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Does the Coronavirus (COVID-19) Pandemic Constitute A Material Adverse Change for Purposes of Merger and Acquisition Agreements?

March 26, 2020


You signed a non-binding letter of intent with a target company in June 2019. You spent the next five or six months on due diligence. In late January 2020, you signed an acquisition agreement (merger, stock purchase, membership interest purchase, asset purchase, etc.) to acquire the target business. The agreement had a deferred closing and the parties did not purchase rep and warranty insurance. The target spent the next sixty days obtaining regulatory approvals and required supplier and customer consents. Closing is scheduled for March 31st. In mid-March, however, the U.S. economy began to shut down due to the Coronavirus (COVID-19) pandemic. Many other countries are following suit. Do you have to close under these circumstances?

To a large extent, the buyer’s obligation to close an acquisition considering the pandemic will depend on the language of the risk allocation provisions in the acquisition agreement. Those agreements typically contain a provision, or provisions, for allocating pre-closing adverse changes in risk through material adverse change and/or material adverse effect (both referred to as “MAC”) provisions.

MAC provisions typically come in two shapes: 1) a closing condition that entitles the buyer not to close if the seller suffers a MAC event between signing and closing and/or 2) a seller representation that has not suffered a MAC event between signing and closing along with a closing condition that permits the buyer to terminate the agreement if the representations are not true as of closing. Some agreements devote significant space to defining what does and does not constitute a MAC but many do not. Whether the COVID-19 pandemic constitutes a MAC entitling the buyer to walk will depend largely on the agreement and the courts.

If the agreement defines a pandemic as a MAC, the seller could have a solid basis not to close. If the definition of MAC excludes changes in markets, or the economy, as a whole, unless the seller is disproportionately affected, which is not uncommon, the issue gets murkier.

If the acquisition agreement has no applicable definition for a MAC, the courts, depending on the jurisdiction, look to a number of factors to decide whether a condition or event is such that buyer is excused from closing. Whether an event is a MAC is a fact sensitive inquiry. The burden of proof will be on the buyer and the court will most likely require the buyer to make a strong showing. Historically, courts have been reluctant to find that a MAC occurred, absent extreme facts, such as fraud or misrepresentation by the seller.

In terms of COVID-19, the duration of the effect on the target will be a major issue. Courts usually view strategic acquisitions as long-term propositions. Consequently, in that context, a court is unlikely to consider a short-term disruption in earnings of a MAC. The politicians, talking heads, and experts are all over the place in terms of how long closure orders and the like should or will remain in effect. There are also differing opinions on how the economy will respond once those measures are lifted. Buyers looking to invoke MAC rights will face a challenge if they have to establish the long-term effect of COVID-19 on the target’s earnings.

Another major issue for buyers will be their knowledge of the potential risk of the pandemic when they executed the agreement. Reports of cases coming out of China go back to at least December 2019. Some courts look at a MAC clause as protecting against the occurrence of only unknown risks. They believe that if there was a known potential for this risk at the time they executed the agreement, the buyer should have drafted for it.

The measure of the change in business affected by the pandemic could also be a consideration. Courts look at both qualitative and quantitative factors. For example, the courts could look at whether the target lost key employees, vendors, or customers due to closure-related furloughs or layoffs. Courts could also look at whether the target has suffered a loss of earnings and, if so, how much both in terms of absolute dollars and percentages.

The analysis will vary from jurisdiction to jurisdiction. It will also be heavily dependent on the language of the acquisition agreement, the MAC provisions, and the specific facts relating to the transaction and the effect of the pandemic on the target. There are no bright line rules.

To avoid the risk of litigation, parties could consider renegotiating the deal to close it. Another option for buyers looking to avoid claims of breach if the refusal to close turns out to be unfounded would be to consider filing a declaratory judgment action asking the court to determine the uncertainty of whether the pandemic is a MAC. Sellers should also be upfront and candid with the buyer about the effect of the pandemic on their business and be proactive and take all reasonable steps to mitigate its harm on the business.

Montgomery McCracken attorneys are available to assist clients with numerous issues related to COVID-19. Visit the firm’s Coronavirus (COVID-19) Resource Center for more information and updates on this constantly evolving situation.