The global outbreak of COVID-19 hit the United States in March 2020. Over a year later, it has irrevocably altered the way that M&A parties negotiate and structure agreements for the purchase and sale of private companies.
In the wake of the pandemic, parties to privately negotiated M&A agreements have begun adding provisions or modifying existing ones to account for the many challenges COVID-19 has presented. For example, since March 2020, many M&A agreements specifically include or exclude the pandemic and its effects from the definition of “material adverse event” (MAE). This definition and the negotiations relating to it are extremely important because the definition serves the purposes of (a) allocating pre-closing adverse-change risk and (b) qualifying the seller’s or the company’s representations or bring-down closing conditions.
As the pandemic set in, private M&A agreements quickly began to account for “pandemics” or “disease outbreaks” in their MAE definitions, carve-outs and the associated “disproportionate-manner carve-outs,” which limit the seller’s carve-outs for changes that adversely affect the business disproportionately to similarly situated companies. However, as of late, M&A parties are now negotiating over whether the MAE definition and the associated carve-outs should involve not only pandemics, but the government regulations and restrictions promulgated in response to them (e.g., travel bans and lockdown orders). Interim covenants relating to a buyer’s right to access and inspection of the target company’s premises and books and records have also changed. For example, pre-pandemic, it was customary for a seller or a target company to promise to make personnel and property available for physical inspection by the buyer in the interim period between the signing of the acquisition agreement and the closing of the transaction. However, due to COVID-19 safety measures, including social distancing and sanitation and practices, this contractual right of the buyer must necessarily be qualified or limited.
Relatedly, most private M&A agreements contain “interim operating covenants” whereby the seller or the company promise that it will continue to operate its business in the “normal course” during the period between signing and closing. The COVID-19 outbreak and resulting public health responses have prevented many businesses from operating “in the normal course” as they had in the past. Consequently, sellers and target companies are pushing for bespoke, tailored interim operating covenants that afford them the flexibility to address COVID-19-related operational issues in the period between signing and closing without giving the buyer a basis to allege noncompliance with the interim operating covenants as a basis to terminate the deal.
The pandemic has also affected the representations and warranties traditionally given by sellers in M&A agreements. Two of the primary functions of representation and warranties in private M&A agreements are to (a) allocate risk as between the seller and the buyer and (b) provide information and disclosures about the business. As a result of the heightened risks and concerns brought to the forefront by the pandemic, new, more detailed representations are making their way into private M&A agreements, including representations relating to compliance with government orders and recommendations relating to COVID-19, reliance on COVID-19-related financial-support laws (e.g., the CARES Act), customer and supplier terminations due to COVID-19, and so on. Whether you represent the seller or the buyer, any such representation must be carefully scrutinized to ensure that it reflects the risk allocation agreed to by the business principals.
The Delaware corporate courts have had an opportunity to interpret and apply these provisions — both those that were signed prior to the onset of the pandemic and those negotiated afterward. These suits have shed light on how courts will resolve COVID-19-related disputes.
Early on, one recent litigated dispute, SP VS Buyer LP v. L Brands, Inc., involved Sycamore Partners’ agreement to purchase a majority stake in the retail clothing store Victoria’s Secret from L Brands. Sycamore Partners ultimately purported to terminate the purchase agreement, arguing that L Brands violated the interim operating covenants by closing virtually all of the Victoria’s Secret and PINK branches in the United States without obtaining Sycamore’s prior consent under the purchase agreement. The purchase agreement’s MAE definition expressly excluded pandemics — which is likely why Sycamore alleged a breach of the purchase agreement’s interim operating covenants as a basis to terminate the purchase agreement. The M&A parties resolved the case out of court and mutually agreed to terminate the purchase agreement.
A recent case taken to trial in the Delaware Chancery Court, AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, arose from a terminated deal involving the sale of a portfolio of hotels. Although the facts of the case are intricate, the important points are as follows: The buyer terminated a signed purchase agreement for the purchase of a hotel portfolio, alleging that the pandemic constituted an MAE under the agreement, thereby excusing the buyer from its obligations under the purchase agreement to close. The agreement did not have express carve-outs for a pandemic or disease outbreak, and the buyer argued that because both deal parties had included such carve-outs in previous agreements, this demonstrated their intent that those carve-outs not be included in the current one. The court did not accept this argument, and instead determined that the pandemic fell under the agreement’s “calamity” carve-out and, therefore, the buyer could not terminate the deal based on the occurrence of an MAE.
However, the buyer also argued that it was justified in terminating the deal because the seller breached the interim operating covenant. The covenant in this agreement stated that the seller was required to continue operating consistent with past practices. It further stated that if the seller intended to deviate from past practices, it could seek permission from the buyer and the buyer could not unreasonably withhold permission. After signing, the seller deviated from the normal course of business in the operation of the hotel business, and never requested permission to do so. Therefore, the court found that the seller breached the covenant and the buyer was justified in terminating the deal on that basis. The L Brands and AB Stable cases highlight the importance of careful drafting of MAE definitions, the attendant carve-outs and interim operating covenants.
In addition to all of the above, COVID-19 has also changed the transactional insurance market. This form of insurance protects against losses resulting from a seller’s or a target company’s breach of representations in an M&A agreement. The pandemic has induced material changes to customary policy coverage exclusions. When the pandemic first began, underwriters began adding blanket “COVID-19 exclusions,” stating essentially that the policy would not cover any loss attributable to the COVID-19 pandemic. As 2020 progressed, some underwriters began offering “underwriting to risk,” meaning that the exclusions would instead be restricted to the event that impacts the company’s ability to perform.
The COVID-19 outbreak has underscored already important concerns in M&A transactions. Both sellers and buyers must take care in drafting and negotiating M&A agreements. A buyer will want to be able to walk away from a signed agreement if the target company has undergone a material change. On the other hand, a seller will want to restrict a buyer from rescinding a deal when events occur beyond the seller’s control. These were concerns for buyers and sellers even before the pandemic. However, COVID-19 has complicated the negotiation and resolution of these ever-present deal points in unexpected ways.