The outbreak of the novel coronavirus disease 2019 (COVID-19) and the uncertainty surrounding its long-term implications have caused a noticeable disruption in the consummation of mergers and acquisitions (M&A) transactions. With the onset of the pandemic, parties revisited through the lens of the pending crisis certain key provisions in acquisition agreements on which closing is conditioned. As time went by and the economic fallout of the government-mandated shutdowns became more apparent, a growing number of acquisition agreements that had been signed prior to the outbreak came under scrutiny. Much like during the 2007 – 2008 financial crisis, buyers pulled the “Material Adverse Effect” (MAE) clause from their toolkit, asserting this provision as a basis for terminating or delaying closings.
This article surveys recent cases in which sellers have challenged buyers who terminated or threatened to terminate transaction agreements because of the fallout from COVID-19, principally on the basis of the MAE clause. It also makes certain drafting suggestions to address potential ambiguities and uncertainties in customary transactional documentation that have surfaced in the current crisis.
The MAE Clause
Closing of an M&A transaction is typically conditioned on the absence of an MAE, the definition of which generally has two prongs. The first prong addresses the deterioration in the circumstances of the company being acquired, referred to as the “target,” and the second relates to the continuing ability of the seller and the target to perform under the acquisition agreement.
Prong one: Business deterioration
An MAE clause permits a buyer to terminate a transaction agreement if, as a result of an event or series of events, a material deterioration in the business, financial condition or results of operations of the target has occurred between the signing of the agreement and the closing of the transaction. An MAE clause functions as a risk allocation tool between seller and buyer. The general risk of an MAE falls on the seller. However, certain specific categories of events are excluded from what definitionally constitutes an MAE — for example, macroeconomic changes, geopolitical conditions, calamities or acts of God — so that the buyer assumes the risk of these events. It typically does not stop there. Buyers will often negotiate a “disproportionality” qualifier into the excluded categories of events. This effectively reallocates the risk of the excluded risk categories back to the seller if the impact of the excluded events has affected the target much more severely than it has peer businesses operating in the same industry.
While there is no bright-line test under current case law for establishing a “prong one” MAE, there is a general consensus that successfully asserting such an MAE requires satisfaction of a demanding legal standard. Much of that consensus is drawn from opinions issued by the Delaware Chancery Court, such as Hexion Specialty Chemicals, Inc. v. Huntsman (Del. Ch. 2008). The first and only Delaware Chancery case in which an MAE was successfully asserted was the 2018 case of Akorn, Inc. v. Fresenius Kabi, AG, which reaffirmed the high burden required to establish an MAE.
Specifically, courts have said that an MAE occurs only if there is a sustained and severe decline in the target’s business and earnings potential, and the decline must be durationally significant. So, for example, a short-term hiccup in earnings would not suffice. The impact of the business deterioration would need to be established over a commercially reasonable period of years rather than months.
Prong two: Ability to consummate
Typically, MAE is separately defined to include an event or series of events that would “impair or materially delay the ability of the seller to consummate” the transactions contemplated by the acquisition agreement. The formulation of this prong is sometimes broadened to address not only the seller’s ability to close the transaction, but also to perform any of the seller’s or the target’s other obligations under the acquisition agreement. The performance-related language is typically not subject to any “in all material respects” or similar qualifiers. Unlike the first prong of the definition, this prong is generally not subject to a standard set of carve-outs.
The function of an MAE clause; covenant bring-down condition
The absence of an MAE is a stand-alone condition to the buyer’s obligation to close the acquisition transaction. In addition, MAE qualifies the “bring-down” condition that the representations and warranties of the seller and the target must be true and correct at closing. Typically, that condition will be deemed satisfied so long as any interim breaches and failures of the representations to be true would not result in an MAE.
There is also a second bring-down condition commonly found in acquisition agreements, which requires that the seller and the target have complied with their pre-closing covenants. Importantly, that condition is most often tested against an “in all material respects” standard. In the Akorn decision, the court commented on the disparity between the in-all-material-respects standard and the much higher MAE standard. Like the common law concept of “material breach,” the qualifier merely “seeks to exclude small, de minimis, and nitpicky issues” and to limit the operation of the covenant or condition to “issues that are significant in the context of the parties’ contract.” But breaches that meet the in-all-material-respects test effectively allow a buyer to terminate the transaction, even though they fall short of an MAE. This has significant implications for certain of the COVID-19-driven termination cases, as discussed below.
