The economic disruption caused by the COVID-19 pandemic has caused certain companies to rethink previously agreed-upon strategic transactions. Other companies, determined to close, have filed suit to compel wavering counterparties to complete planned deals. Companies that have recently executed merger agreements, that are contemplating strategic transactions amid COVID-19 or that are considering whether to litigate to force the closing of a strategic transaction should consider the arguments buyers have made to delay closing or terminate strategic transactions, and the principal defenses against those arguments that sellers have made in an effort to force the closing. In this alert, we summarize the most prevalent COVID-19-related arguments to delay or terminate strategic transactions, and the arguments to compel the closing of such transactions.1
A. Challenging Assertions of Material Adverse Effects to Avoid Closing and Failure to Use Commercially Reasonable Efforts to Force Closing
Given the outsized impact of COVID-19 on business operations, one of the most common bases on which companies have attempted to avoid obligations to close is by invoking the merger agreements’ material adverse effect (MAE) provisions—despite the “typical MAE clause allocat[ing] general market or industry risk to the buyer, and [only] company-specific risks to the seller.”2 Such arguments may have been emboldened by the Delaware Chancery Court’s 2018 decision in Akorn, Inc. v. Fresenius Kabi AG, finding—in a first for that court—that a durationally significant fall in financial performance constituted an MAE.3 But, as the court acknowledged in the Akorn decision, “[a] buyer faces a heavy burden when it attempts to invoke a material adverse effect clause.”4 The buyer must show that “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.”5 Whether a buyer can establish the existence of an MAE necessarily depends on the facts of each case. And, as the unique nature of Akorn demonstrates, buyers will be required to provide detailed financial analysis to succeed on such a claim.
In response, sellers are generally asserting that the relevant MAE provisions carve out industry-wide events—which they assert COVID-19 is—and, following the Delaware Chancery Court’s 2018 decision in Channel Medsystems, Inc. v. Boston Scientific Corp., that their counterparties have not used commercially reasonable efforts to close.6 Commercially reasonable efforts clauses “impose obligations to take all reasonable steps to solve problems and consummate the transaction.”7 To determine whether a party has satisfied those obligations, courts consider whether it “had reasonable grounds to take the action it did” and “sought to address problems with its counterparty.”8 A party fails to use commercially reasonable efforts where, for example, it does not “make any meaningful attempt to confer” with its counterparty and simply “pull[s] the ripcord” on a transaction.9 Sellers seeking to invoke the covenant bear the burden of establishing the buyer’s violation.10
For example, in Snow Phipps Group, LLC v. KCake Acquisition, Inc., the seller of a company engaged in the supply and marketing of cake decorating products is seeking to enforce the buyer’s obligation to close over the buyer’s objection that the seller’s recent drop in sales amid COVID-19 constitutes an MAE.11 The seller’s complaint asserts that the company continues to operate as an essential business, and that the dip in sales it has experienced is only a short-term concern. And in any event, the seller contends, the MAE clause allegedly allocates to the buyer the risk of any adverse event related to, among other things, general economic conditions in the markets or geographical areas where the seller operates, or that affect companies in the same or similar industries. Finally, the seller asserts that the buyer’s attempt to renegotiate a debt commitment letter and to assert that financing was unavailable without more favorable terms than were available when the merger agreement was signed violated its obligations to use “commercially reasonable efforts” and “reasonable best efforts” to obtain and maintain debt financing for the transaction. According to the complaint, the counterparties to the buyer’s debt commitment letter remain willing to provide debt financing on the terms set forth in the letter, and it is only the buyer’s insistence on renegotiating those terms—despite the merger agreement’s apparent prohibition on any such renegotiation—that has precluded the buyer from obtaining debt financing.
In L Brands, Inc. v. SP VS Buyer L.P.—which was voluntarily dismissed after the parties agreed to terminate the transaction and all pending litigation—the seller of a 55 percent interest in certain Victoria’s Secret brands sought to enforce the buyer’s obligation to close after the buyer purportedly sought to avoid closing by claiming that COVID-19 had impeded the seller’s ability to perform, thereby constituting an MAE.12 The seller alleged that the contract’s MAE clause allocates to the buyer the risk of, among other things, changes in conditions affecting the seller’s industry, pandemics, other natural or manmade disasters or acts of God, and any national, international or regional calamity. And, as in Snow Phipps, the seller claimed that the buyer failed to use “reasonable best efforts” to consummate the transaction by seeking to terminate it after the buyer rebuffed its attempt to renegotiate the sales price. Specifically, the seller alleged that, after describing as reasonable the measures the seller implemented in response to the pandemic, the buyer disclaimed its knowledge of and acquiescence to those measures and instead sought to use them as a justification for terminating the transaction.
In Realogy Holdings Corp. v. SIRVA Worldwide, Inc., the seller of a company that provides relocation counseling has sought to enforce the buyer’s obligation to close over the buyer’s invocation of the merger agreement’s MAE provision given the purported disproportionate effect of COVID-19 on the target company and the seller’s potential insolvency.13 Specifically, the buyer argued that, because the company is a low-margin business with a relatively flat cost structure, the pandemic will cause devastating financial results disproportionate to those of similar firms. Once again, the seller contends that the contract’s MAE provision carves out conditions generally affecting the industry in which it operates, and that the buyer, which operates in the same industry, has acknowledged as much both in negotiations with the seller and publicly. On May 8, 2020, Vice Chancellor Morgan Zurn denied the seller’s motion for an expedited trial in large part because debt financing for the transaction expired on May 7 and the parties’ agreement at least arguably limited the availability of specific performance to the period during which debt financing was available.
