Material adverse change clause, shortly defined as MAC, has lately gained the fame of a controversial issue about the interpretation of which there are different views and approaches in the legal and judicial practice of the Republic of Azerbaijan. More likely, this is due to the fact that financial markets and the economy have experienced various events occurrence of which made it challenging for parties to execute contractual obligations. This article will analyse the very nature of such clauses, their applicability, and usage in the legal and judicial practice of Azerbaijan and propose general recommendations to contracting parties.
As the national legislation offers a two-staged way of changing or terminating a contract on the basis of MAC, in this article we will analyse the issue from the perspective of both stages.
- Introduction
Suppose you intend to conclude an agreement, be it either loan or M&A agreement, and you are on the negotiations stage. As financial markets of nowadays are not as stable as they used to be in the past, you are of the realisation that in the future an event could possibly occur which can make it difficult or even impossible for you to fulfil your contractual obligations. Therefore, considering the possibility of the occurrence of any unanticipated event, in order to mitigate potential risks and exit costless, it is recommended to include carefully crafted MAC clause in the contract. The Civil Code of the Republic of Azerbaijan (hereinafter “CC”) allows parties to change or terminate the contract under certain circumstances including cases of material adverse change. The Code defines the term as a change that if parties had been able to reasonably predict, they would have not entered into the contract or the contract would have been made under significantly different terms. [1]
Why is it of significant importance to negotiate MAC provisions effectively? Actually, the negotiation of MACs historically was not the object of bargaining concern[2]. However, recently he occurrence of some unforeseen events made people realise the significance of adding such clauses to contracts and drafting such clauses in a best possible way. Nowadays, MACs are the underlying cause of 69% of acquisition terminations and 80% of renegotiations[3]. The inclusion of this clause is important particularly in economically significant agreements dealing with large amount of money and other risks.
- How to draft contracts in a way to get the most out of MAC provisions when things go wrong?
First and foremost, lawyers while drafting contracts shall include a MAC clause to cover risks unanticipated to occur during its term. This clause should be drafted in a way to allow parties to survive from an unforeseen event with as little damage as possible. Main elements that a MAC clause should possess are the following:
Definition of MAC. In this part of the clause, lawyers should articulate in a detailed way what constitutes a material adverse change and exceptions from such cases. Civil legislation of Azerbaijan allows contractual parties to freely negotiate and agree on the definition of MAC and change or terminate the contract in case an event compatible with given definition occurs.
As the MAC clause is mainly linked to unforeseen events, the precise definition of such events is not recommended for there should be room for the interpretation. It is also necessary to indicate events that are carved out from the definition of MAC. Lawyers representing the seller/lender shall include the highest number of carve-outs possible while ensuring that MAC events are precise. MAC definition with many broad exceptions is friendly to the target, as it weakens the ability of the acquirer to invoke the MAC out.[4]
Effects of MAC clause. The national legislation allows parties to freely define courses of action to be taken in case a MAC occurs. Such actions change from terminating a contract to changing it in countless ways.
- What if the contract is silent on the matter of MAC?
According to the civil legislation, if parties fail to dissolve their dispute by negotiations, the interested party can apply to the relevant court. In general, MAC clauses have kept a very low profile in national courts, and judgments related to this concept are contradicting. The judicial practice discussing this concept mainly relates to the double devaluation of national currency in 2015 (the Azerbaijani currency has lost about 50 % since 2015).
One of the most significant court decisions regarding the MAC clause is the plenary decision of the Constitutional Court of Azerbaijan (hereinafter “the Court”) dated 7 September 2018[5].
A. Background and facts. When the value of Azerbaijani manat experienced a dramatic decline in 2015, debtors who took credits from banks in foreign currency suffered irreparable amount of damage and applied to courts for the termination or change of the contract. It should be noted that none of those contracts included a MAC provision leaving that to courts to decide whether it can be applicable in such cases. As the court decisions varied about their approach, and this posed an obstacle on the way of formation of a judicial practice for such cases, the Constitutional Court on 7 September 2018 accepted a decision regarding the interpretation of the Article 422 of the CC. According to the decision, the Court concluded that devaluation of the national currency cannot be considered a MAC.
