What was a “material adverse change”?

29 June 2023

The court examines whether there had been a “material adverse change” on the acquisition of shares in a company.

The High Court has interpreted the meaning of a warranty in a share sale agreement that there had been “no material adverse change” (MAC) in trading or financial position.

In reaching its decision, the court examined both the scope of the warranty and what the parties mean by a “material” change.

Three key takeaways

  • 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.
  • The courts will not casually apply or adopt thresholds in other parts of an SPA when deciding what is “material”, particularly if they relate to different measures of performance, but equally they will not shy away from identifying a figure. In this case, the court found that a figure of 10% of total sales was material in the context of the transaction.

What happened?

Finsbury Food Group plc v Axis Corporate Capital UK Ltd and others [2023] EWHC 1559 (Comm) concerned the acquisition of a food manufacturing business. The background is as follows.

Finsbury Food Group (Finsbury) was (and still is) a manufacturer of baked goods.

In 2016, it began exploring the possibility of acquiring Ultrapharm Limited, a specialist manufacturer of gluten-free baked goods which Finsbury had already been selling in Europe. Finsbury saw the acquisition of Ultrapharm as a way to expand its own offering of gluten-free products.

This culminated in Finsbury and the owners of Ultrapharm signing a share purchase agreement (SPA) and simultaneously completing the sale of the shares in Ultrapharm on 31 August 2018.

As is usual, the SPA contained several contractual warranties as to the state of Ultrapharm’s business, given by the sellers in favour of Finsbury. These included (among others) the following warranties:

2.1 Since the Accounts Date:
2.1.2 there has been no material adverse change in the trading position of any of the Group Companies or their financial position, prospects or turnover and no Group Company has had its business, profitability or prospects adversely affected by the loss of any customer representing more than 20% of the total sales of the Group Companies or by any factor not affecting similar businesses to a like extent, other than as a result of factors which have affected businesses in the same industry, in general and so far as the Warrantor is aware, there are no circumstances which are likely to give rise to any such effects;
2.1.9 no Group Company has offered or agreed to offer ongoing price reductions or discounts or allowances on sales of goods relating to its business or any such reductions, discounts or allowances that would result in an aggregate reduction in turnover of more than £100,000 or would otherwise be reasonably expected to materially effect [sic] the relevant Group Company's profitability;

The “Accounts Date” for this purpose was 31 December 2017.

Separately, Finsbury entered into a buy-side warranty and indemnity (W&I) insurance policy with a series of Lloyd’s underwriting syndicates, designed to insure Finsbury against the risk of a breach of the warranties in the SPA (see box “What is W&I insurance?” below).

What is W&I insurance?

Warranty and indemnity insurance, or W&I insurance, is a specialist insurance product designed to protect against loss arising from a breach of a contractual warranty or indemnity in a share or business sale agreement (an SPA).

Although termed “warranty and indemnity insurance”, in a UK context, W&I products typically cover only breaches of warranty. This is principally because contractual indemnities in an SPA are normally included to address risks that have been identified before agreeing to the sale, and a W&I policy will not typically provide cover for known risks.

There are two types of W&I policy:

  • Sell-side W&I. This is cover taken out by the persons giving the warranties (the “warrantors”). This could be the seller of the shares or business, or it could be founders or managers who know the business. The policy protects the warrantors against loss they suffer in the event they are sued for breach of the warranties.
  • Buy-side W&I. This is cover taken out by the person who benefits from the warranties, namely the buyer. The policy protects the buyer against loss it suffers as a result of a breach of warranty, which usually equates to any drop in the value of the shares or business.

Unlike under a sell-side W&I, there is no need for a buyer to sue the warrantors to claim under a buy-side W&I policy. In effect, a buy-side W&I policy shifts the economic risk of a breach of warranty claim from the warrantors to the insurers, subject to any agreed cover limits, excess and exclusions in the W&I policy.

Instead of suing the warrantors in the courts, the buyer can claim under the W&I policy, which is conceptually easier. The insurer is then able to assume proceedings directly against the warrantors. Although originally designed to be used only occasionally as a protection against potentially uncreditworthy warrantors, buy-side W&I has now become a widespread transaction mechanism under which risk on a share or business acquisition is effectively pooled and dispersed through the insurance market.

Buy-side W&I insurance is particularly popular with private equity buyers and sellers, and we now see buy-side W&I policies put in place on the majority of transactions on which we advise. It is not uncommon for a willing seller in search of buyers to arrange in-principle buy-side W&I insurance alongside launching an auction process, allowing the parties to “flip” the policy to the successful bidder with more limited policy negotiations so as to close a sale quickly.

The appeal of buy-side W&I products is enhanced by their flexibility. This includes so-called “nil-liability policies”, under which the contractual liability of the warrantors to the buyer is limited to a very small amount (or even zero), with the economic risk resting solely with the insurer. Once particularly popular on transactions involving property-holding companies, this mechanism has now spread more widely to transactions in all sectors.

The dramatic rise in buy-side W&I over the last fifteen years or so has largely neutered sell-side W&I insurance, which is now rarely seen.

In due course, Finsbury realised that, prior to the acquisition:

  • Ultrapharm had agreed with one of its customers to change the recipe for two products, which it then did (the Recipe Change); and
  • Ultrapharm subsequently agreed with that same customer to lower the price of those products on two separate occasions (the Price Reductions).

Finsbury brought claims under its buy-side W&I insurance, alleging that both matters amounted to a MAC and so breached warranty 2.1.2 above. It also alleged that the Price Reductions breached warranty 2.1.9 above.

