As we move into May, the coronavirus (COVID-19) impedes our intended return to economic development, industry growth and business as usual. Consequently, businesses and private equity firms are looking to preserve their financial health and maintain their leverage in an unpredictable economy. The current climate presents exceptional considerations for the mergers and acquisitions market. While we are far from realizing the pandemic’s ultimate impact on our global economy, parties to M&A transactions must account for these uncertainties today. For potential transactions, a key issue will be addressing the material adverse effect, or material adverse change (MAC), clause from the perspective of both buyer and seller. Additionally, parties to current deals are now left to evaluate whether the pandemic gives rise to a material adverse change under the terms of their existing agreements. Mintz provides additional guidance for material adverse events and drafting MAC clauses through our Mintz Insights Center. This advisory will explain the purpose of the MAC provision and analyze its function to date. Although the significance of COVID-19 is undeniable, the question of materiality for the MAC clause remains unsettled for mergers and acquisitions.
The MAC Provision – An Overview
Throughout an M&A transaction, the seller and buyer allocate risks associated with the target entity. A MAC provision is one tool to account for these risks by outlining the material adverse changes that would allow buyers to walk away from certain purchase and sale agreements. MAC provisions generally define “materially adverse” as events, circumstances, changes or effects that, individually or in the aggregate, are materially adverse to the business, operations or conditions (financial or otherwise) of the company and its subsidiaries, taken as a whole. On the other hand, MAC provisions typically acknowledge that business impacts attributable to a general economic downturn and industry-wide risk (i.e., MAC carve-outs), will not trigger the buyer’s termination rights unless such impacts pose a disproportionate adverse event for the target. From the seller’s perspective, a MAC should not shield the buyer from inherent risks associated with a given market or industry. From the buyer’s perspective, the MAC provision should encompass changes that will unfairly divest the buyer from the negotiated value of the target. In light of this divide, the MAC provision can become a contentious negotiation point for certain deals, compelling parties to draft terms that are unique to the transaction at hand.
Due to the nuances of each negotiation, MAC provisions vary among M&A deals. In terms of substance, no standard threshold or amount of loss triggers any given MAC provision. In terms of structure, the MAC provision is almost always a crucial closing condition during a staggered signing and closing deal, where there is a need to allocate among the parties any risk of loss discovered between signing and closing. By functioning as a contingency provision for closing, the terms of a MAC can warrant non-performance of the agreement or prompt the parties to renegotiate the sale.
The Akorn Analysis for MAC Provisions
In the context of COVID-19, our judicial precedent sets a high standard for Delaware corporations asserting a material adverse change as a closing condition. Under Akorn v. Fresenius Kabi AG, the uncertainties surrounding COVID-19’s “durational” impact could render the pandemic an immaterial development for a given target. In Akorn, the Delaware Chancery Court held that a target pharmaceutical corporation experienced a material adverse change and the buyer was entitled to terminate the merger agreement under the closing conditions. The court conducted a heavily fact-based analysis, focusing on the chain of events surrounding the staggered signing and closing. Given the factual background, the court found that the seller’s misrepresentations and the agreement’s MAC provision could not be cured by the closing date. As a result, the buyer met its burden of proving the failure of a MAC closing condition and bring-down of a seller representation. The landmark case presents one of the rare instances where Delaware has found the circumstances to be so egregious as to amount to a material adverse change.
The Akorn analysis focuses on the materiality and durational significance of a change to determine whether the MAC closing condition is satisfied. In Akorn, the court reasoned that the target suffered a downward deviation of “durational significance,” which qualified as a material adverse change from both a qualitative and quantitative perspective. Qualitative measurements, such as regulatory non-compliance, can give way to a material adverse change. In Akorn, regulatory non-compliance amounted to an issue of materiality due to the target’s misrepresentations to FDA regulators and its inability to meet FDA standards. The court predicted long-term damage to the target’s potential success due to these failures. Further, the court noted that the target’s inadequate data integrity controls likely created long-term impairments for the company as well. These qualitative measurements lead the court to conclude that a material adverse change had occurred before closing.
From a quantitative perspective, the court found that an over 51% decline in profits gave rise to a material adverse change under the agreement. Even though the court highlighted the target’s steep drop in earnings, the court stressed that companies and practitioners should not look to Akorn for adopting numeric thresholds. A target’s growth rate alone does not make a material adverse change more or less likely. Although this landmark case provides guidance for interpreting MAC provisions, the court continued to narrowly define “materially adverse” based on a very fact-specific analysis. Under Akorn, Delaware corporations will need to assert a “dramatic, unexpected, and company-specific downturn” in terms of materiality and durational significance. For financial distress caused by COVID-19, in order to be able to avoid closing by invoking the MAC clause, a buyer of a Delaware target would likely need to point to a very significant, unanticipated and enduring deterioration of the business between signing and closing, one effectively eroding the premise of the deal. As parties reconcile their transactions with judicial precedent, buyers and sellers should thoroughly examine how their particular circumstances relate to Akorn.
