The MAE Clause Faces Off With COVID-19 in the Delaware Courts—What Comes Next?

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While the novel coronavirus (COVID-19) continues to disrupt the global economy, it is also causing the number of disputes over pending mergers and acquisitions transactions to rise.

As evidenced by several recent cases in the Delaware Chancery Court (Court), an increasing number of complaints have been filed by sellers in failed mergers and acquisitions, who are seeking, in addition to other remedies, to force remorseful buyers to close. In the past, the Court has been hostile to a buyer’s claims that a “material adverse effect” (MAE) on the target company has occurred. As discussed in more detail below, the Court has only found in one prior case that an MAE properly excused the buyer from closing.

For the most part, the complaints filed in Delaware on this issue are fairly similar—in addition to asserting claims based on specific issues in the underlying transaction, the plaintiffs contend that all conditions to closing the failed transaction have been satisfied and the buyer has breached its obligation to close. The defendants, on the other hand, claim that a MAE on the target company has occurred, so the buyer had a clear walk away right. In an attempt to reinforce their case, some defendants also assert that the seller has failed to operate the target business in the ordinary course and that specific representations and warranties have been breached, such that the seller could not meet the closing “bring down” condition.

Recently Filed Cases

In Juweel Investors Ltd. v. Carlyle Roundtrip, L.P.[1], the sellers, owners of approximately 50 percent of one of the world’s largest travel firms, American Express Global Business Travel, filed a complaint seeking to force the buyers to close the transaction. Not surprisingly, the defendants asserted that a number of closing conditions could not be satisfied, including that an MAE had occurred, that the sellers failed to operate the target’s business in the ordinary course, and that certain representations and warranties have been breached so that they could not be “brought down” at closing.

The dispute largely revolves around whether an MAE has occurred. Vice Chancellor Slights, in his ruling denying the sellers’ motion to expedite the trial[2], hinted that he will likely need to decide on whether or not an MAE has occurred in connection with this transaction, and noted, quoting Chancellor Strine, that this task is “dauntingly complex”[3] and that the inquiry is extremely fact-dependent and time consuming.

Forescout Technologies, Inc. v. Ferrari Group Holdings, L.P.[4], involves a similar claim by the plaintiff cybersecurity company seeking to force the buyer to close the transaction. In this case, the buyer decided to walk away because, among other things, it believes that an MAE had occurred and the sellers failed to operate the company in the ordinary course in the interim period.

The plaintiff asserted in its complaint that the buyer had walked away due to a mere change of heart caused by the COVID-19 outbreak. The plaintiff argued that the merger agreement, which was executed after COVID-19 was declared a global emergency, specifically allocated the risk of any pandemic to the buyer, since pandemics were expressly “carved out” from the definition of the MAE. The plaintiff also disputed the buyer’s argument that the company’s financial decline will last for a durationally significant period of time, and pointed to a recently prepared presentation in which the buyer had agreed that the company would return to business as usual in fiscal 2021. The sellers also argued that the first quarter 2020 results cannot be used to show the company’s long-term financial performance, especially given the effects of the COVID-19 outbreak.

Conversely, the buyer argued that the company’s financial performance and prospects “have fallen off a cliff”, whereas the company’s competitors are thriving. As such, even if pandemics were carved out from the MAE clause, the buyer asserted that the company had suffered a disproportionate impact relative to its peers.[5]

In XHP Santa Barbara LLC v. SBG US Holdings Pte. Ltd.[6], the plaintiffs claim a termination fee is owed due to the termination of the purchase agreement for the sale of certain hotel properties. As described in the plaintiff’s complaint, the defendant buyers were not able to obtain financing for the purchase and have attempted to postpone the closing date without paying the required deposit. When the sellers refused to extend the closing deadline, the buyers sent a termination notice, claiming that the sellers failed to operate the business in the ordinary course. Notably, the sellers contend that notwithstanding the widespread warnings of an imminent global pandemic, and the subsequent declaration of a global health emergency by the World Health Organization, the buyers did not negotiate for the right to terminate the purchase agreement if the pandemic caused a material adverse effect on the hotel properties.

