In late 2019, COVID-19 (more commonly known as the coronavirus) began to spread throughout mainland China, and has since spread around the world, affecting numerous lives and businesses. As a result, companies spanning a wide range of industries have seen impacts on their businesses, and some anticipate drastic changes to their financial performance. Buyers engaged in acquisition transactions may therefore be looking to material adverse effect (MAE) clauses as a way to terminate merger agreements in light of projected downturns in financial performance of their targets. Historically, courts have been reluctant to allow a buyer to terminate a transaction on the basis of an MAE clause, putting the onus on buyers to show that the effect will have a long-term impact on the financial health of the target company. A key Delaware case on the issue, decided in October 2018, reiterated that high burden, stating, “[t]he 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.” Akorn, Inc., v. Fresenius Kabi AG, et al., C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018). This requires a fact-specific demonstration that the event “substantially threaten[s]” the earnings potential of the entire business “in a durationally significant manner.” Id.
If a buyer claims they terminated a contract for an MAE, the court will first look to the specific language of the MAE clause. If the MAE clause carves out pandemics or epidemics from the definition of MAE, then the impact of COVID-19 clearly will not allow a buyer to terminate an agreement on the basis of the MAE. As an example, the February 20thAgreement and Plan of Merger between Morgan Stanley and E*Trade Financial Corp. specifically carves out “epidemic, pandemic or disease outbreak (including the COVID-19 virus)” from events that could result in an MAE. 1 Additionally, an impact that is this widespread across companies and industries will often be caught by a carve-out for changes in general market conditions. If there is no carve-out and it is a generic MAE clause, courts will then look to see if the buyer has shown the requisite substantial threat to the earnings potential of the target in a durationally significant manner.
Current projections of the impact of COVID-19 vary widely by country, industry and severity. As such, models to date have a variety of outcomes with the consensus suggesting potential impacts lasting through 2020. Therefore, while target companies may be adversely affected, the impact of COVID-19 to date will likely not trigger a generic MAE clause because it will be difficult to demonstrate that the impact will cause a long-term effect on financial performance, falling short of the heavy burden placed on buyers by the courts. However, the inquiry into whether an MAE has occurred is always fact-specific, and as more information about the impacts of COVID-19 are discovered, buyers will have to continually evaluate whether the impact will have a significant, long-term effect on the target company.
1 See Grace Maral Burnett, Denis Demblowski & Diane Holt, ANALYSIS: Morgan Stanley, E*Trade Merger Excludes Coronavirus, Bloomberg Law (Feb. 28, 2020, 4:25PM), (also describing epidemic and pandemic-specific MAE carve-out language used in transactions between Celgene Corp. and Bristol-Myers Squibb Co., and Aetna Inc. and CVS Health Corp.).