Does the COVID-19 Outbreak Constitute a Material Adverse Effect? Plus Other Impacts on M&A Transactions
In any M&A transaction, a significant deterioration in the target’s business between signing and closing may upset the fundamental bargain struck between a seller and a buyer. M&A agreements typically address this risk through highly negotiated “material adverse effect” or “material adverse change” (“MAE”) clauses which may entitle a buyer to walk away from its obligations to close if the clause is triggered. With the outbreak of the coronavirus (“COVID-19”), many clients are asking whether the effects of the outbreak or the worsening of COVID-19 would constitute an MAE. If you are currently negotiating an M&A agreement, careful consideration should be given to drafting the MAE definition in light of these evolving developments.
MAE definitions in M&A agreements serve several purposes. They can be used to limit the scope of the seller’s representations and warranties as well as to provide a standard for bringing down those representations and warranties as of the closing. They can also set the parameters for the buyer’s right to terminate the M&A agreement prior to closing or for the failure of a condition to the buyer’s obligation to close.
The typical MAE definition includes “any change, development, effect, circumstance or state of facts that have had, or would reasonably be expected to have, a material adverse effect on the business, assets, financial condition or results of operations of the business to be acquired.” An MAE definition typically includes various exclusions for economic, market, industry, political and other general categories of risk but only to the extent such effects do not disproportionately adversely affect the target’s business relative to other businesses in the same industry and, in some cases, within a specified geographic area. In some cases, the disproportionate adverse effect must be material (not defined).
It has been largely left to the courts to determine whether or not an MAE has occurred. Until Akorn, Inc. v. Fresenius KABI AG, etc. (DE Chancery Court, October 1, 2018), no Delaware court had ruled in favor of a buyer attempting to invoke an MAE clause. The determination whether an MAE has occurred is a highly fact-specific inquiry tested against the language of the MAE definition. In Akorn, the Delaware Chancery Court stated: “A buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close…. A short-term hiccup in earnings should not suffice…the effect should substantially threaten the overall earnings potential of the target in a durationally-significant manner.” The court noted that a duration of significance would likely be years rather than months.
In light of Akorn, it is probably too soon to tell whether the effects of COVID-19 will be durationally significant enough to constitute an MAE. Any such determination will depend on the facts giving rise to the alleged material adverse effect on the target’s business as well as the language of the subject MAE definition.
We are seeing MAE definitions now include specific exclusions focused on events such as the COVID-19 outbreak, or the worsening thereof, to the extent the effects are not disproportionate or materially disproportionate to the target’s business relative to other participants in the industry. Some examples of such exclusions are:
- Any global health conditions (including any epidemic, pandemic, or disease outbreak (including the COVID-19 virus)), including any material worsening of such conditions
- Any epidemic, pandemic or other health crisis (including the COVID-19 virus)
- Any outbreak of disease
- Any global public health emergency (as declared by the World Health Organization)
We anticipate such exclusions will become customary going forward.
Acquisition Financing. If a buyer has arranged for debt financing to fund the purchase price, the debt papers will also contain an MAE clause which typically uses the same MAE definition as in the related M&A agreement. However, buyers may still be at risk that the lenders will claim an MAE has occurred and refuse to fund the debt financing at the closing of the M&A transaction. In such a situation, the buyer would have to prove that an MAE has occurred, and any such claim by the lenders is not necessarily determinative that an MAE has in fact occurred for purposes of the M&A agreement. If a buyer is unsuccessful in asserting an MAE has occurred, it may be required to pay the seller a reverse break fee to terminate the M&A agreement.
Other Impacts of the COVID-19 Outbreak on M&A Transactions
Timing. In certain jurisdictions and in industries particularly affected by the COVID-19 outbreak, some deals are on pause as the parties evaluate the effects of the outbreak. This is likely to lead to price renegotiations and, in some cases, termination of negotiations if buyers are unsure whether they are overpaying for an asset.
Process. Travel restrictions are limiting in-person meetings, management presentations and site visits, although conducting due diligence through electronic data rooms may continue uninterrupted so long as personnel are available to upload and manage content and recipients are able to access the site. Meetings are more often conducted through conference calls or videoconferences.
Due Diligence. Buyers’ due diligence on the target’s business is likely to become more robust in the areas of insurance coverage, emergency preparedness, IT systems for remote working arrangements, ensuring remote employees’ productivity, privacy and other business continuity measures. Buyers will also want to scrutinize the target’s ability to perform under its key commercial contracts as well as the risk of its counterparty’s failure to perform or its counterparty’s reliance on force majeure clauses for nonperformance. Buyers will also need to consider the exposure of the target’s business to jurisdictions where the effects or worsening of the COVID-19 outbreak are more acute.
Reps and Warranties. Buyers may also seek additional representations and warranties about the target’s business relating to the impact of COVID-19 (including the diligence items above), and we anticipate the typical negotiations over materiality and knowledge qualifiers. Sellers may attempt to ringfence representations and warranties related to the effects of COVID-19 so as to minimize a buyer’s post-closing claim that the outbreak resulted in a breach of more general representations and warranties. Sellers will likely attempt to disclose as much as possible in the disclosure schedules about the potential impacts of COVID-19 which of course are largely unknown and evolving.
“Ordinary Course of Business.” Any use of “ordinary course of business” qualifiers in representations and warranties or in interim covenants is likely to be heavily negotiated to take into account any extraordinary measures implemented in the target’s business or workplace as a result or in anticipation of the outbreak or worsening of COVID-19.
Rep and Warranty Insurance. COVID-19 has quickly become a key feature of rep and warranty insurance underwriting. We are seeing caveats in non-binding indications that underwriting diligence will include an investigation on the potential impact of COVID-19 and that, depending on the impact of COVID-19 on the target’s business, the underwriters may require an exclusion for business interruption or other losses arising out of or relating to COVID-19. We can expect underwriters, like buyers, to be keenly focused on MAE and force majeure language in the target’s contracts and the impact on termination rights. Parties relying on representation and warranty insurance should be prepared to accept policy exclusions relating to COVID-19. Parties should try to limit these exclusions to specified jurisdictions where COVID-19 is known to have had detrimental effects and to specified consequences to prevent underwriters from using a broad exclusion to avoid legitimate, unrelated claims. Parties should not expect to rely on the product to cover any downside risks related to COVID-19.
Time Periods. Time periods for completing matters specified in an M&A agreement such as purchase price adjustment calculations may be impacted if companies are unable to prepare or review closing statements and related information on the time frames specified in the M&A agreement. Consider adding extension periods for completion of these matters if either party is anticipated to be adversely affected by COVID-19. Parties may wish to contemplate extensions to “drop-dead” or “outside” dates for the same reason.
Anti-sandbagging Clauses. Lastly, clauses addressing the impact of a party’s knowledge on its ability to bring an indemnity claim may exclude claims related to the impact of COVID-19 because it is a known risk.
Please visit our Coronavirus: Preparation & Response series for additional resources we hope will be helpful.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.