The coronavirus (COVID-19) continues to create extensive uncertainty for individuals and businesses. For parties actively pursuing an M&A transaction, COVID-19 presents the buyer and seller with additional risks both pre- and post-closing, including impacting the valuation of the target company, increasing exposure to liabilities relating to performance and payment obligations, expanding risk of claims from employees and other personnel, among other extraordinary risks that may result in delay or, in the worst cases, termination of the transaction. Traditionally, acquisition agreements include material adverse effect provisions that are designed to ensure all parties have a clear understanding of the target company’s business as of closing with a reasonable belief that no event has occurred that would result in materially adverse changes. In the “new normal” of COVID-19, we discuss why both buyers and sellers in an M&A transaction should closely examine the “material adverse effect” definition and related provisions in acquisition agreements to insulate themselves from future risk of losses.
What Is a Material Adverse Effect?
A material adverse effect is commonly defined in an acquisition agreement as a “material adverse effect on the business, assets, liabilities, condition, property, or results of operations” of the target company. Acquisition agreements often include a “no changes” representation on the part of the seller, which states that no change resulting in (or reasonably expected to result in) a material adverse effect has occurred since a specific date, often the date of the most recent financial statements delivered in connection with the acquisition agreement or since the date of signing, if the transaction will close at a date after signing. This entitles the buyer to be indemnified by the seller for losses associated with a material adverse effect to the extent one exists due to a corresponding breach of the seller’s representation. However, for the reasons explored in more detail below, this standard provision may not be sufficient protection for a buyer in light of the widespread economic disruption resulting from COVID-19.
While acquisition agreements can provide buyers some relief related to material adverse effects, when litigated, courts historically have rarely found that a material adverse effect has occurred. To establish a material adverse effect, courts consider the magnitude and duration of the change. With respect to magnitude, there is no bright-line rule establishing when the magnitude of the change becomes “material.” However, the Delaware Chancery Court has noted that a forty percent (40%) decrease in profits is a useful starting point for the analysis. With respect to duration, the change must have material long-term effects, rather than short-term or seasonal effects. In other words, the material effects of the change must last longer than only a few months. These two factors make it extremely difficult for a buyer to establish that a material adverse effect has occurred. Thus, even if damages are incurred by a buyer in a transaction due to a violation by the seller of a “no changes” representation or otherwise related to a breach of a representation around material adverse effects, the buyer may be unable to recover for such losses if a court finds that such change did not in fact rise to the level of a material adverse effect.
While COVID-19 has had increasingly dramatic effects over a short period of time, the duration of the pandemic and its long-term effects are currently unknown, and estimates of these vary widely. As a result, it is not clear at this time whether COVID-19 may constitute a material adverse effect under these standards if examined by a court in the judicial process.
Carve-Outs
Even if significant, long-term losses are incurred as a result of a change in circumstances or events relevant to a transaction, acquisition agreements often include exceptions to the definition of material adverse effect, carving out certain occurrences to protect the seller from liability associated with events and other changes that have widespread effects or that impact industry as a whole rather than the seller in particular. While relatively uncommon prior to COVID-19, carve-outs that specifically reference epidemics, pandemics, or similar public health emergencies would encompass any effects associated with COVID-19, foreclosing recovery under a material adverse effect clause. More common carve-outs from the definition of material adverse effect relevant to the effects of COVID-19 include changes in the national or world economy as a whole and other force majeure events, which may be incorporated in any carve-outs to the definition of a “material adverse effect.” COVID-19 is currently having substantial effects on the economy as a whole, but over time, certain industries may be more significantly affected than others. The specifics of these provisions and the long-term effects on particular industries will be important in determining whether COVID-19 is carved out of any specific definition of material adverse effect. In addition, the definition of what constitutes a “force majeure” event also varies among acquisition agreements, so the scope of that definition may further exclude the effects of COVID-19 from the definition of “material adverse effect.” We will explore in more detail how COVID-19 may be treated under force majeure clauses in a separate blog post in this series.
Acquisition Agreement Strategies for Buyers and Sellers
While COVID-19 remains an ongoing concern, buyers and sellers can draft provisions in acquisition agreements to provide additional protection from future risk of losses.
Buyers
- Buyers should negotiate for forward-looking language in the definition of material adverse effect to protect against changes that are “reasonably likely” to cause a material adverse effect post-closing rather than only those that “would” have such an effect.
- Buyers should negotiate for scaled back or eliminated carve-outs from the definition of material adverse effect, in particular any related to pandemics or epidemics, effects on the national or world economy as a whole, and related to force majeure events.
- Buyers may also attempt to negotiate for special indemnities or escrows to protect against downside risk and uncertainty for deals that close in the midst of the pandemic. While not uncommon under typical circumstances, buyers may need such added insurance to protect the anticipated value of their investments in order to obtain necessary approvals to fund an acquisition, and sellers may find that they have reduced leverage to push back on such contingencies if the market exhibits further signs of tightening.
Sellers
- Sellers should seek to specifically carve out losses resulting from pandemics or epidemics, including COVID-19, from the definition of material adverse effect.
- Sellers should provide information related to potential material adverse effects related to COVID-19 and changes to the seller’s business that could result from the pandemic in its disclosure schedules in an effort to avoid any potential breach of the corresponding representation should the impact of COVID-19 result in any inaccuracy of the applicable language.
