COVID-19 and “Material Adverse Effect” Provisions

Amid the current uncertainty arising from the COVID-19 health crisis, parties negotiating M&A deals are likely to devote added attention to the definition of “material adverse effect” (MAE) in their acquisition agreements for purposes of determining whether and when the buyer should be able to walk away from a signed deal in the event of a major downturn stemming from the outbreak. Those who have already entered into acquisition agreements that have yet to close are equally likely to be considering their rights under any closing condition tied to an MAE. 

It is as yet unclear whether any downturn caused by the COVID-19 pandemic will have sufficiently long-term effects to constitute an MAE that would permit a contract termination. While language addressing COVID-19 has been included in a few agreements to date, the typical language requiring MAEs to be company-specific raises doubts about any buyer’s ability to cite the pandemic as a basis for terminating an agreement.  

Material Adverse Effect and the Allocation of Risk in M&A Deals

In a typical M&A transaction, the buyer and seller face a period of weeks or months between signing the acquisition agreement and closing the transaction.¹ This delay creates the need to allocate risk between the parties – namely, deciding who is at risk for negative or even potentially catastrophic events affecting the business between signing and closing. While this can partly be addressed through deal economics such as purchase price adjustments for a decline in working capital, post-closing indemnification or insurance coverage for certain adverse developments, or earn-outs that bridge the valuation gap created by uncertain future performance of the business, parties need to address the fundamental question of when problems in the business are significant enough to release the buyer from its obligation to close the deal.

While the allocation of pre-closing risk is typically heavily negotiated (and by necessity that negotiation will also factor in the extent of any post-closing recourse available to the buyer), the parties often start with the basic premise that the buyer accepts that it will have to close the purchase unless problems in the business rise to the level of a “material adverse effect.”²

Material Adverse Effect – Durational Significance and Long-Term Perspective

A buyer faces a high hurdle to establish to a court’s satisfaction that an MAE has occurred. In Delaware, where most of the relevant litigation has been decided, the courts have repeatedly emphasized that to allow a buyer to walk away from a signed deal, the adverse event must be so material as to “substantially threaten the overall earnings potential of the target in a durationally significant manner. A short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror.”³ In practice, this hurdle is so difficult to clear that only once has a Delaware court held that an MAE has occurred, under drastic circumstances of operating losses and regulatory non-compliance.⁴

Material Adverse Effect – Exclusions

Despite the courts’ disinclination to allow a buyer to walk away from a signed deal on the basis of an MAE, a seller focused on deal certainty will insist that the MAE definition be crafted to exclude risks that are not specific to the target company or business, but that sweep along the company with others in it industry or in the general economy. These changes include general economic, financial market, business or geopolitical conditions and changes in law, as well as changes or developments in any of the industries or markets in which the company operates. In these situations, because the changes at issue are beyond the control of the seller and would likely have affected the business equally had it already been under the buyer’s control, the buyer will generally bear the risk that the target business declines along with others in its industry (except, in certain cases, where the change or development has a disproportionate impact on the business being sold).

Of particular note when considering the potential impact of COVID-19 is that some dealmakers negotiate MAE provisions with carve-outs that specifically exclude the impact of epidemics, pandemics, heath crises or similar terms on the target business. While this carve-out is usually observed in only a fraction of M&A deals, we have observed a substantial increase in its usage in recent weeks, with two high-profile deals specifically calling out changes arising out of COVID-19 as excluded from the determination of an MAE. Others may rely on more general carve-outs such as calamities, natural disasters or acts of God, but one can reasonably question whether these concepts capture a health crisis such as the coronavirus outbreak.

COVID-19 as an MAE?