MAE clauses and the reaction to COVID-19
The COVID-19 outbreak crept into the public awareness starting around mid-January 2020 and became a global concern by mid-February. By late February, market participants in the United States began to contemplate COVID-19-related carve-outs in MAE definitions. Increasingly, references to “epidemics,” “pandemics” and the “COVID-19 virus” found their way into such MAE exclusions, with sellers generally bearing the risk of a disproportionate impact of the pandemic on the target business.
Parties also became sensitive to the potential effects of the pandemic on sellers’ ability to make representations and warranties and to comply with covenants, in particular those speaking to the operation of the business between signing and closing “in the ordinary course, consistent with past practice.” Sellers have reacted by making appropriate disclosure schedule exceptions to the representations, warranties or covenants, thus putting the buyer on notice of potential COVID-19-related breaches or noncompliance and essentially shifting the risk to the buy side.
The First Lawsuits
By early April 2020, the government-mandated shutdowns began to take effect across the United States, and the market experienced in significant measure the economic impact of the pandemic. Cases of terminated M&A transactions and related litigation also emerged at this time.
Actions related to the MAE condition
Bed Bath & Beyond, Inc. v. 1-800-Flowers.com. Bed Bath & Beyond brought an action in Delaware Chancery Court to force 1-800-Flowers to follow through on its agreement to purchase the PersonalizationMall.com keepsakes site for $252 million. The acquisition agreement was signed on Feb. 14, 2020, while the COVID-19 outbreak in China and certain other parts of the world was already public knowledge, but the subsequent rapid outbreak across the U.S. was yet to come. The MAE clause of the agreement contained an exclusion for “conditions affecting any of the industries or markets in which the company operates” or “any change resulting from changes in general business, financial, political, capital market or economic conditions (including any change resulting from any calamity, natural or man-made disaster or acts of God, hostilities, war or military or terrorist attack).”
In its complaint, Bed Bath & Beyond invoked this exclusion and asserted that the risk associated with the pandemic should be borne by 1-800-Flowers.com. It also maintained that the pandemic did not have a disproportionate effect on the target business, which was affected in the same manner as millions of comparable retail businesses across the globe. Bed Bath & Beyond’s lawsuit claimed that 1-800-Flowers.com was “attempting to use the unfortunate challenges presented by COVID-19 as a tactic to avoid its contractual obligations and unilaterally impose a 30-day extension to suit its interests, with no assurance whatsoever of a firm closing date.” This litigation remains pending with a trial scheduled for the last week of September.
Level 4 Yoga, LLC v. CorePower Yoga, LLC & CorePower Yoga Franchising LLC. Level 4 Yoga, a franchisee of CorePower Yoga LLC, sued the yoga studio chain in Delaware Chancery Court, claiming it was trying to use coronavirus-caused studio closures to back out of an agreement to buy 34 studios. Suing for specific performance, the seller argued that no MAE had occurred as a result of the COVID-19 outbreak.
The transaction agreement did not include a pandemic-related carve-out in its MAE definition. Level 4 Yoga argued, however, that the effects of the pandemic failed to satisfy the durational requirement for an MAE. Level 4 Yoga’s yoga studios were only temporarily closed pursuant to state and local quarantine directives. The temporary shutdown, it said, would not result in the type of long-term impact on the target’s earnings power required under MAE case law. Level 4 Yoga also argued that the shutdown and other pandemic-related consequences on the Level 4 Yoga business were not disproportionately adverse as compared to how other yoga studios were affected by the crisis. CorePower Yoga has moved to dismiss, and the litigation remains pending.
Operating covenant breaches as an MAE trigger
SP VS Buyer LP v. L Brands, Inc. This action related to a proposed investment by private equity fund Sycamore Partners in L Brands’ Victoria’s Secret business. Sycamore provided a termination notice on April 22, arguing that L Brands remained in “material and incurable breach” of the acquisition agreement as a “direct result of the actions that L Brands took without [Sycamore’s] consent or acquiescence and in breach of the Transaction Agreement.”
Sycamore’s complaint did not rely on the “first prong” of the MAE definition. Indeed, it is questionable whether Sycamore could have relied on this prong, as the definition excluded the existence and continuation of pandemics. Sycamore shifted the conversation by focusing on the second prong and the alleged impairment of L Brands’ ability to perform under the transaction agreement. In response to the pandemic, Victoria’s Secret not only complied with the mandated shutdowns, but it undertook other measures — for example, employee layoffs and changes to inventory and cash management practices. Because of the pandemic-related events and circumstances, Sycamore asserted, L Brands could not comply with its covenants to operate the business in the ordinary course consistent with past practice and to refrain from taking certain material actions without the buyer’s consent. Sycamore did not have to contend with an exclusion for the pandemic in the second prong, because there was none.
