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Viral perils in the practice of contract-writing

Viral perils in the practice of contract-writing

All kinds of new questions are currently being asked when it comes to ongoing contract negotiations or recently concluded contracts for the purchase of a company or property: how will the coronavirus outbreak affect current practice when it comes to contract-writing and what are the legal requirements that need to be considered? 

If you are in the midst of contract negotiations, each party is entitled to refuse to conclude a contract – after all, nobody can be forced to conclude a contract. Of course, this principle of the freedom of contract also applies in times unaffected by the coronavirus. It is true that a person cannot refuse to conclude a contract without good reason if they have already expressed a serious intention to conclude it and the other party has made arrangements with regard to the intention that was shown. However, the virus has an enormous negative impact on the economy, which means a party would indeed have a reason to refuse to conclude a purchase agreement. And for the sake of completeness: in principle, negotiations do not have to be resumed even if the situation relating to the virus eases. 

Withdrawal after a memorandum of understanding has been concluded

Memoranda of understanding are particularly common during company acquisitions or purchases of commercial real estate. As a rule, however, a mere memorandum of understanding does not have a binding effect, meaning that it does not give rise to an obligation to conclude the main contract. But be careful: although a memorandum of understanding does not have a binding effect in most cases, it can also be interpreted as a preliminary contract if worded accordingly. In this case, it would no longer be possible to refuse to conclude the main contract without legal consequences, with the seller then able to sue for the conclusion of the main contract. Consequently, the situation needs to be examined in more detail in each individual case. 

Would the coronavirus trigger a break-up fee? 

Memoranda of understanding often contain a certain break-up fee if one party unilaterally breaks off negotiations. The main purpose of this is to avoid damages needing to be calculated, which is difficult to achieve, in practice. Whether there is an obligation to pay the break-up fee depends on the wording of the clause. If the clause only applies in the event that contract negotiations break down without cause, the outbreak of a pandemic (such as the coronavirus) will probably not constitute an unfounded breakdown of contract negotiations, meaning that the seller would not be entitled to the contractual penalty. It should be noted, however, that the pandemic must actually have a negative impact on the object of purchase. If, for example, the object of purchase is a delivery service which is currently generating its highest sales ever due to the outbreak of the virus, neither the seller nor the buyer would be able to use the coronavirus to justify their withdrawal from the deal. If the seller breaks off negotiations, the seller will probably be obliged to pay the break-up fee. 

Does the exclusivity clause still apply? 

Exclusivity clauses are a common feature of memoranda of understanding and prohibit the seller from conducting parallel negotiations with other interested parties. This is because the buyer invests a lot of time and money in the transaction (e.g. costs for due diligence, technical inspection of the building), and, as a result, the seller should not be allowed to conduct parallel negotiations with other interested parties. The exclusivity arrangement is limited to a particular period of time, with the relevant clauses relating to the duration of exclusivity often stipulating a specific date or period. If the exclusivity clause is not in play for too long a period (making it legally permissible), the seller must always adhere to it. This is also the case if the MoU is terminated prematurely and the parties do not agree otherwise. As a result, the exclusivity period should also end when the memorandum of understanding is terminated by the buyer. 

The fate of the exclusivity agreement must be considered in a nuanced manner. The following example should serve to illustrate this: if the object of purchase is an online streaming service, the seller may not withdraw from the negotiations without consequence because streaming services are unlikely to suffer losses as a result of the crisis. Thus, if the seller breaks off negotiations before the exclusivity period expires, the exclusivity clause continues to apply and the seller is not allowed to enter into negotiations with a new interested party. An exception is the payment of the break-up fee by the seller, which offers exemption from the exclusivity agreement. Tip: a break-up fee actually provides protection for the buyer in this instance, with the seller essentially buying them out of the deal. Depending on the wording of the relevant clauses, the buyer may (or may not) claim additional damages in addition to the break-up fee for the breach of the exclusivity clause. 

Is there any way back once the deal has been closed?

