Introduction

In just two days, you will finally close the long-awaited sale of your widget manufacturing company. All of the closing conditions have been met and required approvals obtained; however, the COVID-19 pandemic has now spread across the United States. You have had to shut down several facilities and layoff hard-working employees, resulting in a sizable earnings drop.

As you open a letter from the buyer’s counsel, you have a feeling of dread. Sure enough, the buyer has determined the effects of the pandemic on your business are too significant to continue and they are terminating the purchase agreement, on the grounds that COVID-19 is a “Material Adverse Effect.” You hastily call up your lawyers and ask how to proceed. They review the agreement and confirm that the negotiated provision lacks any exceptions that would directly cover COVID-19. You immediately call up your litigation team and tell them to prepare for a lawsuit.

In the wake of COVID-19, parties to active M&A transactions are facing countless new challenges and, in many cases, have had to delay or suspend deals. One topic of particular interest for deals that have signed but not yet closed is whether COVID-19 constitutes a “Material Adverse Effect” or “Material Adverse Change” (an MAE) with respect to the target company under the applicable merger or acquisition agreement. In general, an MAE clause would allow the buyer to terminate, not perform certain obligations, and/or be entitled to indemnification from the seller if, between signing and closing, the target company experiences a durationally-significant and company- specific decline in its business that substantially threatens its overall earnings potential.

Anatomy of MAE Clauses and COVID-19 Carve-Outs

A standard MAE provision includes three components. First, an MAE is typically defined as an event or circumstance that has had, or would be reasonably  expected to have, a material adverse effect on the business, financial condition or results of operations of the target company and its subsidiaries (taken as a whole).

Second, MAE clauses usually carve-out certain occurrences to protect the seller from liability associated with systemic risks (i.e., risks not particular to the target company), such as conditions generally impacting the target’s market or industry, natural disasters or other “acts of God,” and geopolitical conditions. Carve-outs referencing pandemics, epidemics or similar public health emergencies that would encompass COVID-19 were not common before the outbreak, but are now appearing more frequently.

Such risks can be broken into four categories of risk generally:

•  Systemic risks, including force majeure events or “acts of God,” that are beyond the control of any party

•  Indicator risks such as credit rating downgrades and failure to meet earnings projections

•  Agreement risks that include any risks from public announcement of the transaction or fulfilling
  the agreement’s terms

•  Business risks that are specific to the target company as opposed to the industry in which it operates

  As noted by the Delaware Chancery Court in Akorn, “[g]enerally speaking, the seller retains the business risk.
  The buyer assumes the other risk.” Stated differently, under a typical MAE clause, the buyer will only be able to successfully invoke an adverse event to cancel a transaction when it is specific to the particular target company as opposed to the industry in which it operates. The typical case involves a buyer attempting to cancel a transaction because the target company has had

  a drastic decrease in earnings prior to closing from a cause that did not affect other companies in its industry and was not the result of a general market downturn.

  Such risks can be broken into four categories of risk generally:

•  Systemic risks, including force majeure events or “acts of God,” that are beyond the control of any party

•  Indicator risks such as credit rating downgrades and failure to meet earnings projections

•  Agreement risks that include any risks from public announcement of the transaction or fulfilling
  the agreement’s terms

•  Business risks that are specific to the target company as opposed to the industry in which it operates

  As noted by the Delaware Chancery Court in Akorn, “[g]enerally speaking, the seller retains the business risk.
  The buyer assumes the other risk.” Stated differently, under a typical MAE clause, the buyer will only be able to successfully invoke an adverse event to cancel a transaction when it is specific to the particular target company as opposed to the industry in which it operates. The typical case involves a buyer attempting to cancel a transaction because the target company has had

  a drastic decrease in earnings prior to closing from a cause that did not affect other companies in its industry and was not the result of a general market downturn.

Third, some or all carve-outs to MAE clauses are usually subject to a disproportionate impact exception, which returns the risk to the seller to the extent that an event falling within one of the carve-outs disproportionately adversely affects the target as compared to other industry participants or peers.

General Legal Standards

Courts often analyze whether an MAE has occurred under an agreement in terms of whether it allocates the risks of an adverse event to the buyer or the seller. But before determining how the risk of an adverse event is allocated, an initial question must be answered which is whether or not the adverse event is “material.” If the adverse event affecting the target company is not material, the MAE clause will not be able to be successfully invoked by the buyer to cancel the transaction. Often, MAE clauses do not define materiality but instead rely on the body of caselaw on the subject. So, what constitutes materiality?