Whether the impact of COVID-19 will constitute an MAE will turn on the specific definition negotiated between the parties and the ultimate impact of the pandemic.⁵ Although intuitively appealing, parties typically do not include explicit dollar thresholds or other objective metrics in the definition of an MAE that could clarify the analysis, leaving the parties and ultimately the courts to conduct a facts-and-circumstances analysis.⁶ The analysis therefore turns on the following issues:

• Durational Significance. Whether the adverse effect of COVID-19 will have the durational impact on most companies necessary to constitute an MAE remains to be seen. This may also vary across industries; for example, even if the outbreak is contained in the near term, there may be long-term declines in certain businesses (such as if vacationers are reluctant to return to cruise ships or fly internationally).
• Exclusions. Sellers who negotiated to expressly carve out effects arising from epidemics or pandemics will rely on that language in their agreements as evidence that the buyer agreed to bear COVID-19 risk. In the more typical case where the MAE definition does not exclude health-specific terms, the seller may point to the general economic or market-condition exclusions for protection, to which the buyer could respond, if and when applicable, that the target business suffered a disproportionate impact from the virus.
  
  • As mentioned, only a few publicly available examples to date have specifically excluded effects from COVID-19, but we expect parties to heavily negotiate the allocation of COVID-19 risk going forward.
    
  • o For example, a recently filed public merger agreement excluded from the definition of MAE any effects “arising out of changes in geopolitical conditions, acts of terrorism or sabotage, war (whether or not declared), the commencement, continuation or escalation of a war, acts of armed hostility, weather conditions, global health conditions (including any epidemic, pandemic, or disease outbreak (including the COVID-19 virus) or other force majeure events, including any material worsening of such conditions threatened or existing as of the date of this Agreement, to the extent that such Effects do not disproportionately impact [the party] relative to other companies operating in the industry or industries in which [the party] operates.”
    

The Buyer’s Efforts Covenant

A pitfall for any buyer attempting to call an MAE and terminate the acquisition agreement to be aware of is that the buyer will almost always have agreed to a covenant of its own to exert efforts to close the transaction. The buyer must therefore strike a balance between exercising the termination provision of the agreement—as is its right to do—and complying with its efforts covenant.

The Delaware courts have addressed this dilemma several times in MAE-related litigation. Critical for the buyer is that it have reasonable grounds for its decision to terminate and not appear to be searching for a premise to terminate the deal out of buyer’s remorse. A buyer can evaluate its contractual rights with its counsel and other advisors without running afoul of its efforts covenant. A buyer that shuts off all communications with the seller before deciding to terminate makes for bad optics that can make it harder to convince a court that it was acting in good faith.  

Footnotes

^{1) While a same-day “sign and close” structure can be used in some deals, a (potentially lengthy) delay between signing and closing is commonly necessary due to the need to obtain governmental approvals for the transaction (such as under the U.S. Hart-Scott-Rodino Antitrust Improvements Act of 1976), finalize the buyer’s financing arrangements, obtain the consents of various stakeholders and/or prepare to transition ownership.}

^{2) This may also be defined in the agreement as a “material adverse change,” or what deal lawyers colloquially refer to as a “MAC.”}

^{3) In re IBP, Inc. S’holders Litig., 789 A.2d 14, 67-68 (Del. Ch. 2001); see also Frontier Oil Corp. v. Holly Corp., 2005 WL 1039026, at *34 (Del. Ch. Apr. 29, 2005); Hexion Specialty Chem., Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008); Channel Medsystems, Inc. v. Boston Scientific Corp., 2019 WL 6896462, at *24 (Del. Ch. Dec. 18, 2019).}

^{4) Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018), aff'd, 198 A.3d 724 (Del. 2018).}

^{5) Note that where the buyer requires financing to consummate the acquisition, the lender commitment will typically include MAE language that tracks the underlying acquisition agreement. Buyers must be vigilant about narrowing any gap between enforcement of the buyer’s obligation to close the acquisition and the lender’s obligation to finance, lest they be required to close the transaction without a way to enforce the debt financing.}

^{6) The Akorn decision explained the rationale for leaving out explicit thresholds. The court acknowledged the difficulty of reaching an agreement on an exact dollar or percentage amount during deal negotiations, and noted that a buyer would be reluctant to agree to a threshold that creates an implication that any drop short of that threshold must not amount to an MAE. (2018 WL 4719347, at *48.)}