Material adverse change clauses in insolvency proceedings
January 2015 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
In this post-2008 economic meltdown era, it is difficult to picture a contract to a major transaction lacking a material adverse change (MAC) clause. These clauses have become the prime escape route for businessmen when deals start turning sour because they entitle one, or sometimes either party, to an agreement to terminate the contract without liability when circumstances between the moment of execution and performance of a certain agreement have substantially changed, thus affecting the initial arrangement. The main field of action of these provisions used to be within the context of mergers and acquisitions, nevertheless their scope of application has broadened into other areas of commerce with business entities including them in a wide array of daily transactions such as sales and supply, among others. Although their effectiveness at court is arguable, in practical terms they definitely ease businessmen’s concerns and lubricate commercial transactions since these clauses are often sold as back exits for the moment when business starts going amiss. However, under Mexican law, there is a peculiar caveat which could, ironically, prevent parties from invoking these clauses at the very time they might prove to be the most useful – and sometimes exclusive – resource.
The Mexican Reorganisation and Bankruptcy Act (Ley de Concursos Mercantiles) §87 provides that any provision whose purpose is to change the contractual terms whenever any party files for reorganisation or bankruptcy – worsening the condition of the party petitioning for reorganisation or bankruptcy – is null and void. This provision intends to protect the bankrupt or reorganised business entity or individual from a termination of contracts it may have with third parties because it has recently filed for an insolvency proceeding. In simpler terms and in the context of MACs, this means that a statutory provision overrides the parties’ will and blocks any chance to resort to these provisions – hence, these clauses may directly clash with the law.
A practical example would perhaps better reveal the issues at stake. Party A is the sole raw material supplier to party B in a fiercely competitive market. The parties are in Mexico and the supply agreement between them is construed upon and governed by Mexican law. The contract calls for a qualitative, broad and boilerplate MAC clause entitling either party to walk away from the deal if a material adverse change takes place or if a circumstance that may elicit a material adverse effect occurs over any of them. The definition of adverse change or effect is any event materially affecting the business of either party related to financial condition, operations, revenue and forecasts, among others.
During the lifespan of the supply agreement and after a series of unfortunate circumstances, party B files for an insolvency proceeding seeking its debt restructuring. Upon becoming acquainted of this piece of news, party A realises that it is extremely likely that party B will default its obligations under the supply agreement and that their relationship may turn sour. Fortunately, they both agreed on a MAC clause sufficiently broad as to comprehend a situation such as filing for a debt restructuring proceeding, which enables party A to immediately terminate the contract without liability. Party A is confident that if party B were to eventually pursue litigation over the termination of the agreement, the MAC clause would stand on its feet and favour the termination because the wording is crystal clear and it is virtually impossible for a situation, such as debt restructuring, to fall through its cracks. Surprisingly, it turns out that, under Mexican law, this would not be the case.
The purpose of an insolvency proceeding is to protect, preserve and avoid the business going bankrupt. It is about the company adopting a frugal management, eliminating unnecessary expenses and negotiating with creditors to keep the business running and putting it back on the thriving track as soon as possible, if feasible. Of course, cutting the cord on essential supplies is incompatible with any of these means of protection; thus, the Act’s drafters legitimised this safeguard by enacting the Reorganisation and Bankruptcy Law §87. If, in the hypothetical case, party A were to hinder supply of essential raw materials, the company looking to restructure its debt would become a sinking ship heading toward an abyss. Without these raw materials, especially in a competitive market, the company would never be able to recover and the insolvency proceeding would become useless since the company would most certainly go into bankruptcy.
