Material Adverse Effects after COVID-19

Joel Cohen: The COVID pandemic has been disrupting business in myriad and unpredictable ways, so how are M&A attorneys building that risk into acquisition documents? Today, we'll discuss and we’ll look particularly at material adverse effect provisions and interim operating covenants. Hello, and welcome to TalksOnLaw. I'm Joel Cohen. Today, we're joined remotely by two law partners of the global firm Freshfields. Meredith Kotler is the head of securities and shareholder litigation, and Ethan Klingsberg is the head of U.S. corporate and M&A. Ethan, Meredith, welcome to TalksOnLaw.

Meredith Kotler: Hi, Joel.

Ethan Kinglsberg: Hi, Joel. Thanks for having me.

JC: Ethan, why don't you get us started with a quick working definition of MAE and how they work.

EK: Material adverse effect is the general threshold used for changes in the business that's being acquired or the target company between a reference date, which could either be the date of signing or often is the last balance sheet provided and through the closing, and the idea that there has not been a material adverse effect during that period. And then over the last 35 years, we've slowly added a longer and longer list of exceptions to what would count toward the material adverse effect.

JC: Is this to give the buyer some type of protection from getting immediate buyer's remorse either before closing, or is there some type of window after closing?

EK: Once you're closed, I mean there is some in the private deal, I guess you could bring a claim for breach there has not been a material adverse effect representation, but the most important role is in the closing conditionality. But there's this long list of exceptions, so following 9/11, we added terrorism. Following a certain market turmoil earlier, we added macro developments. We added exceptions for industry events. We added exceptions for foreign exchange. We added exceptions for wars. Then after hurricanes, we added hurricanes. Now we have pandemics.

MK: The general term is that there's a material adverse impact on the business, and then the exceptions that Ethan mentioned, those are actually, those are the exceptions, so the buyer cannot claim there's been an MAE because of general problems like war, natural calamity, natural disaster, act of God, that would not allow buyer to say there's been an MAE and they can get out of the deal. That's why they're generally viewed as seller-friendly.

JC: We're also going to talk a bit about interim operating covenants. How are they different? What part of the acquisition document are we talking about there?

EK: So there's two different concepts, right? So the MAE is,  you know, there hasn't been a change in the business from the reference date to the closing date that's, as I described, fundamental, etc. Then there's a different requirement to make sure the business is operated in a certain specified manner between signing and closing. And this has to be, you have to perform these and comply with these covenants between signing and closing. And the closing condition here is typically articulated as complying with these covenants in all material respects. So it's a lowercase “m,” not an uppercase “Material,” and it's a lower threshold. And then the tricky part about these covenants are that they're often quite specific. Then there's some that talk about operating in the, just generally, in the “ordinary course,” sometimes in the “ordinary course consistent with past practice.” That's particularly a big issue these days for two reasons. One, the longer you have between signing and closing, the more pressure on these compliance with these covenants and due to the proliferation of foreign investment regimes and intensity of antitrust scrutiny, the period between signing and closing in merger transactions is expanding. And it's not uncommon to have over a year between signing and closing. So that's a long time to have to comply with these covenants, right? The second issue is we're living in extraordinary times, so what does it mean to operate in the ordinary course during extraordinary times?

MK:  And this is the MAPS Hotels case which had a very extensive discussion about compliance with the ordinary course covenant and also discussed the Cooper Tire case. MAPS is a decision by Vice Chancellor Laster where he ultimately agreed with the buyer, and, by the way I think, Ethan, you would agree that all of this at the end of the day comes down to what your specific contract says and what the contractual language is. Because parties can write these clauses any way they want, but as Ethan mentioned, they typically say something like the seller must absent buyer consent operate as historically done in the ordinary course of business. And what the seller had argued in that case was well, we changed our business—it was a hotel business—we changed our business, we shut down some hotels, we limited operations, we slashed headcount, we slashed marketing, we did what every other hotel chain did in response to COVID, and it was absolutely reasonable and appropriate. And Vice Chancellor Laster, in fact, agreed with the notion that this was reasonable and appropriate and consistent with what other hotels did, but found consistent with the Cooper Tire case that what operating in the ordinary course of business means is operating in the historical manner under ordinary circumstances. And therefore, he agreed with the buyer that the seller had not operated in the ordinary course, had not gotten consent from the buyer to operate outside the ordinary course and allow the buyer to terminate.

