Key Takeaways
- A material adverse effect clause lets a buyer walk away only for a serious, lasting decline in the target's business, and its carve-outs for events like pandemics are read as written.
- A separate covenant to operate in the ordinary course can let a buyer terminate even when no MAE has occurred, as the Delaware courts held in AB Stable.
- Sellers facing extraordinary events should seek the buyer's consent before departing from past practice, and drafters should spell out whether efforts or results are required.
When a pandemic upends a business between signing and closing, can the buyer walk away from the deal? And what does it mean to run a company "in the ordinary course" when nothing is ordinary?
In this TalksOnLaw Brief, Joel Cohen talks with Meredith Kotler, partner and co-head of securities and shareholder litigation at Freshfields, and Ethan Klingsberg, partner and co-head of US corporate and M&A at Freshfields, about how COVID-19 tested two key protections in acquisition agreements.
Material Adverse Effect Clauses
Klingsberg explains that a material adverse effect, or MAE, is the threshold for changes in the target's business between a reference date and closing, and its main role is as a closing condition. Over decades, he says, drafters have added a growing list of exceptions: terrorism after 9/11, macroeconomic and industry developments, wars, hurricanes, and now pandemics. Kotler adds that these carve-outs keep a buyer from claiming an MAE based on general calamities, which is why the overall regime is seller friendly.
Interim Operating Covenants
The second protection is a set of covenants requiring the seller to operate in a specified way between signing and closing, often "in the ordinary course consistent with past practice." Compliance is typically required in all material respects, a lower bar than an MAE. Klingsberg notes two pressures on these covenants: sign-to-close periods that can exceed a year because of foreign investment and antitrust review, and the question of what ordinary course means in extraordinary times.
AB Stable and Drafting Lessons
In AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, Kotler explains, the seller closed hotels and cut operations as every hotel chain did, and Vice Chancellor J. Travis Laster accepted that this was reasonable. Following Cooper Tire, however, he held that ordinary course meant the seller's historical practice under ordinary conditions, so the seller breached by not seeking the buyer's consent, and the buyer could terminate. The court also refused to link the covenant to the MAE standard. Klingsberg highlights the weight given to "consistent with past practice," the difference between promising reasonable best efforts and promising a result, and the importance of scheduling specific risks.
What to Know Now
The Delaware Supreme Court affirmed AB Stable in December 2021, confirming that the seller's failure to seek consent for pandemic-driven changes breached its covenant regardless of whether those changes were sensible. Delaware courts have still found an MAE only rarely, most notably in Akorn v. Fresenius in 2018, and in Snow Phipps Group v. KCAKE Acquisition the Court of Chancery ordered a buyer to close a deal it had tried to abandon during the pandemic. As the guests anticipated, pandemic carve-outs and efforts-based ordinary course covenants are now common, and long regulatory review periods keep these provisions in focus. The enduring lesson is theirs: courts enforce the words the parties choose.