One measure that courts often employ to evaluate the materiality of an adverse event is to compare the company’s performance prior to closing against the results of the same quarter of the prior year; however, this is only one, among many considerations,
and Delaware, New York, and other courts have made clear that a prime consideration is whether the adverse event has affected the long-term earning power of the target. As noted by the Delaware Chancery Court in a recent opinion in Akorn v. Fresenius Kabi AG, while quarterly earnings may be a consideration, a “short-term hiccup” does not suffice; “rather the Material Adverse Effect should be material when viewed from the long-term perspective of a reasonable acquirer.”

Assuming that the adverse event is material to the target company, the issue becomes whether the agreement allocated the risk of the adverse event to the buyer or the seller.

Negotiating MAE Provisions in a Post-COVID World

The following are a few practical approaches buyers, sellers and transactional lawyers negotiating a merger or acquisition agreement may wish to consider to limit the risk and uncertainty of MAE claims related to the COVID-19 pandemic.

Buyers:

•  MAE Carve-Outs: Negotiate for scaled back or eliminated carve- outs from the definition of MAE related to the effects of COVID-19, or include express disproportionate impact exceptions to such carve- outs to shift risk to the seller for adverse company-specific effects.

•  Financial and Market-Outs: Consider including in the definition of MAE financial performance triggers related to quantifiable target-specific or macro-economic measures (e.g. a termination right upon EBITDA or a market index falling below a stated threshold).

•  Quantified Threshold: Buyers with sufficient leverage might consider negotiating for a specified dollar threshold that constitutes an MAE for additional clarity and certainty.

•  Synergies and Durational Significance: As courts will generally not consider post- closing synergies in evaluating whether an MAE has occurred
  and their interpretation of “durationally-significant” is unclear and highly context-dependent, consider negotiating for express references to synergies or limits on durational significance in the definition of MAE.

Sellers:

•  MAE Definition: Limit the definition of MAE to only cover the target company and any subsidiaries being sold, and resist inclusion of future prospects
  and financial performance.

•  COVID-19 and Related Carve- Outs: Add express exclusions
  to the definition of MAE for COVID-19 and other pandemics, epidemics, diseases and health emergencies, with the rationale that these are systemic risks and should be allocated to the buyer.

•  Narrow Disproportionate Impact Exceptions: As disproportionate impact exceptions shift risk of
  an MAE to the seller, narrow

  the scope of these by expressly providing that only incremental material and disproportionate impacts on the target may be considered in evaluating an MAE and identify an appropriate comparison group (e.g. industry, market, geography, size, etc.)

•  Reverse Termination Fees: Consider whether it makes sense to include a reverse termination fee (payable by the buyer if the deal falls through) to provide a negotiated out in the event the target’s future prospects are subject to a high level of uncertainty due to COVID-19.

Does COVID-19 Constitute an MAE under the General Standards?

In the context of COVID-19, a buyer invoking an MAE clause to cancel a transaction will first have to establish that the pandemic’s effect on the target company was “material” by not only showing that the company’s short-term earnings have drastically declined but that the pandemic has seriously affected the target company’s long-term earnings power. At this stage of the pandemic, it may be difficult to assess its long-term impact and such determinations will be heavily dependent on the particular circumstances of the target company at issue.

Assuming the buyer meets its burden of establishing that the adverse event is “material,” the buyer will then need to show that the parties’ agreement allocated the risk of the pandemic to the seller. As stated, the typical MAE clause only allocates company-specific business risks to the seller and the buyer retains the other risks, including force majeure events. Often force majeure clauses are drafted to specifically include “pandemics” and in such cases a buyer’s burden to establish an MAE will be difficult. Even in the absence of a force majeure clause expressly referencing pandemics, the seller may have strong arguments that a pandemic constitutes an unforeseeable act of God.

That said, even if the COVID-19 pandemic falls within a force majeure clause that allocates risk to the buyer, if the pandemic has had a disproportionate impact on the target company as compared to other industry participants or peers, the risk can shift back to the seller under the typical clause such that the buyer may successfully invoke an MAE to cancel the transaction. In short, under the traditional MAE analysis, the determination of whether the COVID-19 pandemic is an MAE to a particular target company would likely come down to whether (1) the pandemic has materially affected the long-term earning capacity of the company, and (2) whether the pandemic has had a disproportionate impact on the company compared to others in its industry. But given the
fluid situation that COVID-19 presents, it is not certain exactly how the courts will resolve such disputes as strong arguments may exist for both buyers and sellers depending on the circumstances of the case.