Material Adverse Effect Clauses and the COVID-19 Pandemic

Robert T. Miller is a Professor of Law at the University of Iowa College of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here) and The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here).

In a working paper just posted on SSRN, I consider whether the COVID-19 pandemic, the governmental responses thereto, and a company’s actions taken in reaction to both of these are likely to constitute a “Material Adverse Effect” (MAE) within the meaning of a typical MAE clause in a public company merger agreement. In addition to the conclusions about COVID-19 and MAEs summarized below, the paper also reviews important Delaware caselaw on MAEs, identifies open problems in those cases, and suggests a more comprehensive theory of MAEs that rationalizes the caselaw and solves most of the open problems.

As to COVID-19 and MAEs, although in any particular case everything will depend on the exact effects on the company and the precise wording of the MAE clause, nevertheless because MAE definitions tend to follow common patterns, some general conclusions about typical MAE clauses are warranted, including the following:

(1) Under a typical MAE definition, the first issue will be whether the company has suffered a “material adverse effect” (uncapitalized and not further defined in the agreement). The acquirer will bear the burden of proof on this issue, and the question will turn on whether the future cashflows of the company, as reasonably expected at the time of the alleged MAE, are materially lower than they were reasonably expected to be at the time the agreement was signed. In answering this question, cashflow projections relied upon by the parties when they entered into the agreement and cashflow projections from independent securities analysts from the time of the alleged MAE are likely to figure prominently in the court’s analysis.

(2) COVID-19 and the governmental lockdown orders in response thereto have undoubtedly resulted in a large contraction in economic activity. In Q1 of 2020, US GDP declined at a 4.8% annual rate, and many economists forecast for Q2 declines of 30% or more, which would be by far the largest single quarterly decline on record. Although many economists also forecast a rebound in Q3 and Q4 of 2020, these projections are highly uncertain, and most, even if realized, would still result in a substantial decline in GDP for 2020—e.g., something on the order of 6.3% (using projections from economists surveyed by the Wall Street Journal). This is a very large figure, about two and a half times as great as the total loss in GDP during the recession following the financial crisis of 2007-2008. For many companies today, any reasonable projections will show sharp and prolonged declines in cashflows relative to those made before the advent of COVID-19. For instance, in computing his equity risk premium for April 2020, Professor Damodaran forecasts a 30% decline in corporate earnings for 2020 with a 75% rebound by 2025. Furthermore, given the extreme uncertainty involved in all such projections, it seems inevitable that discount rates will increase, with the equity risk premium or a company’s beta (or both) increasing and thus implying a higher cost of equity capital. All of these factors will combine to make it very likely that, for many companies, the decline in their value could easily exceed the 20% threshold that the Delaware Court of Chancery held to constitute a material adverse effect in Akorn v. Fresenius.

(3) If a company has suffered a material adverse effect since the advent of the COVID-19 crisis, the question will then become whether that effect arose from risks that were shifted to the acquirer under one or more exceptions in the MAE definition. In particular, MAE definitions typically include exceptions for risks arising from various kinds of natural disasters. Starting a few years ago, some of these exceptions have expressly mentioned pandemics. If the exception does not mention pandemics but includes general language such as “and other natural disasters” or “other force majeure events,” Delaware courts would likely read such general language as including pandemics. In other cases, however, Delaware courts are extremely unlikely to read pandemics into an exception that does not mention them. MAE definitions also typically include exceptions for risks arising from changes in law. Especially given the expansive definitions of “Law” found in many business combination agreements, it is very likely that such exceptions will be held to include risks arising from governmental orders shutting businesses or curtailing their operations.

(4) As a result, assuming that a company has suffered a material adverse effect (uncapitalized) since the advent of COVID-19, the main issues in litigation will likely concern the legal effect of exceptions from the MAE definition and the proximate causation of the various adverse effects the company has suffered. That is, depending on which exceptions are present in the definition, the main issues may be whether the adverse effects suffered by the company are caused by the COVID-19 virus itself, by governmental lockdown orders responding to COVID-19, or by actions the company itself decided to take in an effort to remain solvent. For example, if one of the company’s facilities has become a COVID-19 hotspot, the remediation costs would be proximately caused by COVID-19 and so fall into an exception applying to pandemics. Similarly, if a company’s revenues are reduced because operating its business would violate a government lockdown order, the loss in revenue experienced by the company would likely be proximately caused by the governmental order and so fall within an exception related to changes in law. Nevertheless, many actions taken by companies in response to reductions in their revenues—actions such as laying off employees, cutting salaries, or defaulting on debt or rent payments—may be caused by governmental orders not proximately but only remotely. Hence, whether adverse effects on the company arising from such actions fall within an exception related to changes in law or pandemics is unclear.

(5) Finally, MAE definitions typically include exclusions that further qualify exceptions related to systematic risks (like risks of natural disasters or changes in law) and shift such risks back to the seller to the extent that a materializing risk of the relevant kind affects the company disproportionately relative to other companies in some control group specified in the MAE definition, such as other companies operating in the same industries. In general, adverse effects on sellers arising from COVID-19 directly may affect some companies operating in a given industry differently from others, while changes in law will tend to affect all companies in the same industry equally, at least to the extent that they also operate in the same jurisdictions. In any event, the relevance of any disproportionality exclusions is likely to be highly fact-specific.

The complete paper is available here.

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