JC: Interesting, so it's a sort of a tension between “ordinary” meaning what the company had done up into this date versus “ordinary” as in what would other similarly situated companies would do given the same challenges.

EK: And one of the important points is, as Meredith pointed out, is you got to look at the actual wording and the agreement. And he gave a lot of weight to this, a few words that I think a lot of lawyers never thought were worth that much, adding “consistent with past practice.” He said, consistent with past practice really means that we were not talking about ordinary course under whatever circumstances extrinsically may arise. We're talking about doing everything that you did in the past the same way you did it in the past regardless of change in circumstances. Another really important fact is that in most of these provisions, there's a mechanic for the seller or the target to ask for a consent not to be unreasonably withheld to deviate from the ordinary course or from whatever other specific requirement there is. And here, they never asked for the consent, and they said, well if I'd asked for the consent, they would have been obligated to give it to me. And the court said no, no, no. You got to really ask for the consent. But I think what's most interesting—Meredith, I'm curious what you think about this—is not just the mechanics of the consent but what is the heck does it mean not to unreasonably withhold consent because that brings you back to this whole concept of, you know, what is the standard? Are we judging reasonably withheld based on extrinsic circumstances, past practice? Are we basing it based on what's in the best interests of preserving the objective of, preserving the target business or another concept which is sometimes in tension with the concept of preserving the target business, are we looking at this from the objective of execution of the deal, you know, consummation of the deal?

MK: Right, there are different lenses through which you can judge when, you know, consent is reasonably or unreasonably withheld. And a big piece of this though, Ethan, which is good is that a basic tenet of all this is that the court will look to what the parties have agreed to, what the parties want to put in. And so the more detail that you can put into your contracts, right, the more that you can identify what the standard is, what their perspective should be, what the parties want, the better. Now another interesting issue, of course as you know Ethan, is the linking of these two issues MAEs and ordinary course covenants. One of the arguments that the seller had made in MAPS Hotels was, hey, they should be linked and even if we didn't follow the ordinary course covenant, that shouldn't be a basis for termination unless that breach rose to level and created an MAE. And what the court said was nice try. If the parties had wanted to link them together, it could have, but these two types of covenants or two types of provisions are separate and distinct. They address separate and distinct issues. Again, if you want to link them, you can. But the parties hadn't. And I'd be curious, Ethan, to know if you're seeing in practice, I think we're hearing some of this from clients, that they're starting to draft these provisions, at least from the seller's perspective, with a linkage in them.

EK: After Cooper Tire five years ago, there was a decent amount of talk about, well, let's start bringing these concepts over from the MAE carve-outs and making them carve-outs to the interim operating covenants. We haven't seen that take hold, but there's a couple of points that I stress. One is, and this is like Vice Chancellor Laster focused on in the MAPS Hotel case, which is there is some difference between saying reasonable best efforts versus I will cause the ordinary course. And if you say that you will cause the ordinary course and something happens that's beyond your control, you're in breach, right? Because you said you would cause it. You know laws are passed, pandemics happen, there's no way you can stop that. You're not going to be, you're not going to get a pass if it says you will cause everything to always operate the same way it always did. So we are seeing, one, much more reliance on reasonable best efforts as opposed to this direct cause, and the second is you know we got standard carve-outs for so-called coveted measures to interim operating covenants. Although, candidly, that's sort of last year's issue at this point. I think there's a real responsibility on the target’s counsel to work with the client and figure out what kind of risks are we going to build into schedules that qualify the interim operating covenants or to interpretive provisions or otherwise to make sure that you get enough flexibility, especially if you have one of these deals where you're going to have, you know, many months between sign and close.

JC: Ethan, Meredith, thank you for joining us today.

MK: Thanks very much.

JC: And thank you for watching TalksOnLaw.