Sycamore’s reliance on an allegedly pandemic-induced irreparable breach of the “ordinary course” covenant could also be questioned. The issue of whether, in the circumstances of the pandemic, Victoria’s Secret’s actions could be considered operating in the ordinary course was framed by Vice Chancellor Laster in the similarly situated case of AB Stable VIII LLC v. MAPS Hotels & Resorts One LLC (Del. Ch. May 5, 2020). He stated that “the real question is whether an ordinary course covenant means ordinary course on a clear day or ordinary course based on the hand you’re dealt,” adding that “here we obviously have a colossal and viral-based rainstorm, but that’s really the question: Are people doing things that are ordinary course when one is in a pandemic, and is that what the contract contemplates?”
While seemingly novel in its MAE strategy, Sycamore’s reliance on the performance-related MAE prong drew on precedent from a prior case, Cooper Tire & Rubber v. Apollo (Del. Ch. 2014). That case involved a merger agreement between an Apollo affiliate and Cooper Tire. Apollo’s principal purpose was to acquire Cooper Tire’s 65% interest in Chengshan Cooper Tires, a Chinese tire manufacturer. After the merger was announced, the minority owner of the Chinese company apparently caused its union workers to go on strike, and its facility was shut down.
The acquisition agreement in the case contained both the first and second prongs of the MAE definition. In his decision, Vice Chancellor Glasscock noted that, while the first prong may have had carve-outs for certain events or risk categories, the second prong, which picked up compliance with interim operating covenants, was unqualified. In reconciling this apparent conflict between the two MAE clauses, the court stated that “the logical operation of the definition of Material Adverse Effect shifts the risk of any carved-out event onto [buyer], unless that event prevents [seller] from complying with its obligations under the [Agreement]; the parties agreed not to excuse [seller] for any such breach.”
The facts and circumstances in Sycamore v. L Brands are arguably different from those in Cooper Tire. L Brands’ actions in response to the pandemic, and its economic impacts, were arguably in line with how businesses across the industry reacted and were affected, whereas Cooper Tire’s actions were specific to its business and the particular transaction. But the legal construct of “leveraging” a purported breach of interim operating covenants to establish an MAE found some legal precedent in the Cooper Tire decision.
We will never know whether Sycamore would have succeeded with its strategy. The parties settled their litigation on May 4 and parted ways without payment being made by either party. The settlement could have been indicative of Sycamore’s superior legal position. Alternatively, the transaction contemplated an ongoing joint venture between two parties whose relationship had seemingly soured, and L Brands may have decided to simply move on from a point of no return.
Other Pandemic-Related Justifications for Termination
The MAE clause and alleged breaches of interim operating covenants have been the most common bases on which buyers have sought to unwind M&A transactions in the wake of the pandemic. But other arguments for COVID-19-related terminations have been advanced as well.
Logistics and equitable principles
Khan v. Cinemex Holdings USA, Inc. Star Cinema Grill is a Houston-based operator of dine-in movie theaters owned by Omar Kahn. In March, after the outbreak of the COVID-19 pandemic, Cinemex Holdings, a U.S. subsidiary of a Mexican theater chain, entered into an agreement to purchase Star Cinema Grill. Cinemex then refused to close the transaction, based on Kahn’s alleged COVID-19-related breaches of the acquisition agreement. The acquisition agreement provided for the closing to be held in Houston, with which, given the travel restrictions between Texas and Mexico, the parties could not comply. In addition, Cinemex asserted that the seller had breached its covenant to provide access to certain properties and information of the target between signing and closing, and that the buyer’s inability to physically inspect the properties constituted a seller breach. Cinemex also invoked the common law doctrines of impossibility, impracticability and frustration of purpose, arguing that the lockdown was an unforeseeable event that excused the buyer’s nonperformance.
The case, which was originally brought in Texas federal court, was suspended when Star Cinema Grill filed for bankruptcy, but had it proceeded, Cinemex would have needed to overcome a variety of counterarguments. Access covenants are typically qualified by “reasonableness.” And it is questionable whether a provision specifying a closing location, which is an item of convenience rather than a fundamental term, would be a valid basis for termination. Case law also suggests that equitable principles of impossibility, impracticability and frustration of purpose are sparingly applied, and that a court might not give them effect where the cataclysmic event on which they are based was known at the time of signing.
