With the world still grappling with the outbreak of COVID-19, companies across a variety of industries have already suffered and anticipate further declines in their businesses and financial performances. This raises many new considerations for parties participating in business acquisition transactions that have already signed but have yet to close and for those participating in transactions currently being negotiated. At the forefront of such considerations is whether a buyer may walk away from an acquisition transaction or renegotiate central deal terms by asserting that the target company suffered a material adverse effect (MAE).

This Client Alert provides a brief background on MAE clauses and outlines considerations to take into account when invoking existing, or negotiating new, MAE clauses in light of the COVID-19 pandemic. 

What is a MAE clause? 

In the context of a business acquisition, a MAE clause typically provides a buyer an avenue to terminate a pending transaction during the period between the signing and the closing if an event, or a chain of events, amount(s) to a MAE on the target company’s business.  In short, a MAE clause is a negotiated risk allocation tool used to measure the negative effects of certain events on the target company’s business in the pre-closing period and to allocate the risk of those negative effects between the buyer and the seller.

How is a typical MAE clause drafted?  

A traditional MAE clause is drafted to place the general risk of the occurrence of a MAE on the seller with exceptions being drafted to allocate other specific risks to the buyer.  Although each transaction is unique, sellers often negotiate exceptions to the definition of a MAE that allow for certain material adverse events without giving buyers a right to walk away. Exceptions to the definition of MAE typically include the occurrence of: (1) natural disasters (i.e., floods, earthquakes, hurricanes, etc.); (2) political or economic unrest resulting from acts of terrorism and war; (3) general economic conditions in the region(s) where the target conducts operations; and (4) general changes affecting the target’s specific industry.  The aforementioned general exceptions are commonly labeled as “universal risks” outside the control of sellers that buyers should accept as risks of making an acquisition.  

Most MAE clauses are silent on, and do not specify, how risks associated with pandemics, public health crises, epidemics, and other similar events are allocated (between the buyer and the seller).  Likewise, the typical MAE clause does not specify whether the occurrence of a pandemic (and other similar events) constitutes a MAE.  

With the current economic and legal landscape being highly impacted by the COVID-19 pandemic, it is highly recommended that, moving forward, in negotiating and drafting MAE clauses, the parties consider and articulate both (i) how the occurrence of a health crisis such as the COVID-19 pandemic will be viewed in regards to a MAE (constitutes a MAE or does not constitute a MAE), and (2) who will bear the risk associated with such occurrence. 

How to Limit Risks in Pending or Proposed M&A Transaction? 

With the unfortunate rise of COVID-19, there is now an opportunity for both business and legal minds to freshly evaluate and tailor MAE clauses, in light of the current health and economic landscape. 

• Executed Acquisition Agreements (Pre-Closing)

The determination of whether a MAE has occurred is highly contextual and will be evaluated against the specific language and wording of, and exclusions from, the negotiated MAE clause, the facts of the particular target company, and the actual impact of the COVID-19 pandemic on the target company’s business. Close attention should be paid to the notice requirements for invoking a MAE. Unless the COVID-19 pandemic clearly fits into an exception in the applicable MAE definition, a buyer invoking a MAE in order to walk away from the closing needs to consider whether a court would agree that a MAE has occurred. Courts have historically been reluctant to find that a MAE has occurred unless the negative impact of the event was likely to be “durationally significant.”

• Acquisition Agreements in Negotiation

Where an acquisition agreement is currently being negotiated, the parties should consider specifically addressing how the current volatility affects the transaction. Buyers in particular should spell out any risks arising from the COVID-19 pandemic that they are not willing to take by expanding the package of interim covenants in the acquisition agreement. For instance, a buyer can negotiate the inclusion of restrictions on borrowings, workforce reduction or plant shutdowns, which if materially breached would give the buyer the right to walk away from the transaction, without liability. Conversely, a seller who is unwilling to take the deal execution risk related to the COVID-19 pandemic should consider adding pandemics or widespread disease language to the list of MAE exclusions. 

The specific language of the MAE clause in the agreement is critical in evaluating whether the current COVID-19 pandemic offers a way out of the deal. By thoughtfully taking into account the considerations outlined above and other relevant factors, the parties can actively allocate the risks arising from the COVID-19 pandemic and strategically position themselves to achieve their respective transactional goals.