Finally, in Forescout Technologies, Inc. v. Ferrari Group Holdings, L.P., the seller of a cybersecurity company seeks to enforce the buyer’s obligation to close the transaction over the buyer’s objection that COVID-19 is an MAE.14 The seller’s complaint alleges that the parties expressly excluded from the contract’s MAE definition any effects on the company resulting from pandemics, barring a materially disproportionate impact on the company, and—even then—only to the extent the company experiences an incremental disproportionate impact. The buyer’s contention that the seller has underperformed relative to peers is largely irrelevant, the seller argues, since even the buyer’s models—which the seller argues were fabricated to frustrate the availability of debt financing—predict a return to business as usual in fiscal year 2021. The seller also contends that the MAE clause defines an MAE as something that occurs after the agreement was signed, and that the parties were well aware of COVID-19 and the risks it posed when they executed the agreement in February 2020. Finally, the seller claims that the buyer has violated its obligation to use reasonable best efforts to close the transaction, in part by concocting inaccurate financial projections designed to scuttle the deal.
As these complaints demonstrate, MAE clauses amid COVID-19 may not prove to be the off-ramp reticent buyers may hope they are, both because of their express terms and because of the high standard that buyers must meet in order to demonstrate the existence of an MAE. In addition, these and other cases show that sellers stand ready to challenge the invocation of those clauses and the buyers’ efforts to avoid consummating the transaction. The arguments on both sides are heavily fact-dependent, and it remains to be seen whether, based on the facts of each particular case, buyers will be able to prove that COVID-19 has caused an MAE or whether sellers will be able to demonstrate that the buyer’s conduct suffices to establish a violation of the buyer’s obligation to use commercially reasonable efforts to close, especially in the unique circumstances presented by COVID-19.
B. Defending Operations as Being Part of the “Ordinary Course of Business” Amid COVID-19
Another common basis asserted for refusing to close strategic transactions is that the seller has adopted measures in response to the pandemic that have significantly weakened the business, thereby violating its obligation to operate “in the ordinary course of business”—clauses intended to “ensure that the business the buyer is paying for at closing is essentially the same as the one it decided to buy at signing.”15 In Akorn, the Delaware Chancery Court measured whether the target company complied with its obligation to operate in the ordinary course of business by comparing its conduct with that of a “generic” company in the same industry.16 As might be relevant in the current circumstances, “[t]he normal and ordinary routine of conducting business does not include destroying the business assets.”17 Thus, even a company’s “reasonable reaction” to circumstances beyond its control might be deemed outside the ordinary course of business where that reaction causes the target company effectively to cease relevant operations.18
Sellers seeking to enforce their counterparties’ obligations to close have raised a variety of defenses to this argument, including that (1) measures designed to respond to economic downturns are part of the ordinary course of business; (2) other companies in the industry—including, sometimes, the buyer—have taken similar measures; and (3) the measures the seller implemented were necessary to comply with the law, which often is also required by the parties’ contract.
For example, in Level 4 Yoga, LLC v. CorePower Yoga, LLC, the parties—both owners and operators of CorePower Yoga-branded yoga studios across the country—are contesting whether the seller’s decision to close the yoga studios that are the subject of the agreed-upon transaction violates its obligation to operate the studios in the ordinary course of business.19 The seller is asserting that both it and the buyer have closed yoga studios around the country in compliance with temporary orders from state and local authorities, and the agreement requires the seller to comply.
Similarly, in AB Stable VIII LLC v. Maps Hotels Resorts One LLC, the buyer in a transaction involving a portfolio of luxury American hotels has asserted that the measures the seller implemented in response to the pandemic, including temporarily closing certain properties, adjusting staffing, and pausing nonessential capital spending, violated its obligation to operate the hotels in the ordinary course of business.20 In response, the seller once again contends that its actions—complying with relevant orders by federal, state and local authorities and working closely with business and brand partners to preserve key relationships, as well as with its lenders to avoid default—are in the ordinary course of business, consistent with its past practices and, indeed, required by the parties’ agreement. Moreover, the seller alleges, the buyer has responded to the pandemic by implementing similar measures at the luxury hotels it currently owns.
In Juweel Investors Ltd. v. Carlyle Roundtrip, L.P., the buyer has claimed that the seller’s cost-cutting steps in response to COVID-19 justify the buyer’s refusal to close.21 The seller asserts that, like every other business in the travel industry, the target company, American Express Global Business Travel, has responded to events such as economic downturns, changes in government regulations and pandemics by cutting costs in response to decreases in demand. Specifically, the seller argues that it has undertaken cost-cutting steps during past downturns that were commensurate with the anticipated severity and duration of the contraction, and that the circumstances here are not any different. The seller contends that its decision to cut costs in response to the ongoing pandemic is fully consistent with past practice and the ordinary course of business—indeed, the seller argues, it would have been extraordinary for it to not have taken these measures. On May 14, Vice Chancellor Joseph Slights denied the seller’s motion for an expedited trial, reasoning that the seller did not move quickly enough, having waited approximately one month after the buyer’s invocation of the MAE clause to file suit.
Finally, in Forescout Technologies, Inc. v. Ferrari Group Holdings, L.P., discussed above, the buyer has