A Change For The Worse: Material Adverse Effect In Upstream Acquisitions

"Material adverse change" and "material adverse effect" are often used interchangeably to mean a change for the worse. Typically, they are found in finance documents, commodity sale agreements and sale and purchase agreements for upstream acquisitions ("SPAs"). In finance documents, the term allows the lender to call a default if there is an adverse change in the borrower's financial position. In commodity sale agreements, the term acts as a hardship provision which recognises that over the course of long-term contracts, market economics may change, making the original contract price inequitable to either the buyer or the seller during the term of the contract. In SPAs, the term acts as a buyer protection measure, allowing the buyer to walk away from the deal if an adverse event occurs which significantly affects the target or asset between the milestones of signing and completion. In all three types of contract, the material adverse change or material adverse effect makes the deal economically unattractive to the party seeking to rely on the provision, although not impossible for the contract to be performed. Importantly, the event which results in a material adverse change or material adverse effect must be outside of the affected party's control.

This article focuses on how the prospect of a change for the worse can be addressed by buyers and sellers in the context of SPAs, and considers how material adverse change and material adverse effect provisions have been interpreted and applied by the courts.

Upstream acquisition agreements

There is some debate over whether "material adverse change" or "material adverse effect" is the better term. Although material adverse change trumps as being more certain - a change is easier to note than an effect is to measure - material adverse effect is often the preferred choice in SPAs. This is on the basis that it sounds peculiar to refer to an adverse change rather than an adverse effect in the context of valuing the target or asset.

Material adverse effect provisions are only relevant where there is a period of time between signing and completion. In SPAs, there will always be a gap between these two dates in order for the buyer and the seller to obtain the necessary regulatory approvals and other third party consents, and to perform any other conditions precedent. The longer the interim period, the greater the likelihood of a material adverse effect event occurring, at least in the opinion of one of the parties.

In order to protect itself against this pre-completion risk, the buyer can use material adverse effect provisions in two ways. The first is as a condition to completion which entitles the buyer to terminate the deal if there is a material adverse effect which significantly affects the target or asset during the interim period. The second is a representation and/or warranty from the seller that the target or asset has not experienced a material adverse effect between signing and completion, a breach of which may entitle the buyer to damages. These two means of addressing pre-completion material adverse effect risk are explored further below.

As a rule, SPAs include interim period covenants which restrict what the seller can do with the target or asset once a deal has been agreed. One of the usual covenants is that the seller will keep the buyer informed in a timely manner of matters which have, or could have, a material adverse effect on the value of the target or asset. Such matters may include: any physical damage to or destruction of the asset, such as the degeneration of a pipeline or the destruction of a platform; any matters arising which are inconsistent with any of the representations or warranties...