The COVID-19 coronavirus outbreak is already affecting many aspects of M&A transactions, including due diligence, W&I insurance, negotiations and financing. Will the outbreak provide buyers an out from agreed M&A transactions by constituting a material adverse change?
What is a ‘material adverse change’?’
In essence, an acquisition agreement allocates the financial and other risks between the buyer and seller of a target company or business. The buyer usually assumes the most significant risk relating to any acquired business, the business risk, meaning the upside and downside potential of the target following closing of the transaction.
It is common to separate the signing and closing of a M&A transaction for a variety of reasons, such as obtaining regulatory approvals, securing financing, and generally enabling the sale of the target as soon as the parties have reached a mutual understanding on all key particulars of the deal. When such an approach is warranted, a sophisticated buyer will frequently seek to ensure that pre-closing adverse change risk for the target’s business is allocated with the seller. This is something happening before closing that has or, at some time in the future, will have a materially adverse effect or change on the business for reasons other than the seller’s misrepresentations or covenant breaches. In legalese, lawyers call a provision embodying this purpose as a material adverse change/effect clause or simply a “MAC”.
Why is this important?
The occurrence of a MAC can entitle the buyer to walk away from the deal. Further, MAC provisions are used in acquisition agreements to qualify seller’s warranties. For example, Finnish acquisition agreements often include a seller’s warranty stating that the target company’s business has not suffered a MAC between signing or closing, as well as a closing condition relating to the accuracy of the seller’s warranties at closing. This use of MAC provisions allocates the risk that information regarding the business represented by the seller to the buyer is inaccurate, as opposed to pre-closing adverse change risk, and typically entitles the buyer to claim damages for losses caused by a breach. If sufficiently material and fundamental, a MAC event constituting a breach of the seller’s obligations under the transaction agreement could be deemed to entitle the buyer to refuse closing also in the absence of a “no MAC” condition precedent.
What constitutes a MAC?
Neither the buyer or seller are usually comfortable with assuming business risk for the period between signing and closing as this involves factors that are outside their control. That is also why MAC provisions are often thoroughly negotiated. Key questions defining the function, structure, scope and language of MAC clause are typically the following:
- What is considered ‘material’?
- Do general market disruptions constitute a MAC?
- What is the timing of the MAC?
As with force majeure, the threshold for demonstrating that a MAC event has occurred is generally considered to be relatively high. There is little case law in Finland to offer guidance to the interpretation of MACs as disputes concerning M&A transactions are virtually always submitted to arbitration. The burden of proof is on the party claiming that a certain event or occurrence constitutes a MAC (i.e. typically the buyer).
What is considered “material”?
It is possible to specify a threshold defining what actualised or projected loss in value will be considered material, either as a specific monetary amount or relative to for instance target turnover, assets or profits. If the buyer can show that the loss caused by the MAC event will, or depending on the wording of the MAC, is reasonably likely to, exceed the agreed threshold, this element of the MAC clause is satisfied.
There is a recent case from Delaware in which a loss in target company’s value was considered “material” in the context of a public company acquisition (Akorn, Inc. v. Fresenius Kabi AG, 1 October 2018, affirmed by Delaware Supreme Court). Here, the Delaware Court of Chancery held that a durationally significant 20 % diminution in the target company’s equity value was deemed material. It is, however, worth mentioning that Akorn currently represents Delaware’s sole case where the court found that a MAC actually existed, thus exemplifying how high the bar is in other jurisdictions.
Do general market disruptions constitute a MAC?
Buyers often wish to see ─ but rarely get ─ language saying that the target company’s “financial prospects” are included the definition of a MAC. During acquisition negotiations, sellers often provide buyers with financial projections forecasting significant growth after the deal is completed. However, projected performance rarely corresponds with actual performance and cannot be guaranteed, which is why sellers resist the inclusion of such language in MAC definitions.
Now, if a seller has agreed to carry the risk for pre-closing adverse changes caused to the “financial prospects” of the target company, a buyer could argue that the effects of general market disruptions, such as the coronavirus outbreak, is triggering a walk away right based on MAC. If not, then the buyer will likely have to show that the outbreak has caused direct losses to the target company’s business, condition, assets, liabilities, or operations.
Timing of MAC?
MAC provisions typically allow the buyer to walk away only if an event or occurrence has caused an adverse change before the closing. Occasionally, buyers are successful in negotiating forward-looking language which allows the invocation of the MAC clause in respect of pre-closing events which are reasonably likely to have a material adverse effect after the closing. Consequently, the specific language of the MAC clause combined with the timing of the closing will have an impact on whether the MAC can be invoked.
Could the coronavirus outbreak constitute a MAC?
The coronavirus outbreak has caused equity markets globally to enter bear territory. On the one hand, this supports the argument that the outbreak’s effect to a target company’s valuation could be deemed material, at least in respect of M&A transactions agreed before the pandemic began to spread. On the other hand, the outbreak will likely not permanently affect the long-term underlying earnings potential of most companies.
Most transaction agreements do not directly address the impact of “pandemics”, “epidemics” or “COVID-19” on MAC definitions, meaning that parties will have to resort to contract interpretation to establish whether a MAC exists. Consequently, buyers are likely required to show that the outbreak causes direct losses to the target company’s business due to, for example, travel restrictions imposed by public authorities, bans to attend large events and conferences, or compulsory quarantines.
At the time of publication of this article, Europe is the epicentre of the pandemic and appears to be rapidly spreading within the United States. Currently, there is no timeline as to when the uncertainty caused the coronavirus outbreak will end or even subside. For this reason, we predict that specific language concerning the allocation of the pandemic or COVID-19 risk will be introduced in the MAC definition and seller’s warranties of Finnish acquisition agreements.
The first signs that the coronavirus pandemic has caused global M&A activity to decrease or at least pause are present. The stock market volatility may also cause challenges in consummating already announced transactions involving share consideration. In the event that a deal seems to be falling apart because of the coronavirus pandemic, the MAC clause could provide a potential remedy. However, to avoid potentially lengthy and costly disputes, careful advance interpretation of the acquisition or combination agreement is required before a MAC clause is invoked as a ground for terminating a M&A transaction.
D&I’s experts are happy to discuss any questions or concerns that you may have concerning the legal implications of the coronavirus outbreak.