It is in cases such as this where a MAC clause could become ineffective because there is a superior good which deserves protection. And, despite it being potentially burdensome for the supplier to continue dealing with a company right at the tipping point of reorganisation or bankruptcy, this does not mean that its interests will be left vulnerable. Whenever a business files for bankruptcy or debt restructuring, a conciliator (proposed by the Federal Institute of Reorganization and Bankruptcy Activities (IFECOM) – (conciliador under the Reorganization and Bankruptcy Act) is appointed to oversee the reorganised company’s operations and the conduct of the company’s management. The conciliator will make sure that essential operations remain unaltered as much as possible, strive to keep essential input in stock and ensure that the party providing such input is timely and duly paid. The conciliator may even try to negotiate a line of credit, a due date extension or a price reduction of such essential supply and, in turn, will ask the judge in charge of the insolvency proceeding to apportion enough funds from the bankrupt estate to pay the supplier or suppliers in question ahead of any other creditors.
Should it be the case that a contract for essential inputs needs to be honoured to keep the business entity from being liquidated, under the Reorganization and Bankruptcy Act §92, these essential suppliers (declared as such by the conciliator) have the right to request the conciliator to ensure the fulfilment of the agreement by any means deemed proper or, as it is commonly known, to provide adequate assurances. These securities would only be effective for post-reorganisation judgment debts and their primary purpose – besides keeping the business running – is to back up the obligations that could eventually jeopardise the ultimate outcome of negotiations with creditors and of the insolvency proceeding itself.
Conversely, any suppliers or third parties with valid executed agreements with the restructured or bankrupt merchant may request the conciliator to determine if such contract or contracts need to be, and will be, honoured. If the conciliator deems that the products or services under such are expendable, it will communicate to the requesting party that it will not be honouring the agreement and such party is entitled to immediately terminate the agreement without liability. In this regard, the conciliator has a 20-business day window to analyse the requests and render a reply. If the conciliator fails to reply after such a period expires, the requesting party is entitled to deem that it is not considered an essential supplier and that the agreement may be terminated without liability.
It may be discouraging to learn that in desperate situations such as insolvency proceedings – perhaps businesses’ worst nightmare – where creditors more often than not end up losing money, under Mexican law a MAC clause could potentially be unenforceable. Of course, one interesting question is to what extent the Mexican Reorganization and Bankruptcy Law (public order law) could reach those agreements that are executed or have effects in Mexico but are subject to foreign substantive and choice of forum law. A forward-looking judge could order the continuation of the contract and compel the party in good standing to honour the agreement despite notice of termination being given pursuant to the applicable law and contract provisions. In such a case, there could be an arguable – and certainly legally enticing – case at both ends of the spectrum.
This issue becomes especially relevant when the parties or the agreements are subject to jurisdictions that have adopted the UNCITRAL Model Law on Cross Border Insolvency (e.g., the United States, Mexico, the UK and Canada, among others), allowing swift cooperation between bankruptcy courts and agents appointed by them in order to enhance the chances of rescuing the bankrupt company. In this particular case, the court where the proceeding is being heard could ask a foreign court to hamper the termination of the agreement – effectively compelling the terminating party to honour the agreement to avoid further damage to its counterparty and its creditors. This overreaching grasp, and the elimination of almost all bureaucratic red-tape for cooperation between courts in different countries, best captures the spirit of insolvency proceedings and the State’s intention to avoid, to the extent possible, a company going bankrupt.
As of today, despite their wide adoption, MAC clauses under Mexican law are a rare and unexplored breed of contractual provisions for scholars and the judiciary itself. Nevertheless, the issue at stake is noteworthy for both businesses and attorneys. As for businesses relying upon these provisions to serve as a life vest in times of wreckage, it is essential to be aware that in cases of insolvency they may be out of options and will first have to become part of the problem to then push the solution forward. As for attorneys, the ancient discussion of pacta sunt servanda v. rebuc sic stantibus and the very foundation of contractual principles is rekindled with a contemporary twist.
Omar Guerrero Rodríguez is a partner and Erick Clavel Benítez is an associate at Hogan Lovells. Mr Guerrero can be contacted on +52 55 5091 0162 or by email: email@example.com. Mr Clavel can be contacted on +52 55 5091 0157 or by email: firstname.lastname@example.org.
© Financier Worldwide
Omar Guerrero Rodríguez and Erick Clavel Benítez