B. What does the law say? Article 422.2 of the CC being interpreted in this case vaguely defines conditions for the change or termination of the contract by the courts. The provision defines the following requirements for this purpose:
Unforeseeability. At the time of signing the contract, parties have relied on the assumption that circumstances will not change significantly;
Not dependant on any party. The change of circumstances was caused by reasons which the interested party is not able to eliminate after their emergence with the extent of care and caution required by the nature of the contract and terms of the turnover;
Violating property interests of parties. The performance of the contract without changing its terms would violate the property interests of parties and damage the interested party in a degree, that such party would be significantly deprived of what he was entitled to when entering into the contract;
Explicit obligation to bear the risks. The business traditions and nature of the contract do not provide for the interested party to bear the risk of changing circumstances.
According to Article 422.4 of the CC, the contract amendment due to significantly changed circumstances shall be allowed under a court’s decision in exclusive cases, when the dissolution would contradict with public interests or lead to a loss for parties, significantly extending expenses, required for the performance of the contract under changed terms, established by the court.[6]
C. The Court considers that the contract cannot be terminated by the courts since the devaluation is not a MAC and it fails to meet the requirements of Article 422.2 of the CC.
- The Court states that the devaluation is foreseeable.
The Court holds the opinion that change in circumstances should be material. It links the materiality to unforeseeability concept contending that circumstances should change to an extent that if parties had been able to reasonably predict them, they would have not entered into the contract or the contract would have been made under significantly different terms. The Court considers that debtors should have been aware of the possibility of devaluation since it is stipulated in Article 5.0.3 of the “Law on Central Bank of the Republic of Azerbaijan” that Central Bank regularly determines and announces the rate of national currency in respect to foreign currencies.
Approaching the issue from a different perspective, on 15 August 2016 the Civil Collegium of Baku Appellate Court in a similar case[7] concluded that the majority of debtors could not foresee the occurrence of devaluation because the rate of the Azerbaijani manat to USA dollars was stabilised for a long period. For this reason, Baku Appellate Court considered the devaluation of the currency as a MAC event.
Agreeing with the approach of the Baku Appellate Court, I would like to note that the Constitutional Court should have considered the degree of change and the gravity of its consequences when approaching the concept of unforeseeability. I agree that a mere change in the currency is not a material adverse change; however, when the change is dramatic, the gravity of the situation and its potential consequences should be taken into consideration. Double devaluation led the currency to lose its value by 50 %. Moreover, such deterioration is not the result of gradual weakening but a sudden decision. Even if debtors would foresee a change in the currency rate, they would not predict the change of conditions in such a dramatic degree. If they would foresee such change, they would reasonably include several risk-eliminating provisions in the contract or would not enter into it in the first place. Moreover, according to some foreign doctrines, the unforeseeability requirement, which was considered by the Court important in this case, is highly controversial. Several of such doctrines claim that unforeseeability requirement would come close to reading the MAC clause out of existence because, in the cosmic sense, everything is foreseeable, and if an acquirer foresees a particular risk, the natural protective measure would be to include it in the MAC clause.[8]
Therefore, in my opinion, currency devaluation of 50 % is an unforeseeable change that parties, especially debtor, could not foresee when entering into the contract. Therefore, it complies with the first requirement.
- The Court did not analyse the second requirement.
Since the Court considered that the change of currency rate is foreseeable, it did not analyse the second requirement. However, we should note that the given situation meets the second requirement as parties are not able to eliminate reasons giving rise to the devaluation.
- The Court considers that the performance of the contract does not violate the property interests of parties since it is a matter of financial risk.
Furthering its justification, the Court added that it is a risk that the debtor takes when he borrows money in a foreign currency. Change in the value of the currency is a factor establishing financial risk which is taken by the debtor when entering into the contract. In my opinion, even if a debtor was aware of the risk that the currency can change, reasonably no one would guess a 50 % value loss. In our case, the performance of the contract definitely violates the property interests of debtors leaving them in a large amount of debt. Its performance is incredibly unfavourable to the interested party as the debtor is obliged to pay twice the amount he took as a credit. On the other hand, I agree with the opinion that changing the contract in the interest of the debtor is not the solution since it would be hugely detrimental to lenders and would lead to their insolvency. To establish a win-win situation, the Court should have come up with a mechanism to protect the interests of both parties.
