ALERT: Focus on Material Adverse Effect Clauses in Real Estate Agreements
A year ago, corporate and real estate transactional attorneys scrambled to review contracts and advise clients on the effects of material adverse effect/material adverse change (MAE/MAC) and force majeure provisions in pending contracts as a result of COVID-19. The impacts of COVID-19 on contracts have varied depending on context,—mergers/acquisitions, construction, commercial leases or commercial real estate purchase and sale transactions all seeing different changes implications.
MAE/MAC provisions, integral to merger/acquisition agreements, are rarely used in construction contracts, commercial leases, and commercial real estate purchase and sale agreements. Should these provisions be adopted when drafting construction contracts, commercial leases, and purchase and sale agreements?
Corporate practitioners renewed focus on MAE/MAC provisions since IBP, Inc. v. Tyson Foods, Inc., 789 A2d 14 (Del. Ch. 2001) and in Pennsylvania since Allegheny Energy v. DQE, Inc., 74 F. Supp. 2d 482 (W.D. Pa. 1999).
MAE/MAC provisions are used in different parts of a contract and can benefit one party or be reciprocal. They can be included in a representation that no MAE/MAC (individually or in the aggregate) event has occurred as of a date specified. Or an MAE/MAC can modify a specific representation related most usually to specific business requirements, e.g., a party is not subject to any litigation that would reasonably be expected to result in an MAE/MAC. MAE/MACs are also used as closing conditions, i.e. a party’s obligation to close the transaction is subject to no MAE/MAC having occurred with respect to XXX. The difference is that while an unsatisfied condition will allow a party to terminate the contract, an inaccurate representation could also give the party a cause of action for damages against the other party. MAE/MACs can be implemented for third-party events causing the change of business circumstances, to litigation, or simply one party’s financial performance.
MAE/MAC provisions are highly negotiated in merger/acquisition contracts with the choice of verb construction being critical. In Allegheny, after negotiations, it was defined in the merger agreement as:
“Material Adverse Effect” means with respect to any Person, a material adverse effect on the financial condition, properties, operations, business or results of operations of such Person and its Subsidiaries taken as a whole; provided, however, that any such effect resulting from … the application of the Pennsylvania Restructuring Legislation … which affects both [DQE] and its Subsidiaries, taken as a whole, and [Allegheny] and its Subsidiaries, taken as a whole, shall only be considered when determining if a Material Adverse Effect has occurred to the extent that such effect on one such party exceeds such effect on the other party.
The Allegheny Court was straightforward in using Pennsylvania principles of contract construction when interpreting the MAE/MAC provision holding that the materiality of an MAE/MAC should be determined “in light of the size and nature of the transaction and the nature of the parties’ businesses”. Allegheny at 518.
Neither construction contracts, nor commercial leases, nor commercial real estate purchase and sale agreements typically contains a provision similar to the MAE/MAC.
Construction Contracts, Commercial Leases, and Commercial Real Estate Purchase and Sale Agreements
These types of contracts have rarely utilized MAE/MAC clauses to cover changes in circumstances, relying instead on current business contract structures; the principles established in Pennsylvania case law, such as theories of impossibility of performance and frustration of purpose and historic practices.
Under Pennsylvania law, “a party generally assumes the risk of its own inability to perform its contractual duties.” Luber v. Luber, 418 Pa. Super. 542, 549 (1992). “In order to use a force majeure clause as an excuse for non-performance, the event alleged as an excuse must have been beyond the party’s control and not due to any fault or negligence by the non-performing party.” Martin v. Com. Dep’t of Environmental Resources, 120 Pa. Cmwlth. 269, 273 (1988). “Furthermore, the non-performing party has the burden of proof as well as a duty to show what action was taken to perform the contract, regardless of the occurrence of the excuse.” Under Pennsylvania law, “acts of a third party making performance impossible or causing a delay resulting in a substantial increase in expense to the contracting party did not excuse failure to perform if such acts were foreseeable because it was the duty of the contracting party to provide for that situation in his contract.” Luria Engineering Co. v. Aetna Cas. & Sur. Co., 206 Pa. Super. 333 (Super. Ct. 1965). Thus, in Luria, defendant was not excused for its failure to construct a roof under the doctrine of impossibility after its employees went to strike, causing costly delay, because “in a job involving the construction of a building of some magnitude, a labor dispute or strike is certainly foreseeable.”
In Construction Contracts, neither party wants to provide the other party a right to terminate and walk away from its performance, whether due to events in or outside of their control. Use of an MAE/MAC as a condition or representation, whether mutual or not, would not be favored if the remedy was termination. If there are any contingencies, such as obtaining permits or financing or establishing a GMP, as a matter of business, these events are conditions that need to be resolved prior to commencement of construction. Pre-construction services by a contractor are covered separately. After construction commences, the parties rely upon a “force majeure” clause and default and remedy provisions to govern their rights. For example, the simple force majeure provision below broadly helps the Contractor,
Contractor and Subcontractor shall be excused for failure or delay in performance herein due to any event of force majeure, including but not limited to acts of God, labor strikes, or any other contingency beyond the control of either party.
