As a result of the recent unprecedented outbreak of the novel coronavirus (COVID-19), dealmakers and their advisors have yet another set of issues to address in connection with pending and future M&A transactions. While the outbreak and its impact is still evolving, it’s clear that there will be at least short-term consequences for M&A transactions and the way they are approached.
MAE Provisions
While COVID-19 has caused some dealmakers to hit the pause button on yet to be signed deals, parties to pending M&A transactions in the interim period between signing and closing and materially impacted by COVID-19 have a different set of concerns to consider. The reality is that the first question that comes to a buyer’s mind under these circumstances is their ability to walk away from a pending acquisition of a target that has suffered or may suffer potentially grave consequences caused by COVID-19; while sellers, on the contrary, are looking at ways to force nervous buyers to close. In their competing analysis, the first stop for parties in a pending M&A transaction will be to review closing conditions and the definition of “material adverse effect” (MAE) included in their purchase agreement. While the MAE term in a purchase agreement serves a number of purposes, its most critical function is to provide a walk away right for the buyer.
While standard MAE definitions generally provide that any fact, development, change or effect that is, or is reasonably expected to be, materially adverse to the target, its business, assets or operations is an MAE, there are typically a number of “carve-outs” from the MAE definition (i.e., matters that are expressly deemed not to be an MAE). These carve-outs often include matters such as general changes in economic conditions and the securities markets, acts of terrorism, military action or war, changes in applicable law and natural disasters, acts of God and certain other force majeure events. While not the norm in the past, epidemics and public health events have also been specifically carved-out from the definition of MAE in certain deals, in which case, a buyer would be prevented from using a crisis such as COVID-19 as an MAE out (subject to the potential application of the impairment clause in certain MAE definitions as discussed later in this Legal Update). While it is very common for buyers to include a “disproportionate effect” provision to combat carve-outs (which eliminates a carved out matter to the extent such matter disproportionately adversely affects the target as compared to the others in the target’s industry), the buyer still has to prove that the target suffered a disproportionate effect which is no easy task and requires a very fact specific analysis.
Even assuming that a matter such as COVID-19 has not been expressly carved out of the MAE definition, it is a very tall order for buyers to prove an MAE has occurred in any M&A transaction. In fact, until the recent case of Akorn, Inc. v. Fresenius Kabi AG, the Delaware courts had never ruled that an MAE had occurred in an M&A transaction. In Akorn, the Delaware Court of Chancery confirmed that only a serious and substantial downturn in the business which is “durationally significant” could be deemed an MAE and a “short-term hiccup in earnings” will not qualify; such a perspective needs to be “measured in years rather than months.” At this point, not enough time has passed yet to determine with any certainty whether the prevalence of the adverse impact resulting from COVID-19 will be remain long enough to warrant finding an MAE. Of course, this could change over time depending on the staying power of the pandemic and its negative ramifications.
It is important to note that many definitions of MAE include two prongs and an MAE can be found by satisfying either prong. The first prong is typically that a material adverse effect on the target, its business, assets or operations as previously described has occurred, and the second prong is the so-called “impairment clause” whereby any fact, development, change or effect that is, or is reasonably expected to be, materially adverse to the ability of the seller or the target company to close the deal or to otherwise comply with its obligations under the purchase agreement also constitutes an MAE. Many impairment clauses are not subject to the negotiated general carve-outs in the definition of MAE. As found in the Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd. case, when the impairment clause is not expressly modified by the carve-outs (as opposed to the first prong of the MAE definition), 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 Merger Agreement; the parties agreed not to excuse [seller] for any such breach.” While the court in the Cooper Tire case did not rule on the issue of whether an MAE occurred, it found that a matter carved out of the first prong of the MAE definition which caused the seller to breach certain of its obligations under the merger agreement resulted in the failure of a closing condition relieving the buyer of its obligation to close and, despite Cooper’s arguments to the contrary, the court noted that the carved out matter did not prevent the buyer from enforcing Cooper's obligations under the merger agreement. It should be noted that unlike the material adverse effect on business prong of the MAE definition, a buyer-friendly impairment clause might be satisfied by a short-term adverse impact that interferes with a seller’s ability to satisfy its obligations under the purchase agreement (including its interim operating covenants), even if such impact is not a durationally significant disruption to the business. This could open a door to buyers finding an MAE out more easily.
