A change does not always do you good…

06 April 2023

The court assesses what amounts to a “material adverse change” on an acquisition of a business.

This article has since been superseded by a decision of the Court of Appeal. Read our in-depth piece on the Court of Appeal’s decision in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWCA Civ 1284.

The High Court has held that sellers of the shares in a company breached a warranty that there had been no material adverse change (MAC) in the company’s prospects. In doing so, the court provided valuable guidance on how MAC warranties are likely to be assessed.

Three key take-aways
  • A MAC clause allows a party to walk away from a commercial transaction or seek compensation if some event has happened that has had a material adverse effect.
  • There is no single meaning of “material”. The courts will decide what this phrase means and whether an event is material by looking at the specific facts of each individual case.
  • However, in the context of a business acquisition, the courts are, in practice, likely to start by looking at any long-term economic impact on the target business.

Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch) concerned the sale by two individuals of the shares in an IT consulting company to a corporate buyer.

To this end, as is usual, the parties entered into a sale and purchase agreement (SPA) in relation to the shares in the company.

Again, as is usual, in the SPA the sellers gave various contractual warranties to the buyer regarding the state of the company’s business. These included (among others) the following warranty:

Since the Accounts Date … there has been no material adverse change in the turnover, financial position or prospects of the Company.

The SPA also contained a warranty from the buyer stating as follows:

The Buyer warrants that it has no actual knowledge at the date of this Agreement of any fact, matter or circumstances constituting a breach of Warranty save as Disclosed.

This clause – often termed an “anti-sandbagging clause” – is designed to ensure that a buyer cannot walk into an acquisition when it is fully aware of breaches of warranty, then simply claim compensation after the sale. Instead, the buyer should factor any known issues into the purchase price.

As the judgment explains, the company’s business was heavily dependent on continually winning significant new mandates from customers. As a result, revenue was often produced in batches and the company’s prospects measured principally by reference its “pipeline” of new and potential jobs.

Over the course of the negotiations leading up to the SPA, the buyer continually asked the sellers to provide up-to-date pipelines, as well as (in some cases) monthly accounts and invoice schedules.

These were not always provided but, when they were, frequently presented a pipeline or picture that was more optimistic than the company’s actual situation, often inaccurately describing the state of progress of key contracts critical to the company’s pipeline.

In particular, the pipeline indicated that the company’s performance was heavily based on the successful outcome of four key contracts for which the company had pitched.

The buyer expressed concern with the information provided on several occasions. However, ultimately, the buyer and the sellers signed the SPA and completed the sale and purchase of the shares in October 2018. The buyer paid an initial lump sum to the sellers on completion, with further payments to be made under an earn-out if the company hit prescribed EBITDA targets.

However, following completion, it became clear that the company’s prospects were worse than feared. The business went from making a modest loss in October 2018 (£16,197) and modest profit in November 2018 (£1,078), to a significant loss in December 2018 (£97,387) and a similar significant loss in January 2019 (£95,708).

Prompted by this, the buyer proposed a restructuring of the acquisition under which the sellers would repay 40% of the initial purchase price to the buyer and the earn-out targets would be adjusted. The sellers declined.

In March 2019, the buyer notified the sellers that there had been a breach of warranties in the SPA, including the forecast warranty above.

In January 2020, the buyer and the sellers agreed the final figures for the business for 2019. They showed a loss of £615,620.

The buyer brought a claim for breach of warranty. In particular, it alleged that here had been a material change in the company’s prospects since its last accounts date, in breach of the warranty above.

How did the court approach the claim?

Before turning to the court’s decision, it is useful to explore how the court examined the alleged breach of warranty and what principles it employed.

Although material adverse change (MAC) clauses have become increasingly common in recent years (albeit more frequently in the form of conditions precedent or termination rights), claims under MAC clauses are relatively infrequent and so this remains an undertested area of law.

What is a material adverse change (MAC) clause?

Also known as a “material adverse effect” clause, a MAC clause affords protection against the unknown by allowing a party to a contract to back out or claim compensation if something happens that has a serious impact on the commercial transaction.

In the context of the business of an acquisition (whether implemented as a share sale or an asset sale), this normally refers to any event that has a significant, negative impact on the target business.

In a business sale agreement, a MAC will normally be structured in one or more of three ways:

  • As a condition to completion. This means that the parties will not proceed to complete the sale if a MAC occurs after signing the agreement but before the scheduled date for closing the deal. This could be automatic or at the buyer’s election.
  • As a termination right. Similar in effect, this allows the buyer to simply walk away from the transaction if a MAC occurs after signing but before closing.
  • As a warranty that no MAC has occurred. This is slightly different, in that it will normally state that no MAC has occurred between a historic date and the date of signing. Unlike a condition or a termination right, which apply during the period between signing and closing, a warranty normally applies to the period before signing.

