenius remained committed to the transaction and continued to comply with its obligations under the merger agreement since, for example, it continued to work on notifying the antitrust authorities, offered Akorn an opportunity to correct any inaccuracies in Fresenius' understanding of the company's financial situation and regulatory issues, and even offered to extend the closing date in case that Akorn felt it could rectify the situation. This buyer's attitude was of vital importance to the Court considering that if Fresenius had breached its obligation to use its reasonable best efforts to close the deal, it would not have been allowed to terminate the merger agreement.
In conclusion, MAC clauses can be useful for parties to regulate the uncertainty inherent in complex transactions such as acquisitions, especially for transactions in Argentina where economic, political and social uncertainty and legal insecurity give it an uncertain direction.
However, the absence of local jurisprudence and caselaw on this subject and the ambiguity that the materiality of such clauses presents can cause certain difficulties in its interpretation. Therefore, their effectiveness and consequences will depend basically on the precision that the parties give to their wording.
It may also be useful to refer to U.S. jurisprudence, and use the above case as a guide when negotiating the inclusion of a MAC clause in an agreement, regardless of the jurisdiction in which the parties are located.
While "Akorn v. Fresenius" is the first case in the Delaware Court to find that a MAC occurred and to allow a party to terminate a merger agreement based on the existence of the MAC, the facts that lead to a MAC remain extreme. The decision suggests that future disputes over similar provisions should place special emphasis on the context of the transaction and that extreme facts will be required before the Court reaches a conclusion similar to the ruling in commentary.
 RIVERA, Julio C., The relationship between the purpose of frustration and the theory of unpredictability, El Derecho, Argentina, t. 179, p. 61ss.
This article is a brief comment on legal news in Argentina; it does not purport to be an exhaustive analysis or to provide legal advice.