Forescout Technologies, Inc. v. Ferrari Group Holdings, L.P. This matter involves the proposed $1.9 billion take-private of publicly traded cybersecurity firm Forescout Technologies by Advent International. Advent declined to close on the scheduled closing date, making the various COVID-19-related MAE and interim operating covenant breach arguments discussed above. Separately, though, the case implicates application of the termination or outside date, another common feature of acquisition agreements. The termination date is specified in the acquisition agreement and constitutes the date by which the transaction must be consummated, or either party can terminate unilaterally. Typically, termination dates range from three to nine months following the signing of the acquisition agreement, depending on the expected time required to obtain the necessary approvals for the transaction.
Forescout was undoubtedly aware that Vice Chancellor Slights had denied a motion to expedite in the case of Juweel Investors Ltd. v. Carlyle Roundtrip, L.P. (Del. Ch. May 11, 2020), relating to Carlyle’s proposed investment in the American Express Global Business Travel business, notwithstanding the imminent termination date of the buyer’s debt financing commitments. In that case, the plaintiff had been on notice for almost a month that the seller had asserted an MAE before it brought suit. The Vice Chancellor refused to expedite the trial in the midst of the pandemic where the seller had, by its inaction, nearly halved the available time to litigate and consider the matter.
With its contractual termination date approaching on June 6, Forescout filed a motion for expedited proceedings and a temporary restraining order that would prevent Advent from terminating the acquisition agreement until the court ruled on Forescout’s application for specific performance of the agreement. The parties subsequently stipulated to adjourn the termination date until August 6, with a trial in the action slated to commence on July 20.
In an M&A transaction involving a financial buyer, debt and equity commitment letters that secure essential funding for the transaction may also be affected by, and become a point of contention as a result of, the COVID-19 pandemic.
Snow Phipps Group LLC v. KCAKE Acquisition, Inc. On March 6, affiliates of Kohlberg, Kravis & Roberts (KKR) entered into an agreement to acquire DecoPac Inc., the world’s leading wholesaler of cake decorations, from the private equity firm of Snow Phipps Group. Snow Phipps sued the KKR affiliates in Delaware Chancery Court, claiming they were trying to impermissibly withdraw from the transaction over COVID-19 concerns. A major part of the litigation revolves around the purported unavailability of the buyer’s debt financing. Typically, the principal condition to the debt commitments obtained by a buyer at signing is the absence of an MAE. This effectively moves the conversation back to the issue of MAE, as defined in the acquisition agreement. In this case, the acquisition agreement did not contain any financing contingency that would have allowed a buy-side termination in the event that the debt financing became unavailable. But, as commonly seen in these types of leveraged buyout transactions, Snow Phipps’ right to seek specific performance to compel KKR’s obligation to fund its equity commitment was conditioned on the debt financing being available. The case remains pending before the Chancery Court, and a trial has yet to be scheduled.
Sycamore v. L Brands. In addition to the MAE claims described above, Sycamore argued that its equity commitment letter had automatically terminated upon L Brands’ filing a lawsuit that, in its prayer for relief, sought monetary damages as an alternative to specific performance. An equity commitment letter is a letter agreement entered into between a private equity fund and its acquisition vehicle, in which the fund commits that it will invest equity in the vehicle at closing to fund the transaction. Sycamore’s equity commitment letter provided for certain termination triggers, including lawsuits by the seller for remedies other than specific performance. The logic of such a trigger is that the equity commitment letter is only meant to backstop the buyer’s purchase price, not post-termination monetary damages. Like the MAE claims, this one was also mooted on settlement of the lawsuit.
Evolving case law
The wave of COVID-19-related deal disputes is still very much continuing, and new developments are occurring on an almost daily basis. To date, there have been no substantive rulings and, based on procedural orders by the Delaware Chancery Court, it may be months before trials will commence. The incentives for further buy-side deal terminations will naturally depend on the market’s sense of outcome of the currently pending cases, whether through court decisions, settlement or renegotiation of terms. They will also be influenced by the courts’ perceived receptivity to the various MAE-related arguments described above.
It appears unlikely that the courts will adopt a uniform approach on the question of whether the current crisis and its economic implications constitute an MAE or provide other grounds for termination. Rather, as case law suggests, the analysis will be highly facts- and circumstances-specific, and courts will likely place great emphasis on the intent of the parties on risk allocation, taking into account the time at which the agreement was signed and the information then available. Decisions will also be influenced by the severity of the impact on the particular target business, both on a stand-alone basis and when compared to similarly situated peer businesses. However the cases come out, the surge in litigation can be expected to bring greater clarity to the interpretation of the concepts of MAE and “ordinary course of business,” and the intricate interplay of definitions, covenants and closing conditions that hitherto rarely has been put to significant test.
