Will the Pandemic Sink Deals?

Almost everyone has experienced buyer’s remorse. It’s the feeling of purchasing, say, a big-screen TV at full price, only to see it on sale later for 50 percent off. Imagine, though, agreeing to pay $6 million for a chain of yoga studios just before the government shuts down exercise classes to slow the spread of a highly infectious disease. Or, more generally, agreeing to buy a company just before the stock market drops 30 percent, throwing the economic future of entire industries into turmoil.

That’s the kind of buyer’s remorse on steroids hitting scores of acquirers that committed to M&A deals in the months before the coronavirus pandemic. Faced with new and uncertain economic realities — and often with a target company that looks far less valuable than it did just a month ago – many of these acquirers are looking desperately for a way out. So far, the biggest news has been SoftBank’s withdrawal of its $3 billion tender offer for shares in WeWork, the workplace-sharing company whose problems long pre-date the current crisis. But an avalanche of broken deals may be coming, with the first of them already starting to show up in the Delaware courts.

Though not at issue in the WeWork debacle, one obstacle acquirers are likely to face is the material adverse change – or MAC – clause (sometimes also known as the material adverse effect (MAE) clause). MAC clauses of one form or another are found in almost every merger agreement, allowing one party, usually the buyer, to walk away from the deal, prior to closing, upon the occurrence of a MAC: a change in circumstances deemed so significant that it makes the agreement unenforceable.

There is no single, standard definition of a MAC, and the parties to a merger agreement can define it any way they want. In practice, most MAC clauses don’t really define the term directly at all. Instead, they include a long list of exclusions for things that are not to be treated as MACs. What is and isn’t excluded from the definition of a MAC determines which party bears which kinds of risks. If,  say, a volcanic eruption is excluded from the definition, the buyer bears the risk, in the sense that it still has to go through with the deal even if the target company’s facilities are destroyed by lava. If volcanic eruptions were not excluded, the target company would bear the risk, in the sense that the buyer could walk away in the event of a volcano having a material adverse effect on the target company. In theory, the parties can bargain over who bears what risk, with the buyer trading a higher price in exchange for bearing less risk, or vice versa.

In general, MAC clauses tend to allocate to the target company risks that are peculiar to the target company – known as “company-specific” risks – on the theory that the target company’s management is likely to have better information about such risks and be better-placed to avoid them or insure against them. Conversely, most MAC clauses tend to allocate to the buyer – by excluding them from the definition of a MAC – more general “systemic” risks that neither party is in a good position to control. Because the buyer typically gets the upside if systemic factors unexpectedly make the target company more valuable, it may be appropriate that they also get the downside when systemic factors unexpectedly make the target company less valuable. Furthermore, the acquirer is typically larger than the target, and may be better able to insure against risks that neither party can control.

The upshot is that MAC clauses tend to exclude force majeure events like natural disasters, war, terrorism, and … you guessed it, epidemics. For example, in the leading recent Delaware case on MAC clauses, Akorn v. Fresenius, the MAC clause explicitly excluded pandemics. As you might expect, some recent merger agreements – such as the one governing Morgan Stanley’s purchase of E*Trade – excluded “the COVID-19 pandemic.”

The MAC clauses at issue in the first two buyer’s remorse cases to reach the Delaware courts – Level 4 Yoga, LLC v. CorePower Yoga, LLC, and Bed Bath & Beyond, Inc. v. 1-800-Flowers.com – do not specifically exclude pandemics. Even so, there are two reasons why the buyers in those cases might not be able to argue successfully that the current pandemic represents a MAC.

First, both MAC clauses assign general, systemic risk to the buyer. The Bed Bath, and Beyond agreement, for example, excludes from the definition of a MAC “any change resulting from changes in general business, financial, political, capital market or economic conditions (including any change resulting from any calamity, natural or man-made disaster or acts of God, hostilities, war or military or terrorist attack (including cyber-terrorist attack))” except to the extent that such an event “has a disproportionate effect on the Company compared to other participants in the industries or markets in which the Company operates.” It seems likely that the current pandemic would fall within this exclusion. As a result, to back out on MAC grounds, the buyer, 1-800-Flowers, would have to show not simply that the coronavirus has had a large negative impact on the target’s business, but also that the impact is “disproportionate” as compared with other companies in the same business.

The second problem the buyers face is that the standard for what constitutes a “materially adverse effect” is extraordinarily high. The downturn must be both extremely severe and “durationally significant.” While there is no bright-line rule, former Delaware Chancellor William Allen suggested that an earnings decline of 50 percent persisting through two quarters might be a MAC, and then-Vice Chancellor Leo Strine found that a 64 percent drop in a single quarter’s earnings was not a MAC because it lacked “durational significance.”

In fact, the standard is so high that it has been found by a Delaware court to be met only once: in the 2018 Akorn case. In Akorn, the target company’s financial performance “fell off a cliff” immediately after signing, with EBITDA plummeting 86 percent and analyst estimates of value dropping from $32/share to the $5-$12/share range. Furthermore, the collapse was due to company-specific factors such as the simultaneous emergence of new competitors for each of Akorn’s top three products, and (previously undisclosed) regulatory violations leading to the shutdown of facilities and potential withdrawal of regulatory approval for the company’s products. Moreover, by the time of trial, the decline had “persisted for a full year and show[ed] no sign of abating.”

From the outside, it is difficult to tell how dramatic the downturn has been in the cases now before the Delaware courts, though it would not surprise us if they were sufficiently severe, given the dramatic economic effects of the lockdown. Durational significance, however, may be more of an issue, if the lockdown is eased in the coming months and business returns to anything like normal.

None of this is to say that the buyers are necessarily stuck. In particular, they may have available to them common law contractual arguments such as impossibility of performance or frustration of purpose. But taken together, the requirements that the decline be severe, long-lasting, and company-specific may make it impossible for buyers to back out on MAC grounds.

This post comes to us from professors Anat Alon-Beck and Charles Korsmo at Case Western Reserve University School of Law.