But after construction starts, would a modified version of the above drafted as an MAE/MAC better benefit the parties?
The imposition of an MAE/MAC, whether unilateral or reciprocal, permitting termination after construction commences would create negative implications as to the status of construction that would not only impact the parties but the owner’s mortgagee and the contractor’s surety, if the project is bonded. There is a robust, established body of law dealing with construction contracts, force majeure, and defaults thereunder that would be overturned by an MAE/MAC being inserted in the contract. However, one typical MAE/MAC that could be considered in the construction context is a unilateral change in financial circumstances of the owner. Most construction contracts include a default provision for failure to pay by owner, which event is usually the first sign of a change in owner’s financial circumstances and a much more “objective” standard for establishing a default. On the other hand, the most obvious sign of a contractor’s change of financial circumstances is either a failure to pay subcontractors or a slow-down in meeting schedules. Again, these are cleaner, more objective defaults. For all of the aforesaid reasons, I do not foresee MAE/MAC provisions entering the construction contract arena.
Leases are structured from a business viewpoint similar to construction contracts. Contingencies are resolved prior to lease term commencement and force majeure and default and remedy provisions govern thereafter. Since the landlord funds tenant improvements and brokerage fees up-front before a tenant commences rent payments, landlords want a constant, uninterrupted rental stream. While courts have recently utilized “contract” principles in interpreting leases, the history of leases is based upon real property law that abhorred a forfeiture of an estate in real estate. The provision below, used in a post-COVID lease, provides a tenant with more relief than many force majeure provisions in pre-COVID leases, attempting to address that courts frequently did not grant relief to tenants based upon impossibility and similar theories.
Inability to Perform. This Lease and the obligations of each of Landlord and Tenant to perform all of the covenants and agreements hereunder to be performed (other than monetary obligations) shall in no way be affected, impaired or excused because the other party is unable to fulfill any of its obligations under this Lease, expressly or implicitly to be performed by the other party, or because the other party is unable to make or is delayed in making any repairs, additions, alterations, or improvements, or is unable to supply or is delayed in supplying any services, equipment or fixtures, except if the other party is prevented from or delayed in so doing by reason of any Unavoidable Delays (as hereinafter defined), frustration of purpose, impossibility, or impracticability. Landlord and Tenant shall each promptly notify the other party of any Unavoidable Delays or events which prevent the notifying party from fulfilling any of its obligations under this Lease. “Unavoidable Delays” shall mean acts of God, casualty, strikes or labor troubles, accident, acts of war, terrorism, bioterrorism (i.e., the release or threatened release of an airborne agent that may adversely affect the premises or its occupants), pandemic, epidemic, quarantine restrictions, stay at home order by local, state or federal governmental authority, department or agency, governmental preemption in connection with an emergency, conditions of supply and demand which have been or are affected by war, terrorism, bioterrorism, pandemic, epidemic, quarantine restrictions or closures or stay at home order or other emergency or any other cause whatsoever, whether similar or dissimilar to the foregoing, beyond the obligated party’s control, or by any local, state or federal governmental authority, department or agency which effectively results in Tenant not being able to operate the Premises for business at the same business level as before any of the aforementioned events, which event lasts more than three (3) consecutive days. As a result of an Unavoidable Delay solely caused by pandemic, epidemic or quarantine or other similar causes that results in a stay at home or business closure order of a governmental authority, notwithstanding anything contained herein to the contrary, Tenant’s obligation to pay Base Rent and Additional Rent shall be abated for such period of time until Tenant is again able to operate the Premises for business to the public and the term of the Lease shall be automatically extended day for day for the duration of that certain Unavoidable Delay event. As to the payment of real estate taxes as Additional Rent, if Tenant has paid the real estate taxes for the Premises for the year that this certain Unavoidable Delay occurs, then Landlord and Tenant shall pay or reimburse the other, as applicable, to accomplish an appropriate allocation of real estate taxes. Landlord may elect to pay any real estate tax reimbursement it may owe Tenant by way of credits against Base Rent becoming due and payable Landlord pursuant to the Lease, as amended hereby. It is agreed that the duration of the Unavoidable Delay in effect as of the date hereof attributable to the “COVID-19” pandemic shall be deemed ending sixty (60) days after the date of the later of the Governor of Pennsylvania’s Order “green” meaning all business can resume normal operations or the Mayor of Philadelphia’s similar order rescinding any previously issued “stay at home” order.
