Risk Allocation Mechanisms in Mergers and Acquisitions: Part 3 — ADDRESSING BUSINESS CHANGES DURING A SALE
This is the third article in a series addressing some of the mechanisms used to allocate risks inherent in M&A deals.
In our last article, we discussed limiting liability for buyers and sellers in merger and acquisition (M&A) transactions by performing due diligence, using representations and warranties, and including indemnification and limitation of liability provisions in an asset purchase, stock purchase or merger agreement (collectively, “Purchase Agreement”), and by further limiting liability through disclosures made in a disclosure schedule. You can find the article HERE.
In this article, we will focus on provisions which can help shield a party from liability for non-performance in an M&A deal. These include the use of material adverse change and force majeure provisions, closing conditions and termination clauses. The continued effect of the COVID-19 pandemic has highlighted the importance of non-performance provisions, as parties to an M&A transaction may look to these sections in a Purchase Agreement to enforce their rights.
Material Adverse Change
A material adverse change provision in a Purchase Agreement takes into account the risks associated with significant changes, events, circumstances or statement of fact which would reasonably be expected to have a materially detrimental effect on the purchased assets, target company, or the seller or buyer’s ability to consummate the transaction contemplated by the parties. Material adverse change provisions allocate risks that may arise between the execution of the Purchase Agreement and the closing of the transactions. These provisions allow either party (though more typically the buyer) to terminate the Purchase Agreement if there is a material adverse change prior to the closing.
A material adverse change provision allows the buyer or seller to not close the deal, unlike force majeure clauses which define what may give rise to an excuse to perform. It is important for the parties to expressly define what entails a material adverse change. Common exclusions to what may give rise to a material adverse change include:
- changes in general economic and social conditions,
- changes to applicable laws,
- major changes to the industry applicable to the seller,
- changes that arise out of war or terrorism, and
- events that are considered natural disasters and acts of God.
Whether a pandemic or other healthcare crisis (or any other event) is considered a material adverse change requires a case-by-case analysis. Therefore, it is important for the parties to identify what does not constitute material adverse change.
As a result of the COVID-19 pandemic, cases have been filed with Delaware Chancery Court requesting interpretation of material adverse change clauses, and whether the COVID-19 pandemic would give rise to a party’s excuse to perform on a Purchase Agreement.
Particularly, in Level 4 Yoga, LLC v. CorePower Yoga, LLC, the buyer to an asset Purchase Agreement argued that because the seller, a yoga studio, had not operated its business in the normal and ordinary course until the closing date, this action was a material adverse change giving the buyer the right to terminate the Purchase Agreement. The buyer argued that the material adverse change provision was triggered when the seller failed to operate its business in the normal and ordinary course until the closing date. The sellercounterargued that the Purchase Agreement required the business to comply with all applicable laws and given the business was legally complying with orders by state and local authorities to close non-essential businesses in closing its yoga studios, such action should not give rise to a material adverse change.
Consequently, there may be a colorable argument that a party is not in violation of an ordinary course of business warranty when circumstances beyond control have disrupted the operation of a business, especially if other businesses in similar circumstances or industries are also facing like disruptions. The Level 4 Yoga case is currently a pending litigation matter. The outcome of this case could potentially affect the analysis of material adverse changes provisions in Purchase Agreements.
The closing procedure of a Purchase Agreement often includes a period of time to allow the buyer and the seller to execute ancillary documents, transfer payments, transfer the purchased assets, and obtain consents and approvals. During this time, the seller often warrants that it will continue to operate its business in good faith, not in violation of any laws, and in the ordinary course of business. However, given the many mandatory orders by federal, state and local authorities, many non-essential businesses had to shut down or close their brick-and-mortar locations during the COVID-19 pandemic.
Parties to an M&A transaction should conduct due diligence regarding how the target company’s industry compares with other industries, as events such as the current pandemic can have a disproportionate adverse effect on one industry, such as travel accommodation and restaurants, but not other industries such as e-commerce.
Material adverse change clauses can help a buyer’s bargaining power by providing a litigation threat if the seller chooses not to move forward with the transaction, should problems with a target company emerge after execution of a Purchase Agreement, but before closing,
Though the courts tend to interpret the material adverse clause narrowly, it is still a fact-intensive and case-by-case analysis for them to determine whether the effects of the current pandemic give rise to a material adverse change, giving a buyer the right to terminate an agreement.