    However, on occasion a buyer will negotiate the SPA so that a MAC warranty is repeated at closing. In that case, if a MAC does occur between signing and closing, the repeated warranty would be breached and the buyer may well have a right to walk away.

It is now quite common (particularly where a MAC takes the form of a condition or a termination right) to define what is meant by “material adverse change” in the sale agreement. This could be linked to a monetary threshold or to specific negative events occurring.

Alternatively, the phrase can be left undefined in the business sale agreement. In that case, the true meaning of the term will not become unknown unless and until a breach is alleged and legal proceedings are brought. The court will then attempt to understand what the parties meant by the phrase in the specific context of the transaction.

In this case, the judge adopted a refreshingly simple approach.

  • What was the “baseline” position? In other words, what had been forecast in terms of prospects when the parties signed the SPA?
  • What was the actual position? In other words, what were the company’s actual prospects on the date on which the parties signed the SPA? These last words are important: in theory, any further deterioration after the SPA was signed ought not to count towards any breach of warranty, although it could provide evidence that the warranty was not true at the point of signing.
  • Is any difference between those two positions “material”?

The judge suggested that, for a “well-established position”, the baseline position might simply be the historical level of the figure in question. As an example, he suggested that, if a business had historical turnover of £100 per month for the last five years, the baseline figure will be £100 per month.

However, for a business such as the company’s, which had “highly variable turnover”, it was instead necessary to examine how the parties had reached agreement and understand what they would reasonably have expected to be the baseline figure.

This was an “objective test”. The question was what a reasonable buyer and reasonable sellers would have agreed to be the most likely baseline over the period concerned. In the judge’s words, “a wildly over-optimistic purchaser does not acquire a cause of action in this regard as a consequence of [their] over-optimism”.

The judge also clarified that the purpose of comparing baseline and actual figures was to decide whether or not there had been a change in prospects.

This was not the same as calculating the damage (if any) which the buyer has suffered. This was a separate exercise, and it was perfectly possible for a comparison to show that there had been a breach of warranty, yet for the buyer not to have suffered any recoverable loss (see box “How are damages for breach of warranty calculated?”).

How are damages for breach of warranty measured?

Breach of warranty entitles a buyer to bring a claim for breach of contract.

The conventional (but not the only) method of calculating the loss caused by a breach of contract is to award the innocent party an amount of damages sufficient to put that party in the position they would have been in if the contract had been performed properly.

So, in a simple example, if I contract to sell you (and you pay for) 20 widgets, but I only ever deliver you 15 widgets, I am in breach of contract and I would need to pay you the value of the missing five widgets. (That might be more or less than, or the same as, the price you paid for those five widgets, depending on whether you bought them at a bargain or a premium.)

On a sale of shares, the typical reference point is the value of the shares. If there is a breach of warranty, this will often be caused by some undisclosed loss or liability arising within the company which the buyer has acquired (or one of that company’s subsidiaries). This may, in turn, depress the value of the shares the buyer has bought.

The usual way of measuring the buyer’s loss in this scenario is to work out what the shares are worth with the breach of warranty and what they would have been worth if the breach of warranty had never happened. The difference between the two is the buyer’s loss.

So, for example, imagine a buyer acquires shares valued at £20m but then discovers there has been a breach of warranty which results in the shares being worth only £17m. The difference between the value with the breach (£17m) and the value if it had not occurred (£20m) is £3m, and so that it what the buyer will be entitled to recover.

The position is not always clear, particularly if a buyer does not pay market value for the shares. So, imagine, in the example above, that the buyer had, for whatever reason, paid £22m for the shares, even though they were worth only £20m. Following the breach of warranty, the buyer will be out of pocket to the tune of £5m. However, it will still be able to recover only £3m, as that is the diminution in the value of the shares.

Conversely, if the buyer in the example above had paid £18m for shares worth £20m, it would be able to recover £3m, even though it would be only £1m out of pocket.

Finally, to return to the second bullet above, the critical question was whether the warranty was true at the date the SPA was signed. It was clear that the company’s position was significantly worse after completion of the sale than had been forecast, but that was not relevant.

The appropriate question was what the position should have been perceived to be when the SPA was signed, and whether that was different from the forecast that was actually warranted.

What was a “material” change?

To establish a breach of warranty, it was not enough to show that the measure of the company’s actual prospects was worse than the baseline measure. That difference also had to be material.

The judge noted that the word “material” is “an ordinary English word, and its application to a set of primary facts is itself a question of fact”. In other words, “material” will have a different meaning in each case, depending on the surrounding circumstances.