I do not foresee commercial landlords and their mortgagees accepting a reciprocal or unilateral MAE/MAC provision that would allow the tenant the right to terminate the lease as a remedy resulting from a third-party event. In most well drafted commercial leases, tenants require provisions addressing landlord default and remedies. As described above with respect to construction contracts, both parties to a commercial lease have defaults fashioned in a manner that would in effect serve as a change in circumstances provision. If the remedy for a change in circumstances as a result of a third party event that impacts only a tenant’s performance is suspension of the tenant’s performance, it would not provide anything more than a well-drafted force majeure provision. An MAE/MAC relating to a unilateral change in financial circumstances of the landlord resulting in a reduction of services based upon a representation of the landlord’s financial circumstances with remedies other than termination could be considered but usually are included in the landlord’s default provisions or in specific provisions related to landlords’ providing services, such as utilities.
Commercial real estate purchase and sale agreements are generally structured in a format that may be better suited to including an MAE/MAC provision, whether as a representation or as a condition precedent to closing related to the financial circumstances of the purchaser or seller. The most obvious condition precedent would be a material adverse change in the rent roll between the date of execution of the agreement and closing. Except as to the change in rent roll, in my opinion, including MAE/MAC provisions would create an additional layer of legal rights, but would not materially change the legal rights and business terms under existing commercial real estate purchase and sale agreements.
Infrequently, commercial real estate purchase and sale agreements contain a financing contingency in favor of purchaser. More typically, these agreements contain: a thorough due diligence provision in favor of purchaser and a “sold as is” provision benefitting the seller; limited representations and warranties by seller and purchaser, rarely which go to the financial position of either party and as to leases and rents, only certify as to leases in existence as of date of execution; specific pre-conditions to closing based on events outside the control of the parties, such as obtaining third party approvals or consents; a remedy for buyer default limited to seller’s retention of the deposit; remedies for seller default such as reimbursement of buyer’s costs subject to a cap and specific performance; a broadly drafted force majeure clause for third party events. These agreements also typically provide that the time period between expiration of due diligence and closing is short.
A buyer is almost always entitled to the return of its deposit if the buyer terminates the purchase and sale agreement during the due diligence period, and is entitled to reimbursement of expenses and/or specific performance only in the event of a seller default. Thus, if a seller’s financial circumstances, whether caused by seller or a third party event (e.g., change in rent roll), changes after expiration to due diligence period, resulting in the seller not being able to close the transaction, there would be a clear default by the seller which would entitle buyer to those remedies. If these changed circumstances occur prior to the expiration of the due diligence period, a seller would want to argue that the buyer’s only remedy is to terminate the agreement of sale and receive return of the deposit, while the buyer may feel that it should be entitled to reimbursement of expenses (because the change in circumstances should be considered a default) or perhaps the buyer would be willing to proceed with the purchase but with a price, adjustment to account for the change in the rent roll. Thus, even if there was a representation or condition precedent as to leases/rents for which a MAE/MAC could be considered a condition, termination may not be needed as a remedy. The question is could the purchaser with a MAE/MAC condition precedent related to leases and rents negotiate upfront to receive an adjusted purchase price if rents decline. Since COVID 19, even without a MAE/MAC, sellers may have been receptive to a purchase price adjustment based on certain rent roll reductions. A MAE/MAC provision would be another approach. An example of a negotiated price adjustment is below.
Purchase Price Adjustment. No later than twenty (20) days prior to the expiration of the Feasibility Period, Purchaser may send written notice requesting an adjustment in the Purchase Price if monthly rent on the latest Rent Roll provided by Seller is ninety-five (95%) percent or less than the monthly rent set forth on the Rent Roll attached hereto as Exhibit B-3 (but not including rent from leases that have expired by their terms). If this condition has been achieved, Seller and Purchaser shall negotiate in good faith to determine an adjustment to the Purchase Price. If Purchaser and Seller have not agreed to adjustment of the Purchase Price before the expiration of the Feasibility Period, then (i) Purchaser may withdraw its request and close pursuant to the terms of the Agreement; (ii) or Seller or Purchaser may terminate this Agreement whereupon the Deposit shall be delivered to Purchaser and neither party shall have any further rights or obligations to the other hereunder.
Purchase and sale agreements typically do not include a representation as to the buyer’s financial condition nor a financing contingency – the seller is agreeing to give the buyer the right to investigate with a short period between investigation and closing, and relies on the deposit as a remedy if the buyer cannot close. If a buyer’s financial circumstances, whether caused by a buyer or a third-party event, changes after expiration of due diligence and prior to closing, then the seller can terminate and receive the deposit. So, a MAE/MAC related to the buyer’s representation of financial ability to close would give the seller the same right of termination as the seller would typically have in a purchase and sale agreement without a MAE/MAC. The question is whether a seller could negotiate a MAE/MAC related to a change in the buyer’s financial condition to receive damages (e.g., reimbursement for the costs to carry the property pending closing) for breach of a representation in addition to the return of the deposit.