The global efforts to contain the COVID-19 pandemic's spread, and the resulting massive business disruptions and economic uncertainties, raise novel questions for parties in M&A transactions. One such question that has already been the subject of significant litigation is whether a global pandemic such as COVID-19 triggers a material adverse effect ("MAE") clause, allowing a buyer to terminate the deal after signing but prior to closing.

As the COVID-19 crisis continues, more M&A parties will likely continue to look to MAE clauses to attempt to exit deals. This article discusses MAE clauses generally and a seminal case from the Delaware Court of Chancery that provides guidance on the circumstances under which courts might allow buyers to utilize MAE clauses to terminate transactions. The article also summarizes the wave of recently-filed MAE litigation, and provides practical guidance for the drafting of MAE and related clauses in light of the COVID-19 pandemic.

In an M&A transaction, a significant deterioration in the target company's business between the signing of the agreement and the closing may threaten the deal. M&A agreements typically address this issue through negotiated MAE clauses (sometimes referred to as material adverse change clauses), which often provide that, if the target company has suffered an MAE within the meaning of the agreement, the buyer can cancel the transaction. While the specific terms of MAE clauses vary, such clauses typically include three parts:

A definition of an MAE.  Parties often broadly define an MAE to include any event, development, or condition that has had or would reasonably be expected to have a material adverse effect on the business, financial condition, or results of the operations of the target company and its subsidiaries. While an adverse impact must be material to constitute an MAE, deal parties often do not specifically define or put numeric parameters around what is "material."  Thus, the question of whether a specific event or change is material is likely to be determined by litigation after the fact.

Market & Industry Specific Exclusions.  MAE clauses typically exclude specified events—i.e., situations in which the buyer will be deemed not to have a legitimate reason to terminate the deal. Typical exclusions allocate general market or industry risk to the buyer, and can include: (i) general economic or political conditions in any country where the target company operates; (ii) changes or conditions generally affecting the target company's industry; (iii) changes in the market price or trading volume of a target's securities or the target company's credit ratings; (iv) geopolitical conditions, such as acts of war, sabotage, terrorism or calamity; and (v) natural disasters, such as hurricane, tornado, flood, or earthquake. Negotiated MAE exclusions may or may not specifically include pandemics or epidemics.

Exceptions to the Exclusions.  MAE clauses often state that some or all of the specified exclusions still could constitute an MAE to the extent they have disproportionately affected the target company as compared to others in the same industry. Like the question of materiality, this disproportionate effect standard is often not precisely defined and thus subject to determination in later litigation.

The Akorn Decision

Courts have generally interpreted MAE clauses narrowly and have been reluctant to allow buyers to avoid their contractual duties to close based on attempted invocations of such clauses.  However, the Delaware Court of Chancery's seminal opinion in Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018), aff'd, 198 A.3d 724 (Del. 2018) provides important guidance as to when MAE clauses may be used to terminate a transaction.

In Akorn, the parties entered into a merger agreement with the closing expected to occur approximately one year after signing. Before the scheduled closing, the buyer declined to close based on numerous grounds, including that the target company suffered an MAE because of alleged misrepresentations by seller of its compliance with regulatory requirements, and because seller breached its covenant to continue operating the target company's operations in the ordinary course of business.

The Court of Chancery's 246-page post-trial opinion—which the Delaware Supreme Court affirmed—was the first and only Delaware decision to uphold a buyer's invocation of an MAE clause to terminate an M&A agreement (the court also held that the buyer had a right to terminate based on the seller's material and incurable breach of the ordinary course covenant).

The court's decision was based on the unique and buyer-friendly facts in the Akorn case. However, the opinion includes important insights and guidance on how Delaware courts (and courts looking to Delaware for guidance) will interpret MAE clauses and when such clauses may be used to terminate an agreement.

A threshold question in determining whether an MAE has occurred is whether the adverse impact is in fact "material." The Akorn court found that an adverse effect or change is material if a fact-based inquiry shows that it "substantially threaten[s] the overall earnings potential of the target in a durationally-significant manner." The court clarified that durational significance should be "measured in years rather than months," and that "[a] short-term hiccup in earnings will not suffice." Rather, for such a decline to constitute an MAE, "poor earnings results must be expected to persist significantly into the future."

Akorn also provides guidance on evaluating the magnitude of a target company's decline in earnings. While the Akorn opinion notes that most court have found a decrease of 40% or more in the target company's profits to constitute an MAE, it also states that those precedents do not foreclose that a lower percentage could constitute an MAE, or that a higher percentage could not constitute an MAE.  Akorn further instructs that, when evaluating the materiality of a target company's decline in earnings, courts should evaluate the company's performance against its results during the same quarter in the prior year.

Notwithstanding the Court of Chancery's historical ruling in Akorn allowing termination based on an MAE, the court emphasized that determining whether an MAE occurred is highly fact specific and that "a buyer faces a heavy burden when it attempts to invoke a [MAE] clause in order to avoid its obligations to close."

The Recent Wave of MAE Litigation Resulting from COVID-19

The COVID-19 crisis has already spawned a wave of lawsuits involving parties seeking to invoke MAE clauses to exit M&A agreements. On April 30, 2020, Realogy Holding Corporation (seller) sued SIRVA Worldwide, Inc. (buyer) seeking to prevent SIRVA from backing out of a $400 million stock purchase agreement based on SIRVA's assertion that the COVID-19 crisis caused an MAE to occur under the parties' agreement. Realogy Holding Corp. v. SIRVA Worldwide Inc., et al., No. 2020-0311-MTZ (Del Ch. April 30, 2020).

