This is particularly true for “non-essential” retail businesses required to restrict operations due to government orders. With buyers attempting to delay or terminate deals, several recently filed Delaware Court of Chancery cases address the applicability of Material Adverse Effect (MAE) provisions to COVID-related disputes.
MAE clauses are provisions in merger and acquisition agreements used to allocate risk between parties. MAE provisions specifically address risk arising in the time between the signing and the closing of the deal. MAE provisions generally exist to protect a buyer from being forced to close a deal to acquire a target that has been materially impacted by unforeseeable negative events. The seller, meanwhile, will often try to narrowly draft MAE provisions to limit the ability of a buyer to walk away from a transaction, leaving the seller to not only deal with the events giving rise to the MAE, but also the difficult task of resuming operations with employees, customers and vendors who were expecting the transaction to take place.
Delaware courts are beginning to hear cases addressing the question of whether the COVID-19 pandemic should trigger MAE clauses. Importantly, many MAE provisions contain exceptions for systematic risks including changes in economic or financial conditions, changes in the law, and force majeure events.
Delaware courts generally define a materially adverse event in terms of the long- term perspective of a reasonable buyer. The courts addressed MAE provisions in IBP, Inc. v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch. 2001) and Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008).
In IBP, the court ordered a sale to proceed despite the inclusion of an MAE provision. Then Vice-Chancellor Leo Strine explained, “[a] short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of the acquiror.” IBP at 64. In this case, the “hiccup” was a 64% drop in quarterly earnings. The court noted an absence of expert evidence that the drop in earnings would translate into a decline in value or earnings potential.
Hexion Specialty Chems., Inc. v. Huntsman Corp seems to reinforce this long-term analysis. In Hexion, the court explained an MAE clause involves “an adverse change in the target’s business that is consequential to the company’s long term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” Id. at 738.
Given the economic fallout from the COVID-19 pandemic, Delaware courts face the challenging task of applying the IBP and Hexion precedents on a deal by deal basis. Several new cases illustrate how COVID-19 will test the applicability of MAE clauses in the current environment.
New COVID-Related MAE Cases
Several high-profile COVID-related MAE cases, often involving a seller seeking specific performance, are now before the Delaware Court of Chancery.
L Brands, Inc. v. SP VS Buyer L.P., C.A. No 2020-0304-JTL (Del. Ch. Filed Apr. 23, 2020)
L Brands, Inc., better known as the owner of Victoria’s Secret, and buyer Sycamore Partners exchanged complaints against each other after their deal soured in the wake of COVID-19. Sycamore successfully backed out of its agreement to buy 55% of Victoria’s Secret, arguing that the pandemic triggered an MAE provision. Sycamore said that L Brands closure of facilities required Sycamore’s consent. L Brands argued Sycamore was aware of the risk posed by COVID-19 when the $525 billion deal was announced on February 20, 2020. Specifically, L Brands characterized Sycamore’s argument as “nonsense” because the deal contained a pandemic exclusion.
L Brands recently abandoned its lawsuit to allow Sycamore to walk away from the deal. Sycamore says L Brand’s claim for money damages terminated financing agreements which made the completion of the deal impossible.
Level 4 Yoga, LLC, v. CorePower Yoga, LLC, C.A. No. 2020-0249-JRS (Del. Ch. Filed Apr. 2, 2020)
Level 4 Yoga, as the seller, seeks specific performance of a deal involving an asset purchase agreement for the sale of 34 yoga studios across several states. Buyer CorePower declined to go through with an April 1, 2020 closing date after Level 4 shut down several locations. Level 4 argues the temporary closings were required by government orders and did not breach the agreement. In its complaint Level 4 argues the MAE should not apply because, “Like any standard material adverse effect clause, the Agreement’s language is intended to allocate firm-specific or long-term risk to Plaintiff and to keep short-term or market and industry-wide risk, like the effects of a pandemic, on Defendants.”
Bed Bath & Beyond Inc., v. 1-800-Flowers.com, Inc., C.A. No. 2020-0245-SG (Del. Ch. Filed Apr. 1, 2020)
Bed Bath & Beyond seeks specific performance of a $252 million deal to sell PMall to 1-800-Flowers. 1-800-Flowers requested to delay closing for 30 days citing uncertainty due to the COVID-19 pandemic. 1-800-Flowers allegedly failed to provide any additional assurances it would still complete the deal. Bed Bath & Beyond asks the Court of Chancery to find that COVID-19 did not trigger the MAE provision of the equity purchase agreement.
Bed Bath & Beyond agues the MAE is not triggered because “Under the plain terms of the definition, even a calamitous event such as COVID-19 does not permit a party to avoid its obligations unless it causes a disproportionate impact on the Company, which is simply not the case.” Bed Bath & Beyond argues, “the MAE definition explicitly excludes, among other things, ‘any change resulting from conditions affecting any of the industries or markets in which the Company operates,’ as well as ‘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 of acts of God, hostilities, war or military or terrorist attack (including cyberterrorist attack)).’”
The We Company v. Softbank Group Corp., C.A. No. 2020-0258-AGB (Del. Ch. Filed Apr. 7, 2020)
In a deal that did not include an MAE provision, The We Company, better known as the parent company of WeWork, seeks specific performance of a stock purchase agreement in which Softbank agreed to make a tender offer for up to $3 billion of The We Company’s shares. The deal was executed on October 22, 2019, with a closing date scheduled for April 1, 2020. Softbank terminated the stock purchase agreement, alleging that multiple closing conditions had not been satisfied, citing the existence of government actions that impose restrictions on WeWork’s operations as a result of COVID-19, as well as WeWork’s failure to obtain anti-trust approvals and to close a roll-up of a Chinese joint venture.
Softbank invested billions into The We Company after the co-working company scrapped its planned IPO in September 2019. WeWork’s business model is based on shared workspaces. The company received significant criticism for its reluctance to close offices or offer refunds during the COVID-19 pandemic.
The applicability of MAE clauses to COVID-19 disruptions depends on a variety of factors including the precise language of the agreement, the exclusions listed, and the particular effects suffered by the seller.
While it remains unclear how courts will rule on these issues, it seems likely pandemic exclusions will become increasingly standard in the MAE provisions of future deals.
The SBA Focus Group of the COVID-19 Task Force at Klehr Harrison stands ready to assist you in your business and legal needs. We will continue to provide additional information and guidance as the PPP loan program is implemented.
Author Matthew McDonald is a partner in the Corporate & Securities Department.