In Snow Phipps Group, LLC v. KCake Acquisition, Inc.[7], involving a failed sale of a company which provides decorations and other supplies used to create high-end cakes for celebratory events (particularly children’s birthday parties), the buyers claimed that the target company has suffered a severe, disproportionate, and durationally significant material adverse effect. To support this claim, the buyers asserted that “the COVID-19 pandemic has dramatically curtailed birthday and similar celebrations for the foreseeable future,” and, as a result, the recent downturn in the company’s financial performance was not temporary, but instead “the company’s business has cratered with no end in sight”.[8]

The buyers claimed that “like everyone else,” they had no knowledge of the possible effects of the pandemic, and that while there were confirmed cases of COVID-19 in the US when the purchase agreement was signed, there was no indication that the impact of the pandemic would be so severe. [9] However, the buyers had refused to allow an epidemic carveout to the definition of MAE in the purchase agreement, and had renegotiated a significant reduction to the purchase price on the eve of signing, allegedly in exchange for agreeing to proceed with the transaction in the wake of the pandemic.

The seller argued that even though the MAE definition did not contain an exclusion for pandemics, the adverse effect suffered by the company was caused by general economic conditions that affect all companies in the same or similar industries, and therefore was not an MAE.

MAE Challenges Under Akorn

These cases provide the Court with some very complex issues to resolve, each with its own specific set of facts, but all based on COVID-19. The Court’s recent decision in Akorn, Inc. v. Fresenius Kabi AG[10] provides a useful guide for how the Court is likely to analyze the MAE issue in these disputes. Akorn is the only case so far in which a buyer has successfully asserted an MAE to terminate a pending transaction.

In deciding Akorn, which involved the purchase of a Louisiana specialty generic pharmaceuticals company, the Court acknowledged that the current practice for M&A parties is to allocate risk by negotiating exceptions and exclusions to the MAE definition, rather than expending resources in defining specific materiality thresholds. Therefore, the risk of a general MAE is assumed by the seller, whereas the risks associated with any exceptions to an MAE are generally placed on the buyer, who in turn, may “return” any disproportionate effects of such exceptions back to the seller. The Court further noted that a more nuanced analysis of issues raised by MAE clauses shows four types of risks:

(i) systematic risks which are beyond all parties’ control and generally affect constituents outside of the parties to a transaction;

(ii) indicator risks, which generally just signal (but not prove) that an MAE may have occurred, such as a drop in the seller’s stock price;

(iii) agreement risks, which include all risks resulting from the announcement of the transaction; and

(iv) business risks, which are generally those arising from the ordinary operation of the company’s business and over which such company has control.

As a general matter, the seller retains the business risk, whereas all other risks are assumed by the buyer.[11]

In determining whether an MAE had occurred in Akorn, the Court considered the following questions: (i) was the magnitude of the effect at issue material; (ii) did the effect fall within an exception to the MAE; and (iii) did the buyer knowingly accept the risks that led to the MAE.[12]

In resolving the first question, the Court reaffirmed that the adverse effect must be such that it “substantially threatens the overall earnings potential of a target in a durationally-significant manner” and that “a short-term hiccup in earnings will not suffice”. The Court noted that there is no bright-line test as to the extent of a magnitude. While acknowledging that in In re IBP, Inc. S’holders Litig.,[13] a 64% drop in quarterly earnings did not constitute an MAE, the Court noted that this did not preclude a possibility that a buyer may be successful in showing that a lower percentage drop in earnings caused an MAE. The Court also emphasized Delaware’s general approach to follow the plain language of the agreement in interpreting any issues.

The facts in Akorn were especially egregious, and were set forth in great detail in the Akorn opinion. The Court emphasized that any MAE analysis will be very fact specific. First, Akorn’s revenue, operating income and EBITDA had substantially declined over three quarters, compared to its steady financial growth over the prior five years. Second, serious data-integrity issues were discovered at several Akorn locations which were factually documented by an outside facility-inspection firm, and highlighted Akorn’s noncompliance with FDA regulations.  

