COVID-19 and its possible classification as a Material Adverse Effect

What is a Material Adverse Effect?

Interpretation of a Material Adverse Effect (MAE) may vary depending on a certain situation; as it is used to measure an effect of an event, and how it may or may not impact a small business or a larger corporation in various aspects.

When related to finance, a MAE occurs when the following 3 matters are affected:

  • A particular business and its assets, properties, liabilities, operations, financial conditions or prospects for the future.
  • A loan contract, and its need to perform its obligations under any clause.
  • The validity or enforceability of any loan document, or the rights and remedies within these documents accordingly.

On the other hand, while discussing Mergers and Acquisitions the term MAE is used to measure the negative effect of some events on the target business. This is due to the occurrence of widespread events such as a war or a natural catastrophe.

The definition of MAE and impacts it may have all depend on the type of transactions and negotiations between parties and the industry in which they operate. This may lead to governmental exemptions or even parties having to terminate contractual obligations already agreed on, and signed before the pandemic.

 

Nowadays, the questions that business owners have is whether they should classify COVID-19 as a MAE; and if so, how would this affect existing agreements / contracts?

The overall understanding of a MAE has been ambiguous and as such, there does not exist a unanimous interpretation of its definition. With this in mind, there is currently a great pressure on whether or not to classify COVID-19 as a MAE, and whether it is a sufficient reason to terminate the fulfilment of duties and obligations in existing contracts. The COVID-19 pandemic is a non-precedent event and appears to be truly singular. We cannot ignore that the pandemic will have a severe impact on companies, as its impact and duration per se are far different from wars, natural catastrophes, and other uncontrollable scenarios witnessed in the past.

Therefore, many experts believe that the right approach would be to have a case by case analysis. There is a need to review the contract and its particular wording in order to assess how the COVID-19 situation would possibly have an effect on a specific company or contract at hand.

We must keep in mind that these effects may change over time, as the pandemic could have long-term ramifications. Moreover, it is important to note that other provisions of an agreement may also be potentially affected such as ordinary operations, representation & warranties etc.

 

Key factors related to COVID-19:

  • Classification: The classification of COVID-19 as a MAE will be applied on a case by case basis. Since its impact will affect companies differently depending on industry, location, cash flows, etc., there may be specific circumstances for a particular company to which this pandemic may cause a far greater impact. This impact may lead to insolvency and this can be argued as a disproportionate damage to a company, classifying as a MAE.
  • Quantitative Effect: A quantitative effect, is if an actual financial effect can be quantified due to COVID-19. For example, “revenues reduced by 100% in Q1 as a direct result of a city-wide lockdown in response to the COVID-19 outbreak.” Most experts argue it will have severe effects on the valuation of many companies. Moreover, the valuation will have to be made in a global context in order to quantify its drastic effect.
  • Foreseeability: No company or individual actually foresaw how COVID-19 would impact the global economy or its impact on business. The lack of such foresight can be used as support for classifying COVID-19 as a MAE.
  • Contractual remedies under Common Law: Companies or individuals that have entered into contracts must consider other applicable remedies that they can fight over other than MAE. Some examples can be the impossibility of performance, frustration of contract and more. An important matter that will be evaluated in court is the principle of good faith of the parties involved; as well as viewing their capabilities of fulfilling their contractual obligations in light of COVID-19 and its impacts.

 

Therefore, individuals and companies worldwide should initiate preparations under the current circumstances and explore measures that could be adopted to accordingly safeguard their interests.

Various governments worldwide have already implemented relevant legislations to tackle the COVID-19 situation and its impact along with announcing stimulus packages and support.

To conclude, it will be the courts and governments that determine if COVID-19 can be classified as a MAE which will depend on a case by case basis.