On March 18, 2020, the Southern District of New York provided further judicial interpretation for MAC provisions. As noted in our recent Mergers & Acquisitions viewpoint on the Newmont Mining Corp. v. AngloGold Ashanti Ltd. decision, the U.S. District Court for the Southern District of New York recently issued an opinion addressing the absence of a material adverse change. In granting summary judgment, the court struck down the validity of the buyer’s arguments by holding that a material adverse change did not occur to the target’s entire business. Unlike in Akorn, the target in Newmont Mining did not experience an extensive year-over-year decline in performance. The court further noted that the plain language of the stock purchase agreement expressly excluded the failure of the target to meet its business projections as a MAC carve-out. Newmont Mining echoes the interpretations set forth in Akorn and highlights the importance of carefully crafted carve-outs for MAC provisions.
New York corporations and parties to agreements governed by New York law should thoroughly examine Newmont Mining in relation to COVID-19. By accounting for foreseeable events in its carve-outs, sellers may be able to protect themselves against pandemic-related issues in sale processes initiated during the COVID-19 era. Newmont Mining should caution buyers that any material adversity caused by COVID-19 will be viewed in terms of the business in its entirety, as opposed to a particular location, business unit or component. Through a strict contractual interpretation, Newmont Mining reminds parties to use expressed terms to effectuate their intent for MAC provisions.
Novelty of the Coronavirus
From a historical context, parties to M&A transactions should not expect a global crisis to trigger a MAC provision on its own. Unless expressly accounted for in the agreement, buyers often struggle to establish a material adverse change solely due to extreme market volatility. Industry shake-ups during the financial crisis, dot-com bubble and SARS outbreak provide a blueprint for dealmakers today. Private equity firms that tried to abandon leveraged buyouts ultimately resorted to renegotiating deals after failing to assert a material adverse change. Although an economic downturn can generate catastrophic repercussions, these adversities are typically felt by an entire industry or market, as opposed to being a single adverse impact for the target. Unless the agreement captures the crisis elsewhere, a MAC provision will unlikely save a buyer from economic downturn.
Given the global impact of COVID-19, sellers today will likely contend that this pandemic has now taken the form of a general market risk, which should be allocated to the buyer. Acquirers entering into M&A transactions will have difficulty disputing the systemic and pervasive risk posed by the pandemic. Even if the target experiences a disproportionate impact during a staggered closing, neglecting to contemplate the transaction in light of current events may constitute a failure to use commercially reasonable efforts under Akorn. Even so, companies and practitioners should bear in mind that the impact of COVID-19 continues to evolve and the global economic outlook relies on multiple assumptions. Time will tell if courts apply a very fact-specific inquiry under Akorn or institute court policies that provide a broad interpretation for COVID-19 cases. Either way, legislation that directly addresses COVID-19 as a material adverse change may provide a conclusive answer for future litigation. Parties should keep these various possibilities in mind throughout the drafting process in order to protect their financial interests.
Based on these considerations, COVID-19 needs to be addressed by both sides of the table when drafting a MAC provision. From the buyer’s side, the buyer should consider the macroeconomic uncertainties that may hurt the target specifically. In particular, the buyer should evaluate the key functional areas (i.e., supply chain management, R&D, sales and capital structure) of the business that are vulnerable to an adverse event. Buyers should consider events that may develop between signing and closing. In assessing its risk, buyers should question whether such events will likely be cured by the closing date or affect the target in the long-term. In response, sellers should directly address the pandemic in its carve-outs. For example, sellers should define a MAC with COVID-19 specific language, such as “pandemic,” “coronavirus,” and “COVID-19.” Additionally, sellers can try to limit MAC provisions to a single adverse event, as opposed to a series of events affecting different parts of the business structure and operations over time, which may follow in the pandemic’s aftermath. When countering any carve-outs, the buyer should try to protect its interests against any disproportionate effect that the pandemic may have on the target entity. By expressly accounting for the pandemic, buyers and sellers can construct a MAC provision that limits ambiguity during these uncertain times.
Mintz will continue to monitor these events and report recent developments in connection with MAC provisions and M&A agreements. Companies should work closely with their legal and financial advisors when adopting MAC provisions given the specific circumstances.
1 See Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 737 (Del. Ch. 2008) (“Hexion”).
2 Akorn, Inc. v. Fresenius Kabi AG, et al., Memorandum Opinion, No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018) (“Akorn”).
3 Akorn at 190-93.
4 Id. at 144-45.
5 Id. at 129; see generally In re IBP, Inc. S’holders Litig., 789 A.2d 14 (Del. Ch. 2001).
6 Akorn at 163.
7 Id. at 173-74.
8 Id. at 161-64.
9 Id. at 126.
10 Id. at 124-25.
11 Id. at 130-32; see also Hexion at 740-43.
12 Akorn at 9.
13 Newmont Mining Corp. v. AngloGold Ashanti Ltd., et al., Opinion and Order, No. 1:17-cv-08065 (S.D.N.Y. Mar. 18, 2020), ECF No. 143 (“Newmont Mining”).
14 Newmont Mining at 58-60.
15 Id. at 12.
16 Id. at 53.
17 Akorn at 212-14.