In determining that Akorn’s dramatic decline in performance was an exception to the MAE, the Court determined that the decline was not caused by the “industry headwinds” which have affected the generic pharmaceutical industry, but rather was a result of the problems specific to Akorn’s product mix. Therefore, while the buyer assumed the systematic risks, such as those that would be caused by the issues in the generic pharmaceutical industry, Akorn retained the risks specific to its business. The Court further noted that even if the decline in performance was due to the general industry-wide conditions, the buyer nevertheless “returned” to the sellers any risk of a disproportionate effect of such conditions.[14]

Finally, the Court ruled that a buyer is not precluded from raising an MAE defense even if it was aware of any of the risks that caused an MAE. In distinguishing IBP, where the Court noted that an MAE is best read as a backstop protecting the buyer from the occurrence of unknown events, the Court in Akorn decided that such reading would essentially render contractual provisions useless and impose a tort-like assumption of the risk liability. By including an MAE clause in the contract, the parties allocate risks between themselves based on the buyer’s diligence results and the parties’ risk appetite. The Court noted that parties are free to draft MAE clauses as they see fit, including by carving out specific matters that sellers believe may occur prior to closing, or matters disclosed in due diligence, or even risks identified in public filings. Because the MAE definition in Akorn was not limited to only unforeseeable or unknown effects or changes, ruling otherwise would have been inappropriate.[15]

Potential Outcomes Following Akorn

COVID-19 has caused tremendous uncertainty as to the timing and extent of recovery of the general economy, as well as on specific industries. The Board of Governors of the Federal Reserve System (Fed), in its June 2020 Monetary Policy Report, provided a good summary of the risks faced by the US economy: (i) the future progression of the pandemic remains highly uncertain, with resurgence of the outbreak a substantial risk; (ii) the collapse in demand may ultimately bankrupt many businesses; (iii) unlike past recessions, services activity has dropped more sharply than manufacturing—with restrictions on movement severely curtailing expenditures on travel, tourism, restaurants, and recreation—and social-distancing requirements and attitudes may further weigh on the recovery in these sectors; and (iv) disruptions to global trade may also result in a costly reconfiguration of global supply chains.[16]

Notwithstanding this backdrop of unprecedented uncertainty, the Court is likely to follow the Akorn framework which places a heavy burden on the buyer to show that the adverse impact to the target company constituted an MAE.

Applying Akorn, the buyer first will need to prove that the magnitude of the effect on the business was so material, that it “substantially threatened the overall earnings potential of the target” in a manner that is “durationally-significant”. While facts like financial performance of the target falling “off a cliff” are telling, the buyer will need to establish that such negative performance has continued for more than a few months since the outbreak of COVID-19. On the one hand, the US economy has started to reopen, and, as of the date of this article, US economic indicators are improving[17], which may undermine the buyer’s argument that the poor earnings will persist for a lengthy period. On the other hand, the current resurgence of COVID-19 in the south and southwest US may slow the recovery significantly in certain industries which may take an extended period to climb back to pre-pandemic levels. This will require the Court to take a detailed analysis of how COVID-19 has affected a target company’s industry generally, and the target company’s performance relative to its peers in the industry.

