As the coronavirus (COVID-19) outbreak triggers an unprecedented reality of social distancing, business closures and market turbulence, we review how parties may approach related issues while considering M&A deals. In light of the significant impact to date and the uncertain future impact of the outbreak, parties are reviewing and revising relevant provisions of acquisition agreements and conducting additional diligence in an attempt to obtain greater certainty of closing and of result.
In many acquisition agreements, the acquiror will not be obligated to close if the target company suffers a material adverse effect (“MAE”) or breaches its reps and warranties to a point resulting in a MAE. Whether the impact of COVID-19 constitutes a MAE for purposes of a particular acquisition agreement, however, will depend on, among other things, the language of the acquisition agreement and the facts surrounding the target company.
Courts generally have set a high bar for finding that a MAE has occurred with respect to a target company in an acquisition context. In the 2018 Akorn case, the Delaware chancery court found, for the first time, that a MAE had occurred with respect to a target company, entitling the acquiror not to close the acquisition. The court noted, however, that a MAE must “substantially threaten the overall earnings potential of the target in a durationally-significant manner” and that “the important consideration . . . is whether there has been 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.” At this point, it remains difficult to predict how long many of the effects of the virus will last.
Even if the impact on a target company is materially adverse, and for the requisite duration, the MAE definition typically carves out the effects of specified causes, some of which may cover some or all of the impacts of COVID-19. Some recent deals have carved out COVID-19 expressly. Other recent deals carve out pandemics or epidemics. Other potentially related events, such as a “natural disaster” or “act of God” or other “force majeure” event, or more general effects, such as economic declines, or changes in applicable law also may be carved out. As a limit to the carveouts, however, agreements also typically include a “disproportionate effect” exception, permitting specified causes otherwise carved out to be considered if (and potentially only to the extent) the cause has a disproportionate effect on the target company compared to other participants in its industry. The scope of a more general carveout, and what constitutes a “disproportionate effect” in the context of the COVID-19 outbreak will be determined on a case-by-case basis as and when the effects of the outbreak unravel.
Given the lack of certainty around the scope of many of these terms, parties may wish to address the potential impact of COVID-19, and the extent to which those impacts may affect the parties’ respective obligations, more specifically, either through the MAE definition or through more specific conditions or other provisions.
Acquisition agreements commonly provide that, between signing and closing, the target company must conduct its business in the ordinary course. Such obligation may be absolute or may be qualified, such as by requiring the target company only to use some degree of efforts, such as “commercially reasonable efforts,” and/or to operate “in all material respects” in the ordinary course or in ordinary course “consistent with past practice,” or by an exception for applicable law. Some agreements also provide exceptions to the extent approved by the acquiror, and further may require the acquiror not to withhold such approval unreasonably. Other pre-closing operational covenants may require the target company to comply with applicable law or take other steps, which also may (or may not) be subject to qualifications.
Typically, the acquiror’s obligation to close is conditioned on the target company’s compliance with these covenants, though such condition itself is often qualified by some level of materiality, such as by requiring that the target company have complied with its covenants in all material respects. Measuring whether such a condition has been fulfilled “in all material respects” may raise a standard of materiality that differs from that applied in measuring a MAE. In Akorn, the court noted that such a standard was “lower” than the MAE standard, and should be measured by whether there was a “substantial likelihood that the…fact [of breach] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information”. The materiality standard for this condition is also not typically subject to the carveouts to a material adverse effect definition.
Parties may wish to provide further clarification with respect to the interim operating covenants, with the target company seeking to clarify its right to take steps in response to the outbreak, and the buyer seeking to confirm that it is not obligated to acquire a company that has not had to comply with the operating covenants.
Parties generally should assess whether the COVID-19 outbreak may require changes in, or additional disclosures with respect to, the reps and warranties made by them in the acquisition agreement, including with respect to the potential issues noted in the discussion of due diligence below.
When drafting such reps, or providing relevant disclosure (as well as in related diligence), target companies should keep in mind that health data (such as certain data relating to an employee’s or contractor’s COVID-19 diagnosis) may constitute “personal information” and that the disclosure of any such personal information is subject to applicable law and the target company’s internal privacy and data protection policies.