Given the current circumstances surrounding COVID-19, in negotiating future M&A deals, it would be prudent for sellers to push for express carve-outs regarding pandemics and public health events from the definition of the MAE (including the impairment clause, if applicable), and also from certain purchase agreement covenants, to make it completely clear that such events cannot be used as an “out” for buyers via an MAE or otherwise. We are starting to see pandemic and disease outbreak carve-outs creep into purchase and other agreements. For example, the recently entered into agreement and plan of merger between Morgan Stanley and E*Trade Financial Corp. includes a specific carve-out in its definition of MAE for “any epidemic, pandemic or disease outbreak (including the COVID-19 virus)...” (it should be noted that this carve-out was softened with a “disproportionate effect” qualifier similar to that previously described). Depending on negotiating leverage, we expect to see more sellers require a pandemic, disease outbreak or similar carve-out in their MAE definitions arguing that COVID-19 is a known problem that buyers can diligence before signing a purchase agreement and can otherwise account for in determining their purchase price. Buyers, on the other hand, will contend that the long-term impact of COVID-19 and the possibility of other similar outbreaks remains unclear, and if there is a long period time between signing and closing that they need the ability to analyze the ongoing and evolving impact of COVID-19 during the interim period and, at minimum, buyers should require a disproportionate effects qualifier if they accept any such carve-out at all.
Other Deal Points
Enhanced Diligence and Representations & Warranties
In conducting due diligence and negotiating representations and warranties, the impact of COVID-19 or other negative impacts that could be caused by a similar outbreak should be top of mind for buyers to ensure that they are being provided with sufficient information to make informed decisions in valuing the transaction and providing for proper downside protection in the purchase agreement. For example, buyers should conduct more expansive insurance related diligence and seek additional representations regarding the target’s business interruption insurance coverage or lack thereof. Enhanced diligence and representations and warranties should be sought relating to the target’s compliance with the Occupational Safety and Health Act and the target’s policies and practices related thereto and any potential related liabilities. The representations regarding material contracts should include a review of force majeure provisions and most definitely include any indications from the counterparties to such contracts regarding potential non-performance or termination. Additional review should be conducted of the target company’s contingency plans and business continuity practices, programs and policies as well as the protections in place with respect to privacy and cybersecurity in the event of potential long-term need for remote working arrangements.
Interim Covenants
More than ever before, sellers should be focused on negotiating for broader rights with respect to the operation of their business in the interim period between the signing and closing without first obtaining buyer’s approval. This may include an exception from the operating covenants to excuse performance of certain obligations impacted by pandemic or similar event or to make urgent decisions, such as obtaining additional credit or closing a plant which would be mandated by government order or required to keep target’s business float in the face of a crisis such as COVID-19. Of course, given the importance of such decisions, buyers are well advised to continue to preserve their right to approve, or at least be consulted regarding, these actions.
Regulatory Approvals and Third Party Consents/Outside Termination Date
All parties should expect delays in obtaining required regulatory approvals and third party consents. For example, due to COVID-19, the U.S. Department of Justice (DOJ) is asking parties who receive a request for documents and enter into a “timing agreement” with the DOJ to give the agency an additional 30 days to review deals after the parties complete their document production. Moreover, Hart-Scott-Rodino (HSR) notification filings are no longer being accepted by hard copy or DVD and instead, effective March 17, 2020, HSR filings are only accepted via a temporary e-filing system and, while this temporary system is in place, early termination will not be granted for any filing. In addition, counterparties to material contracts may be less responsive to consent requests while dealing with the COVID-19 crisis and, out of the fear of uncertainty, these parties may want to impose less than reasonable terms as a condition to granting such consents.
With likely delays in obtaining regulatory approvals and third party consents, parties should pay close attention when determining the “outside date” in the termination section of their purchase agreement to prevent premature termination rights.
R&W Insurance and Indemnification
While the impact of COVID-19 on the scope of representation and warranty insurance (R&W Insurance) coverage is not completely clear at this time, R&W Insurance will not cover known events and insurers are likely to seek broad exclusions for any losses related to COVID-19. As such, buyers should negotiate for specific indemnities to cover potential losses related to COVID-19, including related to supply chain interruptions, third party contract breaches and increased labor costs due to remote working and otherwise.