If the Court finds that the target company’s industry has suffered an adverse effect, the Court will proceed to analyze whether the adverse event falls within an exception to the MAE. In line with Delaware’s general approach to follow the plain language of the purchase agreement, it will closely examine the MAE provision to determine how the parties allocated the risk of the adverse event between themselves. The Court will examine whether or not “pandemics” or similar events were carved out from the definition of the MAE and whether or not a “disproportionate adverse impact” of such event was “returned” to the seller. Further, the analysis will likely include a review whether the adverse event was a systematic risk caused by the general economic conditions, or whether it was due to seller’s specific business problems that may have worsened as a result of the pandemic. However, it is unlikely that any of the pending cases present crystal-clear facts allowing for an easy analysis by the Court. As noted in Akorn, even though the Court determined that the decline in Akorn’s financial performance was caused by Akorn’s specific business risks, which risk was allocated to sellers, it was also plausible that the decline could have been caused by the general industry-wide conditions, a type of risk typically assumed by the buyer. However, because the MAE provision in question contained a “disproportionate adverse impact” carveout, such risk was “returned” to the sellers because Akorn was disproportionately affected by the general industry-wide conditions. It is also worth noting, that given the broad impact of COVID-19 on the economy, the “disproportionate adverse impact” carveout may not be of much use to the buyer. As such, the one thing that remains clear is that this analysis will be a “dauntingly complex” and an extremely fact-dependent task for the Court.

The Court, applying the Akorn framework, is unlikely to punish the buyer for agreeing to enter into a transaction early in the pandemic with some knowledge of the potential risks of the pandemic. Given how unprecedented the pandemic has been, and the conflicting and rapidly-changing advice from government officials, we believe the Court is likely to reject this argument without clear evidence that one party knowingly accepted the COVID-19 risks.

While the effects of COVID-19 have been devastating to many industries and individual companies overall, it is important to keep in mind that until Akorn, the Court had never found an MAE to have occurred. Therefore, proving that an MAE has occurred will remain a heavy burden for buyers to meet. With the Forescout trial scheduled to take place in the next few weeks, we look forward to seeing how the Court analyzes the impact of COVID-19 on the MAE framework.

 

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[1] Juweel Investors Limited v. Carlyle Roundtrip, L.P. et al., No. 2020-0338-JRS, complaint filed (Del. Ch. May 11, 2020).

[2] Telephonic Rulings of the Court on Plaintiff’s Motion to Expedite, Juweel Investors Limited v. Carlyle Roundtrip, L.P. et al., No. 2020-0338-JRS (Del. Ch. May 14, 2020).

[3] Id. at 16.

[4] Forescout Technologies Inc. v. Ferrari Group Holdings LP, No. 2020-0385, complaint filed (Del. Ch. May 19, 2020).

[5] Defendant’s Opposition to Plaintiff’s Motion for Expedited Proceedings, Forescout Technologies Inc. v. Ferrari Group Holdings LP, No. 2020-0385-SG (Del. Ch. Jun. 1, 2020).

[6] XHP Santa Barbara LLC v. SBG US Holdings Pte. Ltd.. et al., No. 2020-0395, complaint filed (Del. Ch. May 22, 2020).

[7] Snow Phipps Group, LLC v. KCake Acquisition, Inc., No. 2020-0282-KSJM, complaint filed (Del. Ch., Apr. 17, 2020).

[8] Defendant’s Opposition to Plaintiff’s Motion for Expedited Proceedings at 2., Snow Phipps Group, LLC v. KCake Acquisition, Inc., No. 2020-0282-KSJM (Del. Ch., Apr. 20, 2020).

[9] Id. at 4.

[10] Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch., Oct. 1, 2018).

[11] Id. at 49.

[12] Id. at 52, 58 and 60.

[13] In re IBP, Inc. S’holders Litig., 789 A.2d 14 (Del. Ch. 2001); although Vice Chancellor Strine then recognized that whether IBP has suffered an MAE remains a close question.

[14] Id. at 58.

[15] Id. at 60.

[16] The Monetary Policy Report issued by the Board of Governors of the Federal Reserve System on June 12, 2020, at 37.

[17] See e.g., Unemployment Insurance Weekly Claims Report by the Department of Labor, as of June 25, 2020 (dol.gov/ui/data.pdf), showing a gradual decrease in claims as compared to the previous weeks’ data; Advance Monthly Sales for Retail and Food Services by US Census Bureau, as of May 2020, showing an increase in 17.7% from April 2020 (https://www.census.gov/retail/marts/www/marts_current.pdf).