English High Court considers material adverse effect clause in SPA: the “revelatory event”

Background

On 26 October 2021, the defendant agreed to purchase two mines in Brazil (the Santa Rita nickel mine and the Serrote copper mine) from the claimant for over US$1 billion. The sale and purchase agreement (“SPA”) with which the case is concerned relates to the sale of the Santa Rita mine.

The SPA contained a MAE clause, the relevant part of which reads:

“”Material Adverse Effect" means any change, event or effect that individually or in the aggregate is or would reasonably be expected to be material and adverse to the business, financial condition, results of operations, the properties, assets, liabilities or operations of the Group Companies, taken as a whole,….”

The SPA also provided that the closing of the transaction should take place by 14 January 2022, and the occurrence of a MAE before closing meant the defendant was not obligated to complete the transaction.

On 9 November 2021, a geotechnical event (“GE”) occurred at the Santa Rita mine, causing a portion of rock in the east wall of the mine to be displaced and resulting in cracks on the main ramp of the mine. 

The claimant took steps to remediate the GE, including efforts to remove the displaced rock mass. However, the defendant purported to terminate the SPA, citing the GE as a MAE within the meaning of the above clause. The claimant disagreed, and claimed that the defendant had wrongly repudiated the contract.  The claimant further contended that the defendant was guilty of wilful misconduct in terminating the SPA (meaning that, pursuant to a clause in the SPA, it was entitled to alternative common law remedies rather than contractual damages). 

The issues of construction which divided the parties

The central issue before Mr Justice Butcher was whether, on the proper construction of the SPA and a correct view of the facts, the GE was a MAE, as defined. The judge identified three areas of disagreement relating to the construction of the MAE clause between the parties.

(1) Is a “revelatory event” a MAE for the purpose of the clause?

The defendant purchaser contended that the GE had revealed wider and more fundamental problems with the east wall of the mine, and that such a “revelatory event” was a MAE for the purposes of the SPA.  On its construction of the MAE clause, to draw a distinction between the “change, event or effect” on the one hand, and the consequences of the “change, event or effect” on the other, was an “impossible or at least unprincipled” distinction.  Given the clause directed attention as to whether the “change, event or effect” was “or could reasonably be expected to be material and adverse”, it was necessary to have regard to all consequences which would reasonably be expected to follow – including the wider problems that had been revealed by the GE.

The claimant seller argued that, even if the GE had led to revelations about the state of the east wall (which it denied), this did not qualify the GE as a MAE.  The state of the east wall and its underlying geology existed at the time the SPA was signed; in fact, “had existed for millennia”.  It would not be right to say that a “change, event or effect” occurring between signing and closing of the transaction was “material and adverse” because it revealed some other problem or issue.  This would mean that the temporal requirement of the MAE clause could be circumvented and it would allow a  party to identify a “change, event or effect” within the period between signing and closing, even though the problem predated the contract.

The judge preferred the claimant’s argument. He reminded the parties that the MAE clause was only one of a number of risk allocation techniques employed under the SPA (of which the representations and warranties were another). The MAE clause was concerned with risk which had occurred since signing. Thus, it involved the question of whether the GE itself is, or would reasonably be expected to be, material or adverse – not whether the underlying state of the east wall met that test.

(2) What is the meaning of “would reasonably be expected to be material and adverse”?

The second issue of construction related to what is involved in the assessment of “what would reasonably be expected to be material and adverse”.

The claimant contended that what was required was an assessment of whether or not it would reasonably be expected that the matter was material and adverse, and that this would give rise to a simple “yes” or “no” answer. The defendant, on the other hand, said that the assessment might give rise to a range of views held by reasonable people in the position of the parties, and if any of those was that the matter was expected to be material, then it was reasonably expected to be material.

The judge again preferred the claimant’s construction.  He said that the word “would” in the phrase “would reasonably be expected to be material and adverse” indicates that this is not an assessment which anyone needs to have made at the time – and, hence, it is not concerned with whether a conclusion was actually reached and whether it was within a range of reasonable answers, because no conclusion on the subject need to have been reached at all.  What is involved is an evaluated judgment, which will ultimately be determined after the event by the court in the event of a dispute.

The court’s assessment is made from the perspective of a reasonable person in the position of the parties at the time when the termination based on the MAE is notified.  The judge clarified that, in making this assessment, the court will not ignore the parties’ contemporaneous assessment of the position, because that might shed light on what it was reasonable to expect.

The judge added that there is a further question of the degree of likelihood required by this test.  A mere risk that a matter may turn out to be material cannot be enough; instead, given the use of both the words “would” (as opposed to, say, “could”) and “expected” (as opposed to, say, “apprehended”) the assessment is whether a reasonable person would have considered it “more likely than not” that the matter would turn out to be material. 

(3) What is the meaning of “material”?

Unsurprisingly, the claimant submitted that, given the GE was, in its view, of very limited significance, any assessment of its financial consequences would clearly be below any materiality threshold – whereas the defendant contended that the GE was of such importance and with such consequences that it was clearly above any threshold.

The judge held that the concept of materiality needs to be viewed in its context.  In the context of a buyer whose intention is to buy the target company as part of a long term strategy, the important consideration is whether the company has suffered a MAE in its business, results or operations that is consequential to the company’s profitability over a commercially reasonable period, which would be measured in years rather than months.