In M&A deals, it is important for the parties to identify the specific events that do not give rise to material adverse change in an effort to avoid any future ambiguities in the interpretation of agreements. Particularly, if an event is reasonably foreseeable and is industry-wide, such events would not allow a party to use to material adverse change provision to discharge such party’s obligation under a Purchase Agreement.
Closing Conditions and Termination
A termination provision based on not satisfying closing conditions allows the termination of a Purchase Agreement. This protects both the buyer and the seller from unexpected market changes and downturns.
Break-up clauses, on the other hand, allow a buyer to terminate a Purchase Agreement for any reason, or a set of listed reasons, for a fixed amount similarly to penalty payment for early termination in other commercial agreements.
Generally, termination clauses are important when there is a delay between the execution of the Purchase Agreement and the final closing date. This period can give rise to material conflicts for parties to a commercial agreement, including disruptions which affect the operation of business in the normal and ordinary course, changes in employment such as layoffs and furloughs, changes in business expenses and buyer’s inability to obtain financing for payment on the purchase price.
Similarly, closing conditions are a set of circumstances that are required to be satisfied or waived by the parties before an M&A transaction is closed. Closing conditions obligate the parties to use commercially reasonable efforts to consummate the transaction. Closing conditions may include delivering all agreements that are part of the Purchase Agreement, no restraints, no material adverse change, accuracy of representations and warranties, and the performance of obligations (including payment of purchase price for the buyer and transfer of tangible or intangible assets for the seller) as set forth in the Purchase Agreement.
It is important that closing conditions require successfully assigning contracts, obtaining consents, approvals or waivers, absence of any litigations, and entering and executing side agreements, employment agreements and/or independent contractor agreements.
When changes or events arise beyond a party’s control which make performance impossible or impracticable, force majeure clauses allocate risks associated in M&A transactions by excusing a party from a failure or delay in performing the requirements of the Purchase Agreement or other ancillary agreements. It is important to define what events may give rise to an excuse to perform, which may include:
- acts of nature,
- government orders or requirements,
- epidemics, pandemics or other healthcare crises,
- quarantines, stay-at-home orders, government and industrial disruptions and supply chain shortages,
- acts of public enemy, war, blockade, insurrection, riot, general arrest or restraint of government and people, civil disturbance or similar occurrence, or
- a strike, lockout or similar industrial or labor action related to the relevant industry.
A force majeure provision may excuse the affected party from failing to perform the obligations set forth in the Purchase Agreement as a result of the force majeure event.
Force majeure clauses often are drafted for definite events and are narrowly interpreted. As a result, the affected party would need to show a strong causal link between the force majeure event and non-performance. A mere increase in the business expenses or an industry-specific disruption may not trigger the force majeure clause, unless such circumstances are expressly stated in the Purchase Agreement. To properly allocate risks, a buyer and seller should consider the procedure that either party must take to invoke the force majeure clause, including giving proper notice and the potential extension of time a party may need to perform or cure non-performance.
Although force majeure clauses are seen in many commercial agreements, they are not the strongest mechanism in allocating risk in a Purchase Agreement. M&A transactions generally contemplate short-term obligations by the buyer and seller, particularly the buyer transferring funds for the purchase price and the seller executing M&A documents, including assigning contracts.
It may be difficult to show that these obligations are impossible or impracticable to perform as a result of a force majeure event. Nevertheless, should parties to an M&A transaction contemplate continued longer-term performance, such as use of an Earnout Agreement, force majeure clauses may help with allocating risks by excusing non-performance of the affected party arising from a force majeure event.
Though the above risk allocation provisions and procedures are not the only business mechanisms which are used by parties in negotiating M&A transactions, parties entering M&A negotiations should consider these provisions and procedures in determining the appropriate level of risk allocation to protect either or both parties against both foreseeable and unforeseeable circumstances.
To discuss the above topic, please contact Ara Babaian at firstname.lastname@example.org or Durdana Karim at email@example.com or any other Encore Law attorney.