In most cases (unfortunately), the answer is no. When the purchase contract is executed, the risk is also transferred to the buyer, as the consequences of the virus affect the new owner. As a result, the conditions for contesting the purchase contract will not be met in most cases. Avoidance on the grounds of error is ruled out because it is an irrelevant error relating to the future. A warranty is also ruled out because no reasonable seller will give the buyer binding forecasts about the company’s future sales development. As a result, liability for the violation of such warranties is generally excluded. 

A focus on company acquisition

In many company acquisitions, there is a delay between the signing of the contract and its execution. If, for example, the contract was signed in December 2019 and the deal was not to be completed until May 2020 for various reasons, the question arises as to whether the buyer may now withdraw from the deal. Since there are several possible scenarios, the answer here (unfortunately) must begin with a classic legal phrase: namely, “it depends”. If the company becomes insolvent between signing and closing, and if the running of the company is not continued and it is shuttered before the deal is closed, this is probably a case of impossibility. Impossibility (of performance) is evident because the seller cannot provide the contractual item due to the closure of the company. In this instance, the risk would be borne by the seller and the buyer would therefore not have to acquire the company. If the target company continues, depending on the terms of the purchase agreement, the risk has to be taken by the buyer.

If the company’s turnover plummets and the target company is, in fact, worth less than half of the purchase price, the buyer can challenge the purchase contract for reduction of the true value by half (laesio enormis). But watch out: the parties usually contractually rule out the possibility of contesting the purchase contract on the grounds of laesio enormis. At best, the buyer could argue that the basis of the transaction has been eliminated. If the sales market breaks down completely for a particular industry (e.g. when buying a hotel in a region that has been severely affected by the virus), the typical circumstances and conditions that everyone associates with the conclusion of the deal would be missing. Similarly, these circumstances would not be attributable to any party. That said, the seller could argue that the virus is only temporary and that the sales market will not disappear completely. Alternatively, the seller could argue that the circumstances were quite predictable (e.g. if the contract was concluded at the beginning of the year). Withdrawal due to the loss of the basis of the transaction would therefore be anything but certain and it would be necessary to undertake a more detailed examination of the individual matter in question. 

The MAC clause favours buyers

For this reason, sellers insist on ruling out the possibility of contesting the purchase contract on the grounds of error, laesio enormis, impossibility and loss of the basis of the transaction, on the one hand. On the other, buyers want to protect themselves against unexpected developments by insisting on a “MAC clause” (Material Adverse Change), which basically regulates the ceasing to exist of the basis of the transaction. This clause is where the parties stipulate the circumstances under which they can withdraw from the contract. These can be wars, natural disasters or epidemics. But other unforeseen events can also represent a MAC if they have a negative impact on the target company’s key figures. Sellers strongly resist a MAC clause because it gives the buyer the option of withdrawing at any time before the deal is closed. MAC clauses are rather unusual in European deals, but the coronavirus could change this. The wording of the specific MAC clause in question determines whether the buyer can withdraw from the contract. A very simple buyer-friendly MAC clause is as follows: “ceasing to exist of the basis of the transaction means any event, circumstance or development that has, or is likely to have, a material adverse effect on the business operations of the company or its value as a whole”. Depending on the industry within which the acquired company operates, in many cases, this wording would entitle the purchaser to withdraw from the purchase agreement. Indeed, in many industries, coronavirus is “a development that has a material adverse effect on the business operations of the company or its value as a whole.” 

If the purchase contract has not yet been concluded, it is now up to the seller to amend this clause in their own favour. The seller should at least insist that one-off or non-recurring events are not covered by the MAC clause, with this change in itself providing the seller with arguments against the buyer’s withdrawal. The coronavirus is (hopefully) only a one-time and non-recurring event, meaning that the purchaser would probably not be permitted to withdraw. In practice, MAC clauses are much more extensive. They include numerous scenarios (wars, epidemics, natural disasters etc), exceptions to these scenarios and yet more counter-exceptions to them. In this respect, there is no substitute for seeking good legal advice. 

In short, buyers might well demand MAC clauses more often in deals as a result of recent developments. Hopefully, practice will soon reflect this. In any case, this pandemic will not be completely ignored in contractual practice – and we can say that with certainty. 

Author:

Mag. Piotr Daniel Kocab, LL.M., Attorney at Law at LANSKY, GANZGER + partner

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