- The Court considers that the interested party shall bear the risk of changed circumstances
The Court again refers to the financial risk notion to explain why the interested party shall bear the consequences. However, neither the contract nor the business traditions do explicitly provide a basis for the interested party to bear the risk of changed circumstances.
The foregoing points conclude that the currency devaluation of 50 % meets the criteria for relevant contracts being terminated by the courts as the MAC.
D. The Court considers that the contract cannot be changed since the devaluation is not a MAC and it fails to meet the requirements of Article 422.4 of the CC.
Although a dramatic change in the currency value can be evaluated as a MAC for the mentioned reasons, terminating the contract would not be a solution to the problem. It would result in the irreparable loss to parties and violate their public interests. The detrimental effect to the debtor would be that in this case he would be obliged to pay the loan amount immediately. This situation would also damage banks or other lenders. The best approach for the Court could be changing terms and dividing damages incurred or other risks between lenders and borrowers.
The Court sets forth the possibility of applying Article 422.4 of the CC stating that it is possible to change terms of loan agreements in the interest of debtors depending on the financial ability of banks. However, this provision is recommendatory and does not put any obligation on banks.
- Conclusion.
Judging from existing legal provisions and the judicial practice, we can conclude that MAC provisions are not a common practice in the Republic of Azerbaijan. However, due to recent occurrences, when dealing with a significant amount of money, parties are more willing to include such provisions in the contract rather than leaving it to courts to decide if a certain event can be interpreted as a MAC or not.
Decisions made by the Constitutional Court have the binding power in the Republic of Azerbaijan and are final. Therefore, the Court should have made sure that used principles and justifications were sound and in line with the intention of the Legislator. The Court has seemingly tried to eliminate any risk of making an unjust decision with regards to the lenders since they are also subject to detrimental effects. Deciding in the interest of debtors would lead to an economic downturn causing insolvency of banks, on the other side protecting the interest of lenders led to devastating results for small entrepreneurs. Having analysed and evaluated the judgment, I can conclude that even if dramatic currency devaluation meets requirements for being considered as a MAC, terminating the contract would violate public interests and propel banks to the insolvency. Changing the contract to mitigate risks of both parties defining more favourable terms would be the perfect way in such cases. This approach would achieve greater justice.
[1] Civil Code of Azerbaijan Republic, Article 422
[2] Gilson, Ronald J. and Schwartz, Alan, Understanding Macs: Moral Hazard in Acquisitions (February 2004). Columbia Law and Economics Working Paper No. 245; Stanford Law and Economics Olin Working Paper No. 278; Yale Law & Economics Research Paper No. 292. Available at SSRN: https://ssrn.com/abstract=515105 or http://dx.doi.org/10.2139/ssrn.515105. Page 2.
[3] Denis, David J. and Macias, Antonio J., Material Adverse Change Clauses and Acquisition Dynamics (November 21, 2011). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1609765 or http://dx.doi.org/10.2139/ssrn.1609765. Page 2.
[4] Keith A. Flaum, 2007 M&A Deal Points Studies—Public Targets, 12 M&A Lawyer 1 (Feb. 2008);
[5] Plenary decision of the Constitutional Court of Azerbaijan Republic. Available at http://www.constcourt.gov.az/decisions/414
[6] Civil Code of the Azerbaijan Republic, Article 422.4
[7] Decision of Civil Collegium of Baku Appeal Court dated 15 August 2016. Available at http://bakuappealcourt.gov.az/uploads/images/document/%E2%84%96_2(103)-6486-2016_f3d20b8e6bcad27b23c2083bafed0b72.pdf
[8] Daniel P. Dain and Robert L. Brennan, Negligent Security in the Commonwealth of Massachusetts in the Post-September 11 Era, 38 NEW ENG. L. REV. 73, 84 (2003); Saul Litvinoff, Force Majeure, Failure of Cause and Theorie De L’Imprevision: Louisiana Law and Beyond, 46 LA. L. REV. 1, 26 (1985).
Published on SSRN on 30 July, 2019. Available at https://ssrn.com/abstract=3426975
The articles on this blog are not, nor are they intended to be, legal advice. You should consult a lawyer for individual advice or assessment regarding your own situation.