The purchase agreement in Realogy allegedly includes a definition of MAE that does not exclude COVID-19 specifically or a pandemic or epidemic generally, but does exclude, inter alia, "general economic . . . conditions . . . acts of God . . . [and] natural disasters."  According to the lawsuit, the purchase agreement also provides that certain of those exclusions shall not apply to the extent the target company is disproportionately and adversely affected relative to other similarly situated participants in the industries in which the target company operates.

Realogy, seeking to force SIRVA to close on the transaction, alleges that COVID-19 falls within the "acts of God" "or natural disasters" exclusions and that, even if COVID-19 does constitute an MAE, the target company at issue has not been disproportionately affected by the pandemic.  The lawsuit remains pending.

On April 22, 2020, an affiliate of private equity firm Sycamore Partners sued Victoria's Secret parent L Brands, Inc. in Delaware seeking a declaration that the Sycamore affiliate's termination of a $525 million agreement to acquire a majority interest in Victoria's Secret was valid.  SP VS Buyer LP v. L Brands, Inc., No. 2020-0297-JTL (Del. Ch. Apr. 22, 2020).

The complaint alleges that the buyer's termination was valid because, inter alia, L Brands' closing of its Victoria's Secret stores and furloughing of those stores' employees constituted an MAE under the parties' agreement. The buyer asserted, among other arguments, that an exclusion in the MAE clause for pandemics did not extend to the so-called "impairment" prong of the MAE definition, which states that there not be any state of events that would prevent or materially impede the performance of L Brands under the transaction agreement.  On May 4, 2020, L Brands issued a public statement that the parties agreed to mutually terminate the deal and settle the litigation.

On April 9, 2020, Oberman, Tivoli, & Pickert, Inc. sued Cast & Crew Indie Services, LLC and others in Delaware seeking to force Cast & Crew to close on an asset purchase agreement.  Oberman, Tivoli & Pickert, Inc. v. Cast & Crew Indie Services, LLC, et al., No. 2020-0257-PAF (Del. Ch. Apr. 9, 2020).  The complaint asserts that Cast & Crew concocted failures of conditions precedent in an attempt to avoid consummating the closing, including that Oberman failed to respond to Cast & Crew's requests for information.

Although the complaint does not allege a specific invocation of an MAE as justification to exit the deal, it does assert that Cast & Crew's requests for information were a "transparent attempt to find information to avoid consummation of the transaction based on the theory that the COVID-19 pandemic had led to a Material Adverse Effect."  A few days after the complaint was filed, the parties filed a letter informing the court that the parties resolved the dispute. The plaintiff voluntarily dismissed the complaint on April 20, 2020.

On April 1, 2020, Bed Bath & Beyond, Inc. sued 1-800-Flowers, Inc. in Delaware seeking to force 1-800-Flowers to close on a $252 million equity purchase agreement. Bed Bath & Beyond Inc. v. 1-800-Flowers.com, Inc., No. 2020-0245-SG (Del Ch. Apr. 1, 2020). The complaint alleges that one week prior to the closing, 1-800-Flowers unilaterally sought to postpone the closing date so that it could assess whether an MAE had occurred due to COVID-19.

While the complaint does not allege that a "pandemic" is included in the MAE exclusions, the complaint does allege that the exclusions include, inter alia, "any calamity" and "acts of God." The complaint further alleges that the MAE clause only applies when there is a disproportionate effect on the target company, which the complaint claims has not occurred because the target "is in the same position as millions of businesses worldwide facing the impact of COVID-19."  The lawsuit remains pending.

The cases discussed above are just recent examples of lawsuits involving attempts to use MAE clauses to exit M&A transactions, and certainly will not be the last. Whether parties will be successful in pointing to effects of the COVID-19 pandemic as an MAE will depend on the facts of each case.

Under the guidance provided in Akorn, relevant facts will likely include, without limitation, the specific MAE provisions in the agreements at issue, whether the adverse impact of COVID-19 will be "durationally significant" on the results of the relevant business, the magnitude of any business disruptions to the target company at issue, and whether the target company was disproportionately affected compared to other companies in the same industry.

To avoid unwanted litigation, parties to M&A transactions should give careful consideration to crafting MAE provisions in light of COVID-19, and specifically articulate in their agreement the circumstances or conditions that the parties believe constitute exceptions and exclusions to MAE provisions. Sellers should also pay special attention to how the actions they propose to take for target companies in response to COVID-19 may be analyzed under M&A agreement covenants, including any covenant to operate in the ordinary course of business. M&A parties should consider whether it is appropriate to limit obligations to operate the target company consistently with past practice in the face of unexpected and extraordinary events such as COVID-19.

Frank Favia, a partner in Sidley's Commercial Litigation and Disputes practice, primarily practices in the area of M&A and private equity litigation, as well as other commercial litigation, disputes and investigations across the country. [email protected]

Angela Zambrano is a co-leader of Sidley's Commercial Litigation and Disputes practice and member of the firm's COVID-19 Task Force. She primarily practices in the area of M&A and private equity litigation, and represents companies and boards of directors in commercial litigation and internal investigations, including class actions and multi-jurisdictional disputes. [email protected]

Rob Velevis, a partner in Sidley's Commercial Litigation and Disputes practice, handles M&A and private equity litigation, complex civil litigation and arbitrations throughout the United States, including private equity disputes, bankruptcy and distressed financial situations, M&A transaction-related litigation, and oil and gas related disputes. [email protected]

The authors would like to acknowledge the research assistance of Lora Chowdury and Alexa Perez. In addition, the authors appreciate the thought leadership of Brian Fahrney, Chris Abbinante, and Scott Parel in preparing this article.