In this case, the court adopted the following test: if it had known about the difference (that is, the adverse change since the accounts date), would the buyer have entered into the transaction, either at all or on significantly different terms?

Again, the judge said that this is an objective test. The question is what a reasonable buyer would have done, not what the specific buyer in this case would have done.

There is little or no English case law on what this means in the context the sale of a business. However, the judge therefore turned to case law from Delaware (IPB Inc v Tyson Foods Inc) and readily adopted the following principles:

To such an acquiror, the important thing is whether the company has suffered a Material Adverse Effect in its business or results of operations that is consequential to the company's earnings power over a commercially reasonable period, which one would think would be measured in years rather than months…
A short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror.

The judge specifically rejected the idea that a change would be “material” only if it were considered material from an accounting perspective. The two tests were different, and there was “[no] necessary read-across between the accounting concept of materiality and the use of the term in a contract.”

What did the court decide?

In this case, the court found that there had been a breach of the warranty.

The judge had to decide what the parties had meant by the word “prospects”. He decided that the parties had been focused on the company’s future gross profit and that this was, therefore, the appropriate measure to use.

The judge considered how big a disruption needed to be before it became more than a “mere hiccup”. He concluded that this depended entirely on the business model in question.

In this company’s case, “even a short delay in winning a large contract would result in significant losses being accumulated very quickly”. The judge noted that “even a short delay in a substantial portion of the expected revenues could potentially be very material” and that “a significant delay in winning even one of the contracts could potentially, given their size, have been material.”

The court concluded that, although a reasonable buyer would not have abandoned the transaction completely, the true state of the company’s affairs would have been of “very great significance” and the buyer would have further renegotiated the purchase price.

The sellers argued that there had been no warranty breach, because even a reasonable buyer could not have expected quite the deterioration in performance and prospects that had actually occurred and so would not, at the date of signing the SPA, have assessed the company’s prospects on the basis of a significant deterioration.

However, the court did not agree, noting that the only way a reasonable person could have concluded that there had been no material adverse change in prospects would be if they had been “very highly confident” that the business would generate a very significant profit throughout the rest of the year.

The sellers were aware that, of the four key contract bids that underpinned the company’s pipeline, one bid had not yet been formally made, one big had not progressed as far as the pipeline had indicated, one bid had not yet been successful and had been optimistically over-valued, and one had been rejected outright.

As a result, a reasonable seller would have concluded that three of the four contracts would lead to no revenue at all and one would lead to substantially less revenue than had actually been forecast.

Was the buyer prevented from claiming?

Finally, the sellers also argued that, even if there had been a breach of warranty, the buyer had been fully aware of the actual prospects of the business and so was unable to claim for two reasons.

  • First, the buyer was itself in breach of the warranty it had given to the sellers, namely that it was not aware of any breach of warranty. The sellers therefore had an equal counterclaim against the buyer and the two would net out.
  • Previous case law suggested that a lender cannot trigger a MAC clause on the basis of matters it knew about when it signed the contract. By the same token, the buyer should be able to claim based on a material adverse change of which it had been aware.

The court disagreed on both counts for one simple reason. Although the buyer could arguably have discovered the true position if it had made further enquiries and done further investigations, based on the information it had received, it had not actually been aware of the true position or, therefore, the breach of warranty.

Although the buyer had been aware that none of the four key contracts had been guaranteed, it had been under the impression that the likelihood of success and substantive revenue from those contracts would be significantly higher than it was, in fact, likely to be.

What does this mean for me?

MAC clauses and warranties can be the subject of intense negotiation.

From a seller’s perspective, if conceding a MAC clause, it is normally better to set out precisely what will amount to a MAC. Not only does this give a seller certainty as to their own potential liability, but it also allows a seller to make effective disclosure to the buyer and protect its position.

From a buyer’s perspective, it is often more advantageous to leave the meaning of “material adverse change” wide or undefined so as to preserve as many channels of claim as possible.

However, defining “material adverse change” can also have advantages for a buyer, as it takes away the need for a buyer to prove to the court that whatever change has occurred is in fact “material”. Instead, the buyer would merely need to show that the change in question fell within one of the specified categories set out in the sale agreement.

Perhaps the best position for a buyer is to negotiate a sale agreement defining a MAC by reference to specific triggers or monetary thresholds, but also to include a “sweeper” provision that extends to any other event that has a “material adverse effect” or “material adverse impact” on the target business.

Ultimately, the reason why we see so little litigation over MAC clauses is because they are fundamentally and, perhaps inherently, vague. Whilst winning a MAC clause will hardly ever harm a buyer, where possible, it will almost always be more beneficial to negotiate and rely on specific and targeted warranties and protections.