Will the Economy Change Your Contract?

Credit markets are tightening, property values are falling, tenant defaults are increasing, rents are softening and unemployment is spreading. Surely all of this adds up to a material adverse change—and any borrower or lender, buyer or seller, and anyone else who signed an agreement with a so-called MAC clause in it may wonder whether rights under that clause may now be exercised. MAC clauses may be found in loan agreements, commitment letters, rate-lock agreements, merger and acquisition agreements and purchase and sale agreements, providing protection from having to perform certain obligations of a contract after a meaningful or significant event that is negative or disadvantageous occurs. For example, a lender may not be required to fund an advance on a construction loan if there is a material adverse change in the financial condition, business, affairs or control of the borrower or guarantor. Or the lender may have the right to call a default and accelerate the loan if a MAC occurs during the term of the loan. Such clauses come in many different flavors. Parties they protect, such as lenders and buyers, like to see them written broadly to cover unforeseen circumstances. Parties they could harm, such as borrowers and sellers, like to see them written narrowly to identify circumstances in specific, measurable terms. They may be focused on the business or financial condition of a borrower or seller, or on broader industry or general market conditions. The most important consideration is their wording. Typically, a MAC clause uses terms and phrases without defining them, which can lead to ambiguity and uncertainty. But when determining what the words in a contract mean, a judge will give words their ordinary meaning. Just because a term is not defined does not make it ambiguous. If its meaning is derived from a particular industry or trade, the judge will consider trade usage to determine the intent of the parties. For example, in one case, a buyer of five fast-food restaurants agreed to close as long as no MAC occurred with respect to the results of operations of the seller. When the seller’s revenues dropped, the buyer argued this constituted a MAC and tried to walk away from the deal. The court said the buyer had to close because in the context of the transaction “results of operations” means net operating income or profit, not just revenues, and the buyer had not shown any material adverse change in net operating income. Sometimes agreements include a standard for determining whether a MAC has occurred. The party benefiting from the MAC provision may have the right to make this determination, acting in its sole or reasonable discretion or exercising good faith. Often these standards are incorporated within the overall agreement, but sometimes they apply only to certain sections or actions. Whether or not the agreement includes a standard, each party is bound by an implied covenant of good faith and fair dealing. Once meaning has been determined, the next step is to consider the facts of the deal. In simple terms, contracts mean what they say and sophisticated parties will be held to the agreements they bargained for. This was evident when a court permitted a lender to terminate its commitment letter on the basis of a MAC clause after the borrower was sued for complex mortgage fraud on an unrelated loan. Another lender could have withdrawn its commitment letter in reliance on a MAC clause when an unusually harsh winter crippled a borrower’s sales. And a court looked favorably on a lender invoking a MAC clause to reduce the lender’s commitment amount for a development project after the terrorist attacks of Sept. 11, 2001. If it’s clear a MAC has occurred, courts will recognize it. But it is not necessarily easy sledding to invoke a MAC clause. The burden of proof rests on the party seeking to avoid its obligations under the contract, and courts have recognized this is a heavy burden. When one lender withdrew its commitment letter on the basis of a MAC shortly after issuing it, for instance, the court focused on whether the lender had a genuine concern about the borrower’s ability to satisfy its loan obligations or whether the lender was motivated by scooping the non-refundable fee from the borrower. In such cases, the person’s behavior in seeking relief from the contract will be scrutinized to make sure a MAC has actually occurred and there has not simply been a change of heart. Francesco A. De Vito is a partner in the real estate department at DLA Piper LLP (US) and Paul S. Ham is an associate in the litigation department at DLA Piper LLP (US).