Parties will be advised in transactions that are yet to be signed to clearly allocate the risks associated with the COVID-19-related health and economic crisis, and to anticipate similar “deal breakers” that might arise in the future. This includes clarifying whether pandemics should be carved out from the MAE definition and which party should bear the “disproportionality” risk. Introducing clearer metrics for the determination of an MAE could be a double-edged sword, as ambiguity could work in either party’s favor, depending on the facts. Nevertheless, there is value to all parties in minimizing litigation uncertainty, such as by introducing parameters around performance or earnings impacts — for example, expressed as a percentage of the target’s EBITDA — or specifying the time duration required for an adverse event to constitute an MAE.
Cooper Tire and L Brands v. Sycamore provide food for thought on the application of the second, performance-related prong of the customary MAE definition. Sellers should consider limiting this clause solely to the ability to consummate the closing and reject a broader formulation that applies to any and all covenants under the acquisition agreement. Alternatively, sellers could materiality-qualify the language in that prong in a manner that is similar to how the covenant bring-down condition is qualified. Under such a formulation, a second-prong MAE would be triggered only if seller’s ability to perform its obligations “in all material respects” was affected. In addition, but in departure from current market practice, sellers may consider negotiating for the application of some or all of the typical MAE carve-outs in the first, business-related prong to the second, performance-related prong of MAE as well.
Parties may also wish to add definitional clarity to the concepts of “ordinary course of business” and “past practices” in connection with the interim operating covenants. Current litigation has raised several questions on the interpretation of these concepts: against whom a target’s responsive measures to exigent developments should be compared, and whether the “past practice” qualifier is even meaningful in unprecedented and disruptive times. Sellers may consider incorporating force majeure–type exceptions in their obligations under the operating covenants, either through a stand-alone blanket exception for emergency responses or by specifically incorporating MAE-type exclusions into the covenant. With this change, operational changes made outside of the ordinary course in connection with the pandemic or other MAE carve-outs would not result in a breach by the seller.
There is logical justification for some sort of modification along these lines. Interim operating covenants generally include a seller’s obligation both to continue to conduct the business in the ordinary course and also to preserve intact its business organization. In circumstances like the COVID-19 pandemic, where companies may be required to take drastic measures to keep their businesses alive, these two covenants may arguably conflict, and parties should consider clarifying which obligation supersedes the other in an emergency.
Kahn v. Cinemex suggests that sellers should also consider the standard of performance under other interim covenants that are ordinary features of acquisition agreements. For example, rather than an unqualified obligation to provide the buyer with access to facilities and information, sellers would be better off with a covenant that obligates them to use “commercially reasonable efforts” to provide such access. Sellers might also negotiate for event-driven limitations on these obligations, to the extent the buyer is not materially prejudiced. The restrictions on assembly and travel under the COVID-19 pandemic might also incentivize parties to eliminate any provision in their transactional documentation for a physical closing, especially considering that in practice the large majority of M&A transaction closings in the U.S. are conducted remotely, via electronic document exchange.
Lastly, in response to the challenges of COVID-19 and similar unforeseen economically transformative events, parties need to take a holistic view of their documentation set. Debt and equity commitment letters intertwine with acquisition agreements, and a pandemic-driven failure of financing can be just as fatal as the breach of covenants under the principal deal document. This interplay should also be kept in mind when formulating complaints and naming the parties in litigation.
Informed by Forescout v. Ferrari, sellers might also consider providing for automatic extensions of the termination date during the pendency of an action to compel specific performance of the transaction agreement. However, buyers, especially financial buyers that are using debt financing to fund the transaction, will likely resist this modification because their debt commitments will typically expire by the termination date. This would leave buyers exposed as they would be required to fill the funding gap or be liable for buy-side breakup fees if the transaction does not close.
Whether the recent surge of M&A litigation is a sign of widespread buyer’s remorse or stems from the legitimate belief that deals struck pre-pandemic should, at a minimum, be reevaluated in light of the “new normal” is a complex question that will require a delicate balancing of equities and contractual risk allocation. There will likely not be a one-size-fits-all answer. Practitioners will need to closely monitor the courts’ evolving stance on the various legal questions raised by the COVID-19-related disputes. Still, the pending cases already provide valuable insight into the potential soft spots in acquisition agreements that may come under attack by buyers seeking to exit deals that have become undesirable. The cases also suggest potential ways in which sellers could provide for enhanced certainty and protection for their deals, whether in the context of the ongoing pandemic or of the next “black swan” event.