The insurers rejected Finsbury’s claims under the policy. Finsbury brought legal action.

The court had to interpret the warranties in question and, in particular, what the parties meant by the term “material adverse change” (see box “What is a material adverse change (MAC) clause?” below).

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 acquisition of a business (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 share 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.

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 and/or could identify specific events that do not amount to a “material adverse change” (such as general changes in market conditions, changes in applicable laws and force majeure events).

Alternatively, the phrase can be left undefined in the sale agreement. In that case, the true meaning of the term will not become known 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.

What did “material adverse change” mean?

The court noted that, fundamentally, the meaning of the phrase “material adverse change” was a matter of contractual interpretation using well-established principles. This involved examining both the text of the SPA and the surrounding factual context to work out what the parties meant.

The insurers had argued that any MAC had to involve an impact of 20% on Ultrapharm’s total sales. This, they said, was because the no MAC warranty (warranty 2.1.2) was a single, composite warranty, and the reference in the second half of the warranty to “20% of total sales” indicated the threshold the parties had intended to set for a MAC.

Finsbury, on the other hand, argued that the warranty comprised several components – effectively, separate warranties – that had simply been drafted in a single paragraph, and that the reference to 20% of total sales related only to one component that did not contain the MAC warranty.

After briefly mentioning other cases in which the court has considered the meaning of “material adverse change”, the judge alighted on a middle ground, finding that the warranty consisted of two elements:

  • a warranty that there had been no MAC in Ultrapharm’s trading position or turnover; and
  • a separate warranty that there had been no loss of a customer representing more than 20% of Ultrapharm’s total sales.

In the judge’s view, the 20% figure related only to the second element, which dealt with loss of a customer, rather than loss of custom or business. A loss of 20% of sales could not automatically be used to define a MAC in Ultrapharm’s overall financial position for the purpose of the first element.

Having decided this, the judge rather succinctly concluded (without giving any detailed reasoning or explanation) that a MAC, in the context of the SPA, involved a reduction of more than 10% in Ultrapharm’s total group sales.

Was the Recipe Change a MAC?

There was little evidence of the financial impact of the Recipe Change before the court. However, at most, it accounted for reductions in two profit lines that could “not have amounted to anything like 10%” of total sales. The judge therefore concluded that it could not have amounted to a MAC. (The court also dismissed the claim on two other grounds unrelated to the question of a MAC.)

What about the Price Reductions?

The judge noted that, in principle, the Price Reductions were matters that could have fallen within the scope of the no MAC warranty (warranty 2.1.2), if the parties had not negotiated a separate warranty dealing specifically with price reductions (warranty 2.1.9).

However, by including a specific warranty addressing price reductions, the court felt that the parties had intentionally decided to treat them separately according to specific and separate criteria and not through the no MAC warranty.

As a result, Finsbury was unable to claim that the Price Reductions amounted to a breach of the no MAC warranty and the court did not need to decide whether they amounted to a MAC.

The Price Reductions could, in principle, have fallen within the price reductions warranty (warranty 2.1.9). However, the judge noted that the warranty covered only offers of or agreements for price reductions made since the Accounts Date (i.e. 31 December 2017).

By contrast, although the Price Reductions took effect after the Accounts Date (in February 2018 and April 2018), Ultrapharm had agreed to the reductions before the Accounts Date (in October 2017).

The warranty had not, therefore, been breached. Finsbury had attempted to argue that the warranty must have covered agreements made before the Accounts Date that would take effect after it, but the court refused to entertain this interpretation.

How will the court measure a MAC?

As the meaning of “material adverse change” varies from case to case, there is equally no single or consistent way of measuring when a MAC has occurred.

In Kitcatt v MMS UK Holdings Ltd [2017] EWHC 675 (Comm), the High Court held that a “material adverse impact” involved a 20% reduction in operating income or a 10% reduction in revenue. But that was specific to the case in question.

In Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch), the High Court measured materiality by comparing a hypothetical “baseline position” with the actual position and deciding whether the difference was “material”. That case, which you can read more about in our separate in-depth piece, set out useful principles for understanding the purpose and nature of a MAC clause.

What does this mean for me?

This was not a straightforward case, dealing not only with the drafting nuances we have described above, but also whether Finsbury was already aware of the matters forming the basis of its claims (and so barred from claiming) and whether Finsbury could actually establish any recoverable loss.

But the decision on the meaning of the SPA raises some important considerations.

  • There is no fixed meaning of the phrase “material adverse change”. The words will signify something different in each context and the courts will use surrounding evidence to identify their meaning. It is disappointing in this case that the court didn’t give any rationale for the figure it chose, but perhaps this demonstrates the point that this kind of litigation can be unpredictable (see box “How will the court measure a MAC?” above).
  • It is therefore wise to consider defining what is meant by “material adverse change” in a particular context. For example, it may be possible to define the phrase by reference to a specific monetary threshold, whether an absolute figure or a percentage of some variable measure (such as turnover, profits or sales).
  • Parties should structure contractual warranties carefully. In this case, the court reached a sensible decision on the meaning and structure of the no MAC warranty, finding that the figure of 20% applied only to part of the warranty and didn’t define the MAC. But the argument could have been avoided by setting the different components of the warranty out in separate paragraphs.

At times, it can admittedly feel as though legal advisers like to indulge in trivial wordsmithing. But on too many occasions we see courts struggling to pick apart and make sense of the wording of a poorly drafted contract based on the structure of the paragraphs or even the placement of a comma.