The COVID-19 crisis is highlighting pressure points in pending M&A deals that were negotiated before the pandemic’s effects became widespread.
Last week, private equity firm Sycamore Partners terminated its deal to purchase a 55% share of L Brands, Inc.’s Victoria’s Secret and PINK businesses, claiming that L Brands breached the transaction agreement by taking actions that were largely in response to COVID-19. Specifically, Sycamore Partners claimed that L Brands breached certain interim operating covenants in the agreement by making operational changes, including closing its retail stores worldwide, furloughing most employees and halting rent payments for its U.S. retail stores. Sycamore Partners also alleged that the operational changes caused the businesses to suffer a “material adverse effect” and rendered several representations false, including the representation that there were no material breaches of any material contracts.
This deal is just one of many pending deals that were negotiated pre-COVID-19 and that are now the subject of a lawsuit, after the buyer terminated the deal or refused to timely close because of actions taken by the target in response to the pandemic.
Below are the key provisions that are pressure points in most, if not all, of these lawsuits, as parties to pending deals revisit the terms of their transaction agreements and consider their rights, obligations and options in light of COVID-19:
- Material Adverse Effect. Under most transaction agreements, if a target suffers a “material adverse effect” between signing and closing, the buyer would not be obligated to close. The definition of material adverse effect often contains a list of exceptions that cannot be taken into account when determining if a material adverse effect has occurred. Prior to COVID-19, pandemics, epidemics and other similar events were seldom included as specific exceptions. However, the definition usually did include, as exceptions, changes generally affecting the industries in which the target operates, changes in general market conditions and acts of God. In addition, for most material adverse effect definitions, even if pandemics or other similar events were to fall within an exception, if that event had a disproportionate adverse impact on the target relative to other companies in the industry in which the target operates, that disproportionate impact may nonetheless be considered when determining if a material adverse effect has occurred. Ultimately, the specific facts and circumstances, as well as the particular words of the transaction agreement, will play a significant role in the outcome of whether a material adverse effect has occurred due to COVID-19.
- Representations & Warranties Bring Down. In most deals, as a condition to closing, the target’s representations and warranties must be true as if made at the time of the closing, with the business representations typically qualified by a materiality or material adverse effect standard. In light of the massive disruptions caused by COVID-19, it may not be possible for some targets to remake all of their representations as of closing. The following representations are examples of those that could be impacted (depending, of course, on the specific language of the representations):
- Material Contracts: Has the target or any counterparty breached or defaulted under the terms of any material contract?
- Real Property: Is the target still in material compliance with the terms of its real property leases, including the requirement to timely pay rent?
- Material Customers: Are the material customers still operating, and, if so, are they purchasing products/services from the target at the same levels as prior to signing?
- Material Suppliers: Are each of the material suppliers still in business, and, if so, do they continue to supply the target at the same level as prior to signing?
- Inventory: Has inventory been maintained in accordance with the target’s regular business and accounting practice?
- Labor Matters: Has the target taken any actions that would require compliance with the WARN Act? Has the target experienced any work stoppages?
- No Undisclosed Liabilities: Has COVID-19 created additional liabilities that were not incurred in the ordinary course of business?
- Data Security: If the target’s workforce is “working from home,” is the target complying with all data security requirements in connection with this new arrangement?
- Interim Operating Covenants. In most deals, the target is required to operate its business between signing and closing in the “ordinary course” and sometimes “consistent with past practice.” The requirement to operate this way can be qualified by an efforts standard (e.g., “commercially reasonable efforts,” “reasonable best efforts” or “best efforts”), though it can also be an unqualified requirement. There is also typically a carve-out for actions required by applicable law. Transaction agreements also contain various negative covenants that govern the target’s operations between signing and closing with respect to certain specific actions, including termination of employees, the collection of accounts receivable, the maintenance of inventory levels and cash management.
Many of the recent lawsuits focus on the tension between these covenants and the operational changes made by targets in response to COVID-19. For example, in Level 4 Yoga, LLC v. CorePower Yoga, LLC, Level 4 Yoga claimed that CorePower Yoga had wrongfully terminated the deal based on, among other things, Level 4 Yoga’s alleged breach of its covenant to operate in the ordinary course of business by closing yoga studios due to COVID-19. Similarly, in the Victoria’s Secret lawsuit, Sycamore Partners asserted that L Brands breached its obligation to operate the business in the ordinary course consistent with past practice during the interim period.
- Outside Date. Transaction agreements set an outside date, which is the date the deal can be terminated by either party (to the extent that party is not in breach) if the deal has not closed by that time. The outside date is typically chosen based on practitioner experience of how long it will take to satisfy the closing conditions, with the time to obtain regulatory approvals (e.g., HSR, CFIUS) often being the main consideration. As regulatory agencies manage “working from home” and other work-related constraints, they are not moving at the speed they once did, and it could take longer to obtain the approvals necessary to close deals. Indeed, the FTC and DOJ announced that early termination for antitrust review will be granted in fewer cases, and more slowly, than under normal circumstances. Moreover, for deals that raise substantial antitrust issues and likely to be subjected to an in-depth second request investigation, it may take parties longer to comply with the document and information requests while employees are working remotely, and agencies are likely to insist that any negotiated timing agreements relating to the scope and duration of the investigation provide them with sufficient time to complete their review following the parties’ compliance with the second request. If antitrust and other regulatory clearances take longer than anticipated and begin to push up against the outside date, some buyers may threaten termination and try renegotiating aspects of the deal. In addition, some sellers may allege that buyers are not using the required efforts to obtain regulatory approvals (for example, by dragging their feet in response to document and information requests), hoping to reach the outside date and be excused from continuing to pursue the deal.
 SP VS Buyer LP v. L Brands, Inc., No. 2020-0297 (Del. Ch.).
 See AB Stable VIII LLC v. MAPS Hotel and Resorts One LLC, No. 2020-0310 (Del. Ch.); Bed Bath & Beyond Inc. v. 1-800-Flowers.com, Inc., No. 2020-0245 (Del. Ch.); Level 4 Yoga, LLC v. CorePower Yoga, LLC, No. 2020-0249 (Del. Ch.); and Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., No. 2020-0282 (Del. Ch.).