Those seeking rep and warranty insurance should also be mindful that rep and warranty insurers are developing underwriting protocols to address COVID-19 related risks. Some such insurers are proposing to exclude coverage of business interruptions and other business downturns arising out of COVID-19 (including any government or other regulatory sanctioned responses related thereto), and any supply chain disruptions or adverse effects on the company’s customers or other counterparties that are attributable to COVID-19. Some such insurers are also seeking to exclude coverage on COVID-19 focused representations and warranties. Insurers also may increase their own diligence efforts, or their review of the acquiror’s diligence efforts, with respect to COVID-19.
With government office closures, remote working, and videoconferencing and telephone calls replacing face-to-face interaction at government level – both in the U.S. and abroad – it is likely that governmental and regulatory approvals, and other consents required prior to closing, may take longer than usual. For example, on March 17, 2020, the United States Department of Justice’s antitrust division advised that the review of existing transactions may be prolonged by an additional 30 days. Parties should consider whether they wish to provide for longer than usual “Outside Dates,” or mechanisms to extend such dates in acceptable circumstances, to accommodate delays in approvals. Parties also may need to consider the steps to take (or that they can require the other party to take) to obtain such approvals within a particular time period.
Typically, an acquiror offering cash consideration will have access to cash on hand or other sources of funds, which may include a committed facility or commitment(s) to lend from an equity and/or debt financing sources. The COVID-19 outbreak, however, has rattled equity and debt providers along with acquirors and target companies. In this context, a target company should confirm whether an acquiror’s debt and/or equity financing sources remain available and the terms on which the financing is offered.
In some cases, parties may want to consider using the acquiror’s stock, rather than cash, to pay the purchase price. For example, where parties are having difficulty agreeing on a cash value for the target company, given recent stock price volatility, stock of the acquiror, where available, may facilitate agreement, if both parties are subject to similar pressures resulting from the outbreak. Parties also may turn to earn-outs and other deferred consideration mechanisms to help find a mutually agreeable method for valuing the target company.
Given the significant measures implemented to slow the spread of COVID-19, the due diligence process has become all-remote, with in-person management presentations, site visits and other meetings being conducted by telephone or videoconferencing, and documents being disclosed by virtual data rooms. The process for conducting due diligence will need to change in response, taking advantage of remote working technologies.
Acquirors also may seek further understanding of the impact of the virus on specific aspects of the target company, such as:
Along with heightening market volatility, the COVID-19 outbreak has raised the potential for unsolicited takeover activity, as well-positioned companies and other acquirors seek to take advantage of the dramatically lower stock prices. Directors of listed companies should keep in mind that their companies may become targets of opportunistic acquirors or activists and, when time allows, consider their preparations in that regard. Among other things, while premature implementation of a rights plan may draw criticism from proxy advisory services like ISS and Glass Lewis, directors might consider whether it would be prudent to have a rights plan “on the shelf” and ready to launch if needed to protect the interests of stockholders.
Morrison & Foerster Associate Amy Chen (qualified to practice in England and Wales, but not licensed to practice in California) assisted in the preparation of this client alert
 For a more detailed discussion of Akorn, see our client alerts, Delaware Supreme Court Upholds Lower Court’s Material Adverse Effect Finding (Dec. 10, 2018), and Delaware Court of Chancery Finds a Material Adverse Event and Excuses Buyer from Obligation to Close (Oct. 9, 2018).
 For example, the agreement between Morgan Stanley and E-Trade, announced on February 20, 2020, carved out “any acts of God, natural disasters, terrorism, armed hostilities, sabotage, war or any escalation or worsening of acts of war, epidemic, pandemic or disease outbreak (including the COVID-19 virus).”
 5 out of 22 of the most recent acquisitions of private companies with agreements filed by public companies with the SEC expressly carved out pandemics, epidemics or outbreaks of diseases.
 For further information on antitrust issues, see our client alert, The Impact of COVID-19 on U.S. Antitrust Enforcement: Updates and Practical Guidance for M&A (March 19, 2020).