The early days of the crisis
Although the potential impact of COVID-19 was beginning to register in the early weeks of 2020, it was largely business-as-usual for the principals and advisers on the large number of M&A deals signed during this period or in the final weeks of 2019. The worsening situation crystallised with the WHO’s declaration of a global pandemic on March 11, 2020. As governments around the world began to issue stay-at-home or shelter-in-place directions, impose travel restrictions and order businesses to close, the economic consequences of the global health emergency began to come into focus.
It quickly became clear that the economic impact of the emergency would be uneven. Technology businesses and those with a strong online offering performed well, while hospitality, travel and traditional retail all suffered badly as a result of the pandemic.
One of the early M&A casualties was the acquisition by Sycamore Partners of a 55 per cent interest in the Victoria’s Secret retail business. This transaction was formally terminated in early May 2020 on settlement of an action launched by the seller (L Brands, Inc) in the Delaware courts, to compel Sycamore to complete the deal and for a declaration that Sycamore’s purported termination of the transaction agreement was invalid. Sycamore had argued that the business decisions taken by the seller (such as furloughing staff, reducing the compensation of senior staff, closing stores and failing to pay the April rent bills) were in breach of the transaction agreement even though they were taken as a result of or in response to the COVID-19 pandemic.
Press reports in the following months suggest that many more deals were either terminated or otherwise proceeded on revised terms. However, there remains little judicial legal authority either in the UK or in the US as to whether the pandemic, and the actions and events which followed it, might give buyers legitimate grounds for terminating their M&A deals.
In this briefing we review pre-pandemic authorities and two cases (one in the UK and one in the US) which considered the effect of the COVID-19 pandemic on deals which had been due to close in 2020.
How did the law stand before the pandemic?
Potential grounds for terminating M&A agreements would typically be either by invoking a material adverse effect (MAE)1 termination right or by arguing that other breaches of the transaction agreement (such as the failure to comply with pre-closing business conduct undertakings2 or breaches of warranty on their repetition at closing) gave rise to a right to terminate.
Whilst English law acquisition agreements often, but by no means invariably, contain such termination rights,3 there is no direct English law authority considering a buyer’s right to terminate an acquisition agreement on grounds that there has been a MAC or a MAE event.4 Further, such authority as does exist has considered events that were specific to the target business or its owners rather than events or circumstances of general application or effect. In particular, there is no authority in the context of previous disease outbreaks such as SARS (2003/2004), swine flu (2009) or MERS (2012). Other commonly referred to authority has considered the interpretation of a MAE in the setting of a lending relationship rather than in a merger or acquisition context.5
In the US, and looking at decisions in Delaware, whilst there is no useful precedent from previous disease outbreaks, there is certainly more existing authority on the scope of a buyer’s right to terminate merger or acquisition agreements for events or circumstances arising after signing but before closing of a deal.
Akorn, Inc. v. Fresenius Kabi AG6 is an important case, being the first in which the Delaware Court of Chancery found the existence of a MAE on which the buyer was entitled to rely as a basis for refusing to close its acquisition of the target (the generics drug manufacturer, Akorn). In that case, shortly after signing of the merger agreement, the target business’s financial performance “fell off a cliff”. This was compounded by a whistleblower’s allegations, later confirmed by the company’s own investigations, of failures to comply with regulatory requirements and Akorn’s own quality compliance programs. Akorn’s business continued to deteriorate and, on April 22, 2018, Fresenius gave notice that it was terminating the merger agreement. In the court action which followed, VC Laster ruled in favour of the acquirer, Fresenius as follows:
- Fresenius properly relied on the fact that Akorn had suffered a MAE7 as a basis for refusing to close and:
(a) Fresenius showed that the decline in Akorn’s performance was material when viewed from the longer-term perspective of a reasonable acquirer, which was measured in years.
(b) Fresenius also showed that Akorn’s poor performance resulted from company-specific problems, rather than industry-wide conditions. Even assuming for the sake of argument that the results could be attributed to industry-wide conditions, those conditions affected Akorn disproportionately.
(c) The events that caused Akorn’s problems were unforeseen by both parties.
- Akorn’s representations regarding its compliance with regulatory requirements were not true and correct, and the magnitude of the inaccuracies would reasonably be expected to result in a MAE.
- Akorn materially breached its obligation to continue operating in the ordinary course of business between signing and closing. The relevant covenant in the agreement consisted of a broad affirmative covenant8 and 16 categories of prohibited acts. Even though these ordinary course covenants were framed in terms of an obligation to use “commercially reasonable efforts” (not an absolute obligation to comply) it was significant that in making the commercial choices it made, Akorn chose consciously to depart from the ordinary course of business that a generic pharmaceutical company would follow.
- Fresenius had fulfilled its contractual obligations. If Fresenius had been in material breach of its own obligations under the merger agreement, it would not have been able to exercise either of the termination rights on which it relied.
Judicial guidance during 2020
Despite extensive press coverage of troubled deals in 2020, judicial guidance in this area in the context of the pandemic remains relatively undeveloped.
In a UK context, the principal consideration of these issues came in the Wex case.9 This was not a full trial of the matter, but was a hearing of some preliminary issues of construction.
