Clarity on material adverse change

Article 26
Article 26 of the Second Interpretation stipulates:

If a material change in the objective circumstances that could not have been foreseen by the parties at the time of the conclusion of the contract caused by something other than force majeure and falling outside the realm of commercial risk occurs after the formation of the contract, so that continued performance of the contract would be manifestly unfair to one of the parties or realisation of the objectives of the contract has become impossible, and a party petitions a people's court for amendment or termination of the contract, the people's court shall, based on the principle of fairness and taking into consideration the actual circumstances of the case, determine whether to amend or terminate the contract.

Following the promulgation of the Second Interpretation, the SPC issued additional guidelines and opinions on the application of Article 26, including the Circular on Correct Application of the Interpretation on Several Issues Concerning the Application of the 《PRC Contract Law》 (2) in Serving for the Overall Work Situation of the Party and the State (关于正确适用《中华人民共和国合同法》若干问题的解释（二）服务党和国家的工作大局的通知), promulgated on April 27 2009, and the Guiding Opinion on Several Issues Concerning the Trial of Civil and Commercial Contract Disputes under Current Circumstances (关于当前形势下审理民商事合同纠纷案件若干问题的指导意见) , promulgated on July 7 2009. These have been taken into account in the discussion below.

While Article 26 is substantively different from the relevant laws in the US (which has a longer history and more experience in dealing with MAC disputes), a US court and a Chinese court share two common principles that they must consider when deciding a MAC dispute: (i) the freedom of the parties to enter into a contract and (ii) the parties' legal obligations to perform a duly constituted contract without any unilateral amendment or termination of the contract. It is not unlikely that Chinese legislators and the SPC might refer to US case law when drafting future laws, regulation or guidelines on MAC.

US courts have historically set a very high bar for materiality in the context of MAC. The decision in the landmark case of IBP, Inc. v Tyson Foods means that for an event to constitute a MAC, it must be an unknown event (or unforeseeable by the parties at the time of entering into the agreement) that is significantly adverse and detrimental to the target company “…when viewed from the long-term perspective of a reasonable acquirer”. This decision was recently reaffirmed in Hexion Specialty Chemicals, Inc. v Huntsman Corp. Consequently, the threshold for proving a MAC is very high; documents recently discovered pursuant to the investigation into Bank of America's acquisition of Merrill Lynch show that Bank of America had received caution from its lawyers that Delaware courts have never allowed a buyer to back out of an acquisition in reliance of a MAC clause.

It is possible that the Chinese people's courts may not set as high a bar for materiality in MAC disputes. In drafting a MAC clause or invoking MAC in China, contractual parties, in particularly those who are familiar with and used to the high standards set by the US courts, may have to adjust their expectations, strategies and risk allocation.

Goals and key features of Article 26
One of the goals of Article 26 is to provide a legal basis and a clear standard for all levels of people's courts in deciding the large number of MAC disputes arising from the financial crisis. This will provide more clarity and certainty to contractual parties in their negotiation and invocation of MAC clauses.

Another stated goal of Article 26 is to help China overcome the financial crisis by maintaining a high level of commercial activity. In order to achieve that, the SPC encourages people's courts to actively mediate and, in the event of a MAC, to allow contractual parties to invoke Article 26 to modify the contractual terms so that relevant transactions can proceed. Although the SPC has warned against abuse of Article 26 and required people's courts decisions to invoke it to be reviewed and approved by a higher people's court or the SPC, it remains to be seen how the people's courts will balance such macroeconomic consideration with the concern of Article 26 abuse by parties that seek to invoke MAC to repudiate or change a bad deal that they have come to regret.

Some of the more important requirements under Article 26 are as follows:

(i) Material change
A MAC under Article 26 must be a “material change in the objective circumstances” that is so material that further performance of the contract would be grossly unfair to one party or would not achieve the goals of the contract. However, the key terms “material” and “objective circumstances” are neither defined nor further explained.

The exact definition of the term “material” in each case is specific to the facts, circumstances and nature of transaction of that case, and the absence of any further explanation of the term, coupled with the lack of a promulgated standard or definition of the principle of fairness, means that the people's courts will have significant discretion in each case. It would be helpful for the SPC to provide further guidance on issues normally associated with the determination of materiality; for example, will short-term difficulties faced by a business suffice or must the material change have a long-term effect?

In other jurisdictions, the term “objective circumstances” normally refers to situations, facts or circumstances that are separate from and independent of the relevant acts of the contractual parties. However, there is no standard or promulgated definition of the term in China.

(ii) Principle of fairness and review of decisions
The SPC has repeatedly stressed the importance for people's courts to decide MAC disputes pursuant to Article 26 based on the principle of fairness. Like the term “material”, the principle of fairness is fact specific and has no express standard or definition under Chinese laws. However, the SPC has identified a non-exhaustive list of factors for the people's courts to consider: whether the distribution of profits and risks among the parties is fair, whether an amendment of the existing contract would allow a fair and reasonable distribution of profits and risks among the parties, and whether sufficient protection has been given to the party that is not in breach of the contract.

