The changed economic landscape caused by COVID-19, with a shortage of debt financing and volatility in the stock market, has resulted in a dramatic downtick in M&A activity.  Not only are buyers skittish about making acquisitions in the first instance, many buyers are now faced with the difficult decision of whether to terminate pending deals that have been signed, but have not yet closed, based on the “material adverse effect” (“MAE”) clause contained in their merger agreements.  MAE clauses are used to both condition a purchaser’s obligation to consummate the merger on the absence of an MAE and to qualify the parties’ contractual representations and warranties, which typically are deemed not only made on the date of the contract but also carried forward to the date of the closing.

In the wake of COVID-19, many buyers have already unilaterally backed out of consummating merger transactions, especially after the World Health Organization categorized COVID-19 as a pandemic.  While some transactions were terminated by mutual agreement of the acquirer and the target, or renegotiated to a lower purchase price, many terminations have been, and will continue to be, unilateral and contested as evidenced by the recent rash of lawsuits filed in Delaware’s Court of Chancery (often referred to as “the Mother Court of corporate law”) by would-be buyers who terminated pending transactions based on the decline in value of the target company and its prospects for long-term earnings.   As of the date of this post, no court has yet addressed whether the impact of COVID-19 is an MAE, but buyers considering whether or not to unilaterally terminate a transaction can find guidance from courts who have analyzed MAE provisions in M&A litigation triggered by events other than COVID-19.

The Structure of an MAE Clause:  An Exercise in Risk Allocation

MAE clauses are heavily negotiated, tailored to the particular transaction at issue and reflect the allocation of risks the parties are willing to take that an event will not occur between contract signing and closing that materially changes the business of the target and the economics of the transaction.  Traditionally, an MAE clause has three components, beginning with a general affirmative statement that conditions the obligation to close the transaction on the non-existence of an MAE and permits the buyer to terminate the transaction at no cost in the event of an MAE.  A typical MAE clause broadly defines an MAE as any development, event, or series of events that had, or would reasonably been expected to have, a material adverse effect on the business, assets, financial condition, or results of operations of the target company.  Thus, in terms of risk allocation, the seller assumes the initial risk that an MAE will not occur.

The general affirmative statement is followed by carve-outs – i.e., an enumerated list of events or developments that a buyer cannot rely on to unilaterally terminate a transaction.  The carve-outs are usually events that are not specific to the seller and beyond the control of both the buyer and the seller, such as changes in the law or changes in economic conditions that generally affect the target’s industry.  Pandemics have historically not been included in merger agreements as an MAE carve-out, but the trend is changing in the wake of COVID-19.  In terms of risk allocation, the buyer assumes the risk that the carved-out events will not occur between contract signing and closing.  The carve-outs, however, are themselves subject to a “disproportionate effect” exception—the third component—which shifts the risk back to the seller and gives the buyer the right to terminate the transaction when the carved-out event has a disproportionate effect on the target company as compared to other companies in the industry.

A Difficult Road to Hoe

Historically, a buyer’s ability to unilaterally terminate an M&A deal in the midst of a severe economic downturn—such as the 2008 global financial crisis—based on an MAE has been exceedingly difficult.  Indeed, prior to its 2018 decision in Akron v. Fresnius, no court in Delaware—where the vast majority of corporations are incorporated and whose law usually governs merger transactions—had let a buyer off the hook as a result of an MAE.  Because courts presume that an acquirer is purchasing the target as part of a long-term strategy, buyers invoking an MAE clause have the burden of demonstrating that the alleged transaction-terminating event is expected to have a long-term impact on the target’s financial condition, results of operations or earnings potential.  As the Delaware Chancery Court held in In re IBP, Inc. Shareholders Litigation (applying New York law), the important factor to an acquiror considering whether to terminate a transaction “is whether the [target] has suffered a Material Adverse Effect in its business or results of operations that is consequential to the company’s earnings power over a commercially reasonable period, which one would think would be measured in years rather than months.”  789 A.2d 14, 67 (Del. Ch. 2001) (emphasis added).  The court in IBP held that an MAE clause “is best read as a backstop protecting the acquirer from the occurrence of unknown events that 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 [MAE] should be material when viewed from the longer-term perspective of a reasonable acquirer.”  789 A.2d at 68.

The Delaware Chancery Court faced another opportunity to analyze an MAE clause in Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008), a case arising out of Hexion’s termination of its acquisition of Huntsman Corp. after Huntsman reported a decline in quarterly earnings and questions arose about its ability to remain solvent after the merger.  The Court again reiterated that a short-term decline in earnings is insufficient to trigger an MAE clause.  The Court reaffirmed that the purpose of an MAE clause is to protect the buyer from an adverse change in the target’s long-term earnings potential, and that to be considered an MAE, “poor earnings results must be expected to persist significantly into the future.”    In a recent decision from the United States District Court for the Southern District of New York, the Court reaffirmed that the financial impact of the event must be “‘viewed from the longer-term perspective of a reasonable acquirer,’“ and that to be material, the effect of the unforeseen event must “substantially threaten the overall earnings potential of the target in a durationally-significant manner,’ “and that “‘[a] short-term hiccups in earnings should not suffice.’“  Newmont Mining Corporation v. Anglogold Ashanti Limited, No. 17-CV-8065 (S.D.N.Y. March 18, 2020).

Will the Effects of COVID-19 Constitute an MAE?

So, how will these rules apply to buyers who are considering terminating a transaction because of COVID-19’s effects on the seller’s financial condition? The buyer should carefully analyze the terms of the MAE clause in the operative agreement.  Initially, it should determine whether the agreement has carved out pandemics, generally, or COVID-9, specifically, from the definition of an MAE.  If pandemics have been carved-out, then the buyer will have to determine if the impact on the target was disproportionate to other companies operating in the same industry.  Assuming the MAE clause does not contain a carve-out for pandemics, the buyer will have to undertake a fact-based analysis to determine whether COVID-19 threatens the overall earnings potential of the target in a durationally-significant manner—i.e., years, not months.  Such a showing may be difficult because the outbreak of COVID-19 is relatively recent and the scientific community is unable to predict—least for now—its duration.