Court of Appeal re-examines test for “material adverse change”

09 November 2023

The Court of Appeal re-assesses what amounts to a “material adverse change” on an acquisition of a business.

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

The Court of Appeal has now reversed that decision, finding that the High Court has adopted the wrong test for deciding whether a MAC had in fact occurred.

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.
The court will measure whether a change has occurred by comparing the same data or criteria as at two different dates. The contract should make it clear which dates are relevant for these purposes.

What happened?

Decision Inc Holdings Proprietary Ltd v Garbett concerned the sale by two individuals of the shares in an IT consulting company to a corporate buyer.

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

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 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 to 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, but the buyer and the sellers signed the SPA and completed the sale and purchase of the shares in October 2018.

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).

The buyer brought proceedings against the sellers for breach of the MAC warranty, alleging that there had been a material change in the company’s prospects since its last accounts date.

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 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 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 the High Court say?

In its judgment ([2023] EWHC 588 (Ch)), the High Court agreed that there had been a breach of the MAC warranty.

In coming to this decision, the judge set out the basis for assessing whether a MAC has occurred. In doing so, he adopted the following 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 were important: in theory, any further deterioration after the SPA was signed ought not to have counted towards any breach of warranty, although it could provide evidence that the warranty was not true at the point of signing.
Is there a difference between those two positions? The purpose of this is to decide whether or not there has been a change at all. If there has been a change, the court would then decide whether that change was both “material” and “adverse”.

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

But, he suggested, for a business with “highly variable turnover”, where it was not possible to fix a baseline by reference to historical figures, it was instead necessary to understand what a reasonable buyer and reasonable sellers would have expected the baseline figure to be.

Having set this approach out, the judge went on to conclude that there had been a change, the change had been both “material” and “adverse”, and there had therefore been a breach of warranty.

What did the Court of Appeal say?

In its judgment ([2023] EWCA Civ 1284), the Court of Appeal said that the High Court had applied the wrong test for deciding whether there had been a change in the company’s prospects.

Specifically, it said that the judge should not have attempted to determine the actual position regarding the company’s prospects as at the date on which the parties signed the SPA.

The court gave four reasons for this:

Wrong date. The High Court had assessed the position as at the date of the SPA (October 2018). However, the warranty stated that there had been no MAC since the “Accounts Date” (31 December 2017), which preceded the date of the SPA. If the test was indeed to identify the actual position, it should have referred to the actual position on the Accounts Date.
Wrong comparison. The High Court had compared two different things: the expectation which a reasonable buyer would have had on the date of the SPA, and the actual prospects on the date of the SPA. Rather, it should have compared the company’s actual prospects on 31 December 2017 and its actual prospects in October 2018.
Wrong assessment period. The MAC warranty referred to the company’s prospects, which referred to a point in the future (i.e. after the relevant date). However, the High Court instead assessed the company’s prospects by reference to historical financial information. In doing so, the High Court had assessed whether the MAC warranty had been breached by reference not to how the company might fare in the future, but to how it had already performed.
Wrong reference data. The High Court had to interpret what the parties meant by the word “prospects”. It assessed this term by reference to the company’s EBITDA and, in doing so, effectively equated prospects with EBITDA. However, the term prospects did not refer simply to EBITDA, but rather to future “chances or opportunities for success”.

As a result, the Court of Appeal overturned the High Court’s original decision.

In other circumstances, this decision alone may have resulted in a re-trial, so that the High Court could reconsider the claim but using the proper approach.

However, in this case, the Court of Appeal held that the claim for breach of warranty failed because the claim notice had not properly set out the amount being claimed.

The court said the SPA required the claim notice to set out a separate claim amount for each breach of warranty. In part, this was because there was commercial logic to setting out different figures. The sellers might wish to settle a stronger claim but fight a weaker one. To make this decision, they would need a separate figure for each claim.

However, the notice in this case had simply stated a single, aggregated figure for all alleged breaches. As a result, the notice was defective and out of time. The court therefore concluded that a re-trial would be pointless, since the claim could not succeed.

A key question for the Court of Appeal when deciding whether to overturn the initial judgment was whether the High Court had reached its decision based on matters that were not argued before it.

As a general rule, a court should take into account only the matters which are pleaded before it, or which are explored through witness evidence. The court should not make findings for which the claimant is not contending. Any decision should be made based on the arguments put before the court. This is the nature of the adversarial system on which the English and Welsh courts operate.

A judge is entitled to invite, even encourage, the parties to litigation to recast or modify their arguments. But the court cannot decide a case based on its own reasoning.

Reaching a judgment based on unargued facts or assumptions is sometimes called finding on the basis of the “third man theory”.

This might seem odd at first glance. If a court reaches a decision based on its own reasoning, rather than the parties’ arguments, and that reasoning is correct in law, why should the decision not stand? The main reason is that parties to litigation should have an opportunity to challenge and respond to points of law as part of their case. When a court unilaterally adopts an analysis without argument, the parties will not have had that opportunity.

In this case, the High Court reached its judgment by comparing expected prospects as at the date of the SPA with actual prospects as at that date. But no party to the litigation had suggested this as an approach to assessing whether a change had occurred.

The normal and appropriate remedy where a court has decided on the basis of the “third man theory” is to order a re-trial. The case will be heard all over again, but the court will try to reach a decision based solely on the arguments put before it.

What does this mean for me?

The Court of Appeal’s judgment doesn’t set any new law, but it does show how difficult it can be for a court to assess the concept of a material adverse change.

The best way to avoid uncertainty and, ultimately, any kind of litigation is to ensure any MAC clause is clear, unambiguous and well-drafted. This is not always easy: MAC clauses and warranties can be the subject of intense negotiation.

When drafting a MAC, parties should strike a sensible balance between breadth and detail. If a MAC clause is drafted too widely and generically, it may be difficult for the parties to identify whether a MAC has in fact occurred without potentially costly and lengthy court proceedings.

By contrast, if the MAC clause is drafted too narrowly by reference to specific events or thresholds, it may not capture a sufficiently wide range of potentially adverse circumstances. In this circumstance, it is unlikely a court would allow a party to invoke a MAC based on an event not within the specific wording of the clause.

Ultimately, we see little litigation over MAC clauses, perhaps because they are 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.

Access the Court of Appeal’s judgment in Decision Inc. Holdings Proprietary Limited v Garbett [2023] EWCA Civ 1284

Read our original update on the High Court’s decision in Decision Inc Holdings Proprietary Limited v Garbett [2023] EWHC 588 (Ch)