Material Adverse Effects in the Onslaught of the Coronavirus
The World Health Organization recently declared Coronavirus Disease 2019 (COVID-19, or Coronavirus) a pandemic as it continues to spread throughout the world. Long-term effects of the Coronavirus on markets and the broader economy remain uncertain, but buyers and sellers in mergers and acquisitions (M&A) transactions should examine their pending deals and also address the Coronavirus and its effects in various contexts when negotiating and documenting new M&A transactions—from due diligence, including the effects on a business’s supply chain and labor force, to tailored representations and warranties, and indemnities, as well as evaluating and drafting appropriate material adverse effect / material adverse change (MAE) provisions.
A typical MAE clause enables a buyer to terminate a pending M&A transaction upon the occurrence of an MAE on the business, properties, assets, prospects, results of operations or condition (financial or otherwise), of the target company. MAEs are usually subject to carve-outs such as general market, economic or political conditions, except to the extent the condition disproportionately affects the target company as compared to other similarly situated companies. MAE clauses are also used to allocate risk in representations and warranties and as a means to narrow diligence issues.
Delaware courts have been reluctant to find that an MAE has occurred, so the real-world impact of MAE clauses was often minimal. However, in the recent case Akorn, Inc. V. Fresenius Kabi AG, the Delaware Court of Chancery held for the first time that a buyer had properly terminated a pending acquisition on the basis of an MAE and provided a basic framework for determining whether an MAE has occurred.
In Akorn, the court stated that an MAE occurs when the effect is “material when viewed from the longer-term perspective of a reasonable acquirer.” This standard imposes a significant burden of proof on a buyer. A short-term decline in earnings will not suffice. The court further stated that an MAE will exist only when there is a substantial effect on the target company’s overall earning potential in a “durationally-significant manner.” As noted in our prior article, this determination requires an intensive, fact-based inquiry that accounts for many variables, including seasonality, industry trends and a detailed analysis of the target company’s business.
Pending M&A Transactions
For pending M&A transactions governed by Delaware law and that include typical MAE clauses, buyers and sellers should evaluate the effects of the Coronavirus under the Akorn framework and in light of any applicable MAE carve-outs. A target company may not be disproportionately affected, and an MAE may not be triggered, even if the company operates in an industry that is particularly susceptible to the effects of the Coronavirus, such as the travel or hospitality industries. In this case, typical MAE carve-outs may enable a seller to force the buyer to close the transaction even when the effects of the Coronavirus on the target company are material and otherwise meet the standards articulated in Akorn. If, however, the buyer can demonstrate a disproportionate MAE on the target company, or if typical MAE carve-outs are excluded or otherwise do not apply, then the buyer could potentially terminate the M&A transaction.
In light of recent events, MAE clauses may have other potential consequences. Sellers should expect buyers to use existing MAE clauses for deal-price renegotiation and other concessions, as purchase price multiples are likely to contract in the private market just as they have for publicly traded companies through the recent compression of price-earnings ratios. Sellers and buyers should also reassess representations and warranties, and related disclosures, to ensure they remain accurate as the parties move toward closing. Supplemental disclosures and agreement on further risk allocation may be required.
Future M&A Transactions
For future M&A transactions governed by Delaware law, buyers and sellers should pay close attention to the Akorn framework to determine whether to modify by contract the standards articulated in the case. To provide additional certainty, buyers and sellers could draft additional, quantitative MAE triggers that more precisely delineate their risk allocations.
M&A parties should also focus on MAE carve-outs to determine the appropriate risk allocation of the effects of the Coronavirus. For example, buyers may be uncomfortable with some carve-outs in light of recent events, such as with respect to pandemics, epidemics or disease outbreaks. Sellers may desire to shift the risk of already-known outbreaks, such as the Coronavirus, as presumably their anticipated effects have already been factored into purchase price negotiations for new M&A deals, and thus the associated risks are more properly allocated to the buyer.
Given the severity of the effects of the Coronavirus on capital markets and the anticipated effects on the broader economy, we expect heavy negotiation around these issues for upcoming M&A deals. Buyers and sellers should work closely with legal counsel to draft MAE provisions that allocate risk clearly and appropriately.