The COVID-19 pandemic has raised a fundamental question for M&A participants: does the outbreak of COVID-19 and the impact on a business constitute a "Material Adverse Change" (referred to as a "MAC") under merger agreements? The answer is important because if the pandemic is a MAC, then buyers can typically walk away from a deal without penalty or legal exposure. On the other hand, if it is not a MAC and buyers try to walk the seller can seek damages and/or seek specific performance of the agreement to force the buyer to close.
The law on MACs
In Canada there is virtually no case law on what constitutes a MAC, so most M&A practitioners look to the jurisprudence from Delaware for assistance (where there are several thoughtful and well-articulated decisions). Not wanting to empower buyer's remorse at the expense of public shareholders, Delaware courts have been extremely reluctant to find a MAC to have occurred. In fact, there is only one case in which a Delaware court has found a MAC and allowed a buyer to walk from a merger agreement. See our previous blog post for reference.
Although difficult to establish, the case law has focused on two key elements: that the adverse change is "material" and "durationally significant." Put differently, a MAC needs to be much more than a short-term drop and essentially reflect a fundamental change in the business to be acquired.
The structure of MACs
Although each MAC definition is subject to negotiation, they typically have three elements:
- A general statement of what is materially adverse along the lines of "any event, development or condition occurring that has had, or would be reasonably expected to have, a material adverse effect on the business, financial condition or results of operations of the company and its subsidiaries (taken as a whole)".
- Exclusions of certain systemic or industry risk, as well as risks that are known by both parties at the time of the agreement (it is in this list that parties have, in certain agreements, included an exception for "pandemics" and in the current situation could consider specifying "the COVID-19 pandemic").
- A recapture of certain of the exclusions in the second part to the extent that they disproportionately impact the seller as compared to others in the same industry and that are of similar size.
No doubt, the COVID-19 pandemic is a major shock that has the potential to have a significant impact on companies and that could have a lasting impact. That, however, does not necessarily mean that it constitutes a MAC. First, there may be specific exclusions in the definition that address the risk and it will depend on the specific impact to the business at hand. As a result, general statements about if the pandemic is or is not a MAC are impossible. Moreover, we anticipate that MAC definitions will evolve as more is known about the potential duration of the pandemic and its impact on businesses and the economy more generally.
Other contractual provisions
Buyers looking to exit an agreement will likely review the representations and warranties of the seller very closely to see if they continue to be true (as such representations and warranties typically need to true at closing subject to either a general "materiality" qualifier or possible a "MAC" qualifier). In addition, buyers will likely review the interim period covenants of the seller to determine if such covenants have been complied with in accordance with applicable standards. Again, the determination will depend on the specific wording of the agreement and the facts.
Other remedies for consideration
Buyers might also consider invoking the common law remedy of frustration of contract. This is a difficult claim to make but is possible where parties have not addressed the issue in a contract and performance of the contract becomes impossible or otherwise radically different from what was contemplated at the time of entering the contract. A buyer would need to establish that the original purpose of the contract has been frustrated, and it would be unjust for them to be bound to the contract under the existing circumstances.
The truth is that we are in uncharted waters. While courts will be reluctant to find a MAC or otherwise find a reason not to enforce a merger agreement (particularly given that they involve sophisticated parties that are well advised by counsel), courts have proven remarkably adept at responding to change and reaching conclusions that are fair and reasonable. We also anticipate that, should the pandemic continue for an extended period, government and regulatory bodies may adopt specific measures that will further inform the analysis of MACs.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.