Private Equity

In 1647, an English court held a tenant liable to pay the entire rent contracted to be paid under a lease; and this was notwithstanding the fact that for 3 years of the lease term the defendant had been deprived of use of the land because a civil war was raging and the Cavaliers (the supporters of Charles I, not the Cleveland basketball team) were in possession of the rented land.  Unfortunately for the tenant, he had apparently not provided for a covenant of quite enjoyment in the lease, which might have excused his obligation to pay rent during his ouster.  Thus began the common law’s strict construction of contractual obligations; and while the common law has independently developed in each U.S. state after its importation from England, the basic policies and theories that underlie the original doctrines remain largely unchanged in the U.S. law of contract.  If you want to excuse performance of your contractual obligation based on some subsequently occurring event that will make your bargained-for benefit no longer worth the bargained-for obligation, you need to specifically provide for that excuse in your agreement.  Otherwise you will have to perform or pay damages for nonperformance notwithstanding a change in circumstances.

Thus, consistent with that English holding in 1647, the Massachusetts Supreme Court recorded these immortal words in 1825 that should be read as a warning by all private equity deal professionals:

But where the party by his agreement voluntarily assumes or creates a duty or charge upon himself, he shall be bound by his contract, and the non-performance of it will not be excused by accident or inevitable necessity; for if he desired any such exception, he should have provided for it in his contract.  … In these and similar cases, which seem hard and oppressive, the law does no more than enforce the exact contract entered into.  If there be any hardship, it arises from the indiscretion or want of foresight of the suffering party.  It is not the province of the law to relieve persons from the improvidence of their own acts.  Adams v. Nichols, 36 Mass (19 Pick) 275, 276, 278 (1825).

And a December, 2015 decision by the Michigan Court of Appeals, Kyocera Corporation v. Hemlock Semiconductor, LLC,  provides a more modern opportunity to revisit this doctrine.  Kyocera Corp. involved a “take or pay” contract and the ineffectiveness of a force majeure clause to relieve the party agreeing to “take or pay” from that obligation.

Kyocera Corporation, a producer of solar panels, entered into a long-term polysilicon supply agreement with Hemlock Semiconductor.  The agreement was structured as a “take or pay” contract—i.e., Kyocera, as buyer, agreed to purchase a specified quantity of polysilicon from Hemlock, as seller, at a fixed price, and Kyocera agreed that if it failed to order the specified quantity it would nonetheless pay Hemlock the agreed price for the agreed quantity.  As noted by the court:

The very essence of a take-or-pay contract is therefore to allocate to the buyer the risk of falling market prices by virtue of fixed purchase obligations at a long-term fixed price, and to thereby secure for the buyer a stable supply, while allocating to the seller the risk of increased market prices and, by virtue of the buyer’s obligation to take or pay for a fixed quantity of product, removing from the seller the risk of producing product that may go unpurchased.

The agreement contained a “force majeure” provision that provided in relevant part:

Neither Buyer nor Seller shall be liable for delays or failures in performance of its obligations under this Agreement that arise out of or result from causes beyond such party’s control, including without limitation: acts of God; acts of the Government or the public enemy; natural disasters; fire; flood; epidemics; quarantine restrictions; strikes; freight embargoes; war; acts of terrorism; equipment breakage (which is beyond the affected Buyer’s or Seller’s reasonable control and the affected Buyer or Seller shall promptly use all commercially reasonable efforts to remedy) that prevents Seller’s ability to manufacture Product or prevents Buyer’s ability to use such Product in Buyer’s manufacturing operations for solar applications; or, in the case of Seller only, a default of a Seller supplier beyond Seller’s reasonable control (in each case, a “Force Majeure Event”). (Emphasis Added)

After the agreement was executed, the buyer claimed that it was excused from performance because of the actions of the Chinese government, which had sought to corner the solar industry by providing subsidies to Chinese companies, the result of which was to significantly lower the price of polysilicon and make the bargained-for prices in the agreement devastatingly unprofitable for the buyer.  So impactful was the price deterioration that it was alleged that the seller had effectively exited the business of manufacturing polysilicon because no one was taking delivery—instead they focused on enforcing the “pay” side of their various take or pay contracts, including the one with Kyocera.

Clearly this action by the Chinese government was beyond the control of the buyer.  But, under the plain language of the force majeure clause, the buyer was only relieved of its obligation if the force majeure events “prevented” the buyer from using the polysilicon in its manufacturing of solar panels.  The governmental action may have made the use of polysilicon purchased from Hemlock under the long-term take or pay agreement prohibitively expensive, but it did not actually prevent the buyer from using that polysilicon in its manufacturing of solar panels. The fact that the buyer could no longer produce solar panels because the price at which they could be sold was uneconomical based on the bargained for prices set forth in the agreement was not an excused force majeure event according to the plain language of the agreement.  According to the court:

Plaintiff opted not to protect itself with a contractual limitation on the degree of market price risk that it would assume. It cannot now, by judicial action, manufacture a contractual limitation that it may in hindsight desire, by broadly interpreting the force majeure clause to say something that it does not. …Plaintiff does not allege any “act[] of the Government” that directly prevented its performance under the contract. It merely alleges that the depression of prices in the solar panel market caused performance by plaintiff to become unprofitable or unsustainable as a business strategy. But plaintiff did not (although it again could have) negotiate a contractual force majeure clause that by its terms would have excused contractual performance resulting from unprofitability due to governmental market manipulation. Having failed to do so, plaintiff cannot now, through judicial action, effectively reform the contract to say that for which it opted not to negotiate as part of its contract with defendant.

Words matter.  The buyer could have tried to negotiate for a provision that would have relieved it of its obligation to purchase the product at the specified price or reduced the price proportionately if the market price fell below a certain floor (and the seller may well have considered such a provision if the buyer agreed that the price would proportionality increase if the market price rose above a certain cap), but the buyer either did not consider it, was unsuccessful in such negotiation, or determined that the upside of such a provision was not worth the potential downside. If the buyer considered the risk and determined that it was a risk it was prepared to assume, then this result is just part of the deal the buyer made.  But if the buyer never even identified the risk or wrongly believed that the force majeure clause would actually protect the buyer in this situation, this is a tragic outcome for the buyer (apparently involving more than a billion dollars).

Although the common law does recognize certain equitable defenses to contractual obligations where the performance has been subsequently rendered impossible or there has been a complete frustration of the purpose for which the contract was entered into, courts generally hold contracting parties to the bargain made in the written agreement and these doctrines rarely provide relief.  Always consider what could go wrong and make the deal you have modeled and negotiated no longer the good deal you worked so hard to achieve. If you want to condition your performance on the occurrence or nonoccurrence of a specifically identified risk you need to specifically so provide in your agreement. And for goodness sake, don’t rely on a standard MAC clause to accomplish this objective in the context of an acquisition agreement (this 2006 Private Equity Alert is still a fair summary of the limited utility of the MAC clause as a way out of a deal gone bad).