In January 2020, Wex Inc agreed to buy two targets which are payment service providers in the travel industry (eNett International and Optal) for a total consideration in cash and Wex shares of some $1.7 billion. Although two companies were purchased, the deals were interlinked and documented under the terms of the same share purchase agreement (SPA). Soon after the deal was signed and announced, it became clear that the target businesses had been hit badly by the vast reduction in travel and corresponding payments in the travel industry caused by the pandemic. In a letter of May 4, 2020, Wex stated that it was no longer obliged to close the transaction because a MAE had occurred such that the relevant condition precedent to its obligation to close the transaction could not be satisfied.
In early October 2020, a trial of certain preliminary issues took place to assist in determining whether a MAE had occurred, or was reasonably expected to occur, such that Wex was not obliged to close the transaction.
The court gave detailed consideration to the components of the MAE definition. “Conditions resulting from … pandemics” were carved out from the definition preventing Wex from asserting a MAE unless that event had had “a disproportionate effect on [the eNett or Optal Groups], taken as a whole, as compared to other participants in the industries in which [they] operate”.
In other words, as the buyer, Wex, could not rely on a “pandemic” as a MAE because this was excluded from the scope of the MAE save to the extent that such an event had a disproportionate effect on the targets as compared to other industry participants. The central question for the court was whether the relevant “industries” were, as Wex contended, the business to business payments industry or the payments industry generally (the broad construction) or, as the sellers contended, the narrower market segment of the travel payments industry. The court found in favour of Wex that, in the absence of drafting or specific guidance in the sale documentation as to the comparator industries, there was no support for the sellers’ assertion of a narrow construction of the MAE clause. This finding would have been important in supporting Wex’s argument that Optal and eNett were in fact disproportionately affected by the pandemic and therefore that the MAE clause was engaged. However, the case was settled in November 2020 and the acquisition proceeded, albeit for a much reduced cash consideration of $577.5 million, so a trial of the main issues, including whether the buyer was entitled to invoke the MAE condition, was never heard.
In the US, by contrast, in the Stable case,10 a Delaware court considered the validity of the buyer’s termination (in April 2020) of an agreement entered into in September 2019. The court did not accept that the buyer could terminate the merger agreement on the grounds of the pandemic because, whilst the merger agreement contained a MAE clause, COVID-19 constituted a “calamity” and calamities were carved out from the scope of the definition of MAE.
However, the merger agreement also contained a covenant requiring that the business of the target group be operated “only in the ordinary course consistent with past practices in all material respects”. The court held that the actions taken in response to the COVID-19 pandemic (including hotel closures, severe operating restrictions on those hotels which remained open, significant headcount reductions, marketing and capital expenditure spend freezes) amounted to a breach of the ordinary course undertaking and gave rise to a termination right. The court found that the presence of the words “only” and “consistent with past practice” in the ordinary course covenant meant that this phrase should not, for example, be construed in the context of actions taken by similar businesses or based on what might be ordinary course during a pandemic since the purpose of such provisions was to ensure the buyer had got what it paid for. Of note, is that VC Laster observed that there were “credible and contestable issues” as to whether the seller’s separate covenant to comply with the law should take precedence over the “ordinary course” covenant. However, the court did not address this issue because the actions taken in response to the pandemic were taken before any state or local governments had issued stay-at-home orders affecting the hotels.
Where does this leave us?
It remains to be seen if other cases, whether in the UK or the US, which are still to be heard will further develop the law in this area.
For deals subject to English law, what legal and practical points can we take away as things stand?
- Whilst case law may afford some guiding principles applicable to the interpretation of MAEs/MACs,11 outcomes are very fact-specific and construction of the actual words used is key with (as the Wex case illustrates) a high evidential burden to be faced.
- In Wex, the Judge did not find there to be any special principle applicable to MAE clauses as a matter of English law, or any binding dictum from the authorities, nor did MAE clauses fall to be construed contra proferentem (i.e. strictly against the party seeking to invoke them). The question was one to be considered on the usual principles of contractual construction.
- Delaware law may be influential in an English court. In the Wex case, the Judge put it this way: "There is a dearth of relevant English authority. While I would agree that the cases are not admissible as factual matrix, this is just the kind of situation where a review of the authorities from a foreign court is called for. Those authorities will obviously not be binding or formally persuasive, but to ignore the thinking of the leading forum for the consideration of these clauses, a forum which is both sophisticated and a common law jurisdiction, would plainly be imprudent – as well as discourteous to that court. The same goes for the academic learning which is often cited in the Delaware Court."
- Where recourse is made to the courts, timescales for resolution may be challenging. Even where courts proceed on an expedited basis, achieving a meaningful judicial outcome in the period within which an M&A deal would typically close may not be realistic. For example, in the Wex case, it took a number of months for a preliminary issues trial to be heard (in part, it is assumed, due to the need to assemble the expert evidence required for the construction points to be considered).
- Sellers need to have regard to the dangers of termination rights arising beyond a MAE or MAC clause – for example repeated warranties or pre-closing undertakings where these are tied to an ability to terminate. Whilst these may be a less common feature of UK deals, they are customary for US deals or deals documented according to US market practice. Where such termination rights exist, as Stable illustrates, the real battle ground may not be over the drafting of a MAE but over the failure to comply with ordinary course undertakings. Accordingly, sellers may wish to clarify that “ordinary course” includes actions required to be taken during the pandemic or industry practices responding to material events or changes in circumstances.
- Finally, buyers must be aware of the risks of damages claims against them for wrongful termination of merger or acquisition agreements and should take care to ensure their own compliance with the terms of the transaction documents as a failure to comply may negate their ability to rely on termination rights. In this respect it is notable that, in its public statements, Wex consistently stated its position to be that it was not obliged to complete.