Considering the threshold for materiality the judge held, unsurprisingly, that “material” is intended to mean “significant or substantial” but there is “no bright line test” for what constitutes materiality which will be applicable to all MAE clauses. A number of considerations will be relevant as to what is to be regarded as material in a particular case. In this case, the judge considered that the following considerations were all relevant, and militated against setting the bar of materiality too low: (i) the size of the transaction; (ii) the nature of the assets concerned, including that they are susceptible to such matters as GEs; (iii) the length of the process of sale; (iv) the complexity of the SPAs; and (v) the fact that the MAE clause is relied on to terminate a very large contract to which the parties had devoted considerable time and effort.

As to putting a percentage on that materiality, the judge considered some of the relevant authorities. In one case, it was decided that an over 20% reduction in the equity value of the target company was material on the facts; and in another, it was held that a reduction of 10% of the total group sales was sufficient.  In this case, the judge said that his “intuitive response” was that a reduction of 20% or more in the company’s equity value would be material, but that a somewhat lesser reduction might also be material. He tended to consider that a reduction of more than 15% might well be material.

The ultimate question: was the GE a MAE?

The defendant argued that materiality should be judged on the quantitative and qualitative aspects of the GE – as to which, the judge commented that he understood the intended distinction to be between matters which could be measured in financial terms and matters which could not.

The judge was sceptical about whether the qualitative aspects alone of a “change, event or effect” will ever, at least in a commercial setting, be material. The GE was an occurrence of the type which often happens in open pit mines.  The Santa Rica mine had recorded 166 GEs, of varying degrees, during 2021.  While the scale of this particular GE made it large compared to others, it was not large compared to GEs occurring in other mines.  It involved a dislocation, as opposed to a detachment, of the slope. No one was killed or injured, and no equipment was lost.  Movement stopped at the time but resumed on 9 November 2021.  And the GE did not have any adverse regulatory consequences.

As to quantitative aspects, the judge said that there were two limbs of the MAE to consider – whether the GE (i) “is” material; or (ii) “would reasonably be expected to be” material.

Limb (i): “is” material

The cost of the GE in terms of clear-up, the reduction in ore production due to mining being stopped while the GE was cleared up, and a further incident caused by the clear-up (which caused further instability in the mine) was not more than some US$20 million – which was well below 5% of the purchase price of the mine.

Limb (ii): “would reasonably be expected to be” material

This was to be assessed as at the date of purported termination of the SPA.  Anything which came to light after this date was not relevant. Hence, the judge discounted various reports produced by the parties after this date.  Also, the assessment would not take into account what the GE revealed about the east wall, as explained above.

The most useful evidence for the judge was the parties' contemporaneous assessment of the GE's likely effect.  He accepted that such an assessment, if performed objectively and reasonably, could be of some assistance in indicating what a reasonable person in the position of the parties would have expected at the time.  That said, he found the defendant's assessment was influenced by its desire to be able to argue that the materiality threshold was met, so it was not objective or reliable evidence. He also noted that the defendant's assessment exercise was not shared with the claimant prior to termination, and said that the defendant's decision not to show its assumptions and conclusions to those running the mine and to ask them whether they were reasonable, vitiated the reliability of the exercise.

Instead, the judge preferred the claimant’s contemporaneous assessment of the likely effect of the GE.  This assessment envisaged that there would be a reduction of ore mined in 2022 from approximately 6.4 metric tons to approximately 6.1 metric tons, but with the mine having caught up with its monthly budgeted amounts by November 2022, and with more ore being mined than previously projected in November and December 2022. This assessment, made by what the judge considered to be the competent and responsible management of the mine, was of relevance when it came to considering what, as at the date of termination, would reasonably have been expected.

Wilful misconduct

The claimant based its allegations of wilful misconduct on the defendant having:

1. no reasonable basis for believing that the GE was a MAE; or
2. no genuine belief that the GE was a MAE; or
3. been reckless as to whether the GE was a MAE. 

The judge held that (i) did not amount to wilful misconduct, but was more akin to negligence.  On (ii), he found that the defendant genuinely believed the GE was a MAE (albeit that its belief was based on a flawed assessment). And on (iii), he held that, although the defendant may have made the decision in a hurried manner, it was not reckless as it was based on an assessment (albeit a flawed one).

Decision

Taking the above matters into consideration, the judge concluded that, at the date of purported termination, the GE was not, and would not reasonably have been expected to be, material. The defendant was therefore under an obligation to close the transaction and there was no basis for it to terminate the SPA when it did (although there was no wilful misconduct on its part).

The decision relates only to liability. A further hearing on quantum, to decide the amount of damages due to the claimant, is due to follow (unless the parties settle in the interim).

Commentary

Given there are not many English authorities on the construction of MAE (or MAC) clauses, which tend to be on largely similar terms, this case is a helpful guide as to how a court is likely to construe a clause – in particular, how a court is likely to go about assessing materiality.  The judge makes it clear that there is no one size fits all approach to materiality, and it must be viewed in context, but he gives a helpful list of considerations that may be relevant to what is material in a particular case.

In assessing whether the GE was, or was reasonably expected to be, material, the judge placed considerable weight on the parties’ evidence at the time of purported termination, and their respective assessments of the effect of the GE.  Interestingly, he found that the defendant’s failure to share its assessment with the claimant at the time vitiated the integrity and reliability of that evidence. 

Therefore a party wishing to assert that an event is a MAE may be well advised to gather as much evidence as possible at the material time, ensure it is impartial and above scrutiny, and consider sharing it with its counterparty.  This may also have the added effect of prompting a re-negotiation of the deal between the parties, and avoiding litigation altogether.