The SPC's emphasis on the principle of fairness can be interpreted as a message that Article 26 should not be casually exploited by a contractual party to renegotiate for better terms or walk away altogether.

As a further measure to prevent abuse and frivolous invocation of Article 26 that could consequently result in unfair losses, uncertainty of performance of contractual obligations and disruption to commercial activities, the SPC has informed people's courts that Article 26 is to be applied only in special circumstances after deliberate consideration, with full regard to the principle of fairness and all the facts and circumstances specific to the case. In the unusual event that warrants the application of Article 26, the people's court's decision is to be submitted to a higher people's court, and the SPC, if necessary, for review and approval, to limit market disruptions caused by such renegotiation or termination under Article 26. It is expected that this measure would also allow the SPC to monitor and review the judicial application of Article 26, identify any problem and make further adjustment as necessary.

(iii) Foreseeability
Another important criterion under Article 26 is that a MAC must be unforeseeable by the parties at the time of entering into the contract. The SPC has clarified that an objective standard will be used in determining if a MAC was foreseeable, i.e. by taking into account the circumstances and facts existing at the time of the execution of the contract by the parties, could a reasonable person, put in the shoes of the parties, have foreseen the MAC at that time? For example, not all events or changes under the global financial crisis were unforeseeable, so the parties should, in some cases, have foreseen such events or changes.

(iv) Commercial risk
A material change that is deemed a “commercial risk” by a people's court will not constitute a MAC under Article 26 because the parties to a transaction are expected to bear the burden of, and to have factored in, certain risks that are inherently or commonly found in such transactions. Examples include changes in price of the target company's shares or seasonal dip in revenue of the target company within normal range. The SPC has outlined certain factors that people's courts are to consider in determining a “commercial risk”: having regard to the nature of the transaction, the market conditions, facts and circumstances surrounding it, whether the risk is foreseeable and normally associated by a reasonable man with such a transaction, whether the severity of the damages caused by the risk is beyond the reasonable expectation of a reasonable man, and whether the risk could have been prevented and controlled. Certain risky, volatile types of transactions (for example, trading of commodities, securities or futures) are inherently less open to a party successfully invoking Article 26. Contractual parties must fully understand the nature of the transaction, the industry and the subject matter in order to better identify the commercial risks involved in a transaction. In particular, financial investors who invest in different industries, companies and products are advised to adjust their expectations, negotiation tactics and risk allocation accordingly.

(v) Force majeure
A material change will not be deemed a MAC under Article 26 if it is caused by force majeure, a concept that is defined in Article 117 of the PRC Contract Law (中华人民共和国合同法). In the event that a contract cannot be performed because of force majeure, the Contract Law allows contractual parties to terminate their contract and exempts the party that fails to perform its obligations due to a force majeure event from any legal liability.

In a nutshell, Article 26 clarifies that if a contract cannot be performed because of force majeure, the parties can rely on the Contract Law to relieve them of any legal liability arising from their non-performance; if, in the absence of force majeure, a contract can still be performed, but a MAC exists which satisfies the conditions under Article 26, a party could still rely on Article 26 to terminate or amend the contract.

(vi) MAC as legal rights
Before the promulgation of Article 26, it was unclear if a contractual party could invoke MAC if the relevant contract did not contain a MAC clause. It is now clear that, even in the absence of a MAC clause, a contractual party still has the legal right under Article 26 to terminate or amend a contract because of MAC. Furthermore, contractual parties could make variation, supplement or waiver of their legal rights under Article 26 in the relevant agreement.

Recommendations
It is crucial for contractual parties to discuss with their legal counsels and advisers the important issues related to MAC, including but not limited to the following:

• Invocation of Article 26 is expected to be unpredictable because its definition of MAC is broad and could vary with the facts and circumstances of the deal, its parties and nature of the deal, and given the lack of established standards in respect of certain components of Article 26 like the principle of fairness.
• If contractual parties decide to include a MAC clause in their contract, a broad and general clause might not provide the necessary protection and certainty. An effective clause takes into account all relevant facts, circumstances and nature of the transaction, the industry and the parties. Parties should also consider including specific metrics, benchmarks or time period to better define the MAC clause, tightening it with insertion of exclusions or carve-outs. Parties could also specify the allocation of the burden of proof of a MAC.
• Different metrics or benchmarks might need to be used for determining a MAC if the MAC concept is used in different sections of a contract, for example, as part of the representations and warranties (for example, “there has been no MAC since the date of the latest balance sheet”) and as a closing condition (“closing is dependent on, among other things, absence of an MAC”).
• In respect of specific events or changes that are particularly important to a party, the parties should consider incorporating such events or changes as separate conditions to closing instead of relying on the general MAC clause or Article 26.

Sean Tai, counsel, O'Melveny & Myers, Shanghai office. The author would like to express his gratitude to Walker Wallace, partner of O'Melveny & Myers, for his guidance and advice in completing this article.