Short-term Hiccup or Significant Long-term Effect? Material Adverse Effect Clauses and the COVID-19 Pandemic

Parties to merger, acquisition, and financing agreements may be considering whether the COVID-19 pandemic affects their obligation to close the deal.  M&A agreements and financing commitment letters often contain material adverse change or material adverse effect (“MAE”) clauses.  An MAE clause may relieve the buyer of its obligation to close in the event of “a significant deterioration in the selling company's business between signing and closing [that] may threaten the fundamentals of the deal.”[1]  In light of the economic impacts of the coronavirus, parties to M&A deals may be questioning whether an MAE has occurred.  The answer:  probably not—at least not yet.  But it might, depending on duration and magnitude of economic dislocation related to the COVID-19 pandemic, among other factors, and the specific language of the MAE provision.

An MAE clause typically appears as a condition that the selling company must meet before the buyer is obligated to close.  The clause will generally provide that the seller must not have suffered a Material Adverse Effect.  For example, the agreement may provide:

• No Material Adverse Effect. Since the date of this Agreement there shall not have occurred and be continuing any effect, change, event or occurrence that, individually or in the aggregate, has had or would reasonably be expected to have a Material Adverse Effect. [2]

The agreement will also define “Material Adverse Effect.”  The definition is often lengthy and convoluted.  It typically starts with a general statement of what constitutes an MAE, such as “any effect, change, event or occurrence that, individually or in the aggregate . . . has a material adverse effect on the business, results of operations or financial condition of the [target] Company and its Subsidiaries, taken as a whole.” [3]  The definition then provides for several exclusions—events that will not constitute an MAE.  Notably, it is common for those exclusions to include events generally affecting the target company’s industry or the economy as a whole. [4]  Also sometimes excluded from the definition of MAE are acts of war, terrorism, natural disasters, or other so-called “force majeure events.” [5]  However, the MAE definition may then go on to state that these excluded events, including general economic or industry-wide downturns, may nonetheless constitute an MAE if they have a disproportionate adverse effect on the target company’s business.

While the above terms are common, whether a given event constitutes an MAE will depend on the specific language of the contract.  That is, whether an MAE has occurred is a question of contract interpretation.  The party invoking an MAE to avoid closing—usually the buyer—bears the burden of establishing the occurrence of an MAE. [6]  That burden is a “heavy” one. [7]

Importantly, “[a] short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquirer.” [8]  Thus, the key inquiry is “whether there has been an adverse change in the target's business that is consequential to the company's long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” [9]  For a decline in the target company’s earnings to constitute an MAE, such “poor earnings results must be expected to persist significantly into the future.” [10]  Put another way, the MAE “should substantially threaten the overall earnings potential of the target in a durationally-significant manner.” [11]

In terms of the magnitude of the decline required, courts have observed that decreases in profits of 40% or higher would likely constitute an MAE. [12]  But a decrease of even greater magnitudes might not be an MAE if the target company’s earnings are subject to known cyclical downturns in the industry and the decrease suffered is consistent with the known cyclicality. [13]

A buyer might face significant hurdles in showing an MAE as a result of a general economic downturn.  As noted, such market-wide events are often carved out of the definition of MAE, instead requiring such a generally-applicable event to disproportionately affect the target company.  For example, a buyer could not show an MAE to avoid closing a deal signed in the summer of 2007, just before the onset of the credit crisis and Great Recession. [14]  Despite 20% declines in the target company’s earnings over the prior quarter and downward revisions of projected future earnings, the court held that no MAE had occurred—“particularly in the face of macroeconomic challenges [the target] has faced” since deal signing. [15]

MAE clauses in financing agreements are also interpreted narrowly.  For example, a lender was unable to invoke an MAE to avoid a funding obligation based on the borrower’s impending bankruptcy filing. [16]  Because the agreement did not include a term specifically requiring that the borrower be solvent at the time it sought to draw on the credit facility, the court would “not infer a solvency requirement where none was drafted by the parties” and, therefore, the lender could not “stretch the MA[E] clause to include  it.” [17]

Turning to the COVID-19 pandemic, at present, a buyer would likely face significant challenges in relying on an MAE clause to avoid closing.  First, an M&A agreement may exclude events such as coronavirus, which affect the economy in general—and the agreement may even specifically exclude pandemic from the definition of MAE.  But it is possible that coronavirus may disproportionately affect certain sectors, like hospitality, travel, and tourism, and enable invocation of an MAE (depending on the language of the agreement).  Second, it is probably too early to tell whether the adverse effects of the COVID-19 outbreak will “persist significantly into the future.”  The severity and duration of the pandemic’s effects are presently unknown.

That said, it is important to remember that every contract is different, and MAE clauses are often heavily negotiated, so the occurrence of an MAE will depend on the language of the particular M&A or financing agreement.  With the rapidly changing landscape presented by the coronavirus, we will continue to monitor this and other issues affecting businesses.

If you have questions about the above or any matters related to your business, please feel free to contact author Mark Rosen at 603.373.2015 or mrosen@pierceatwood.com.

[1] Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347, at *47 (Del. Ch. Oct. 1, 2018), aff'd, 198 A.3d 724 (Del. 2018).
[2] Id. at *50.
[3] Id.
[4] Id. at *51.
[5] Id.
[6] Id. at *52.
[7] Id. at *53.
[8] Id. (quoting In re IBP, Inc. Shareholders Litig., 789 A.2d 14, 68 (Del. Ch. 2001)).
[9] Id.
[10] Id. (quoting Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008)).
[11] Id. (quoting IBP, 789 A.2d at 68).
[12] Id.
[13] Id. at *54.
[14] Hexion, 965 A.2d at 738-46.
[15] Id. at 743.
[16] In re Lyondell Chem. Co., 567 B.R. 55, 149 (Bankr. S.D.N.Y. 2017), aff'd, 585 B.R. 41 (S.D.N.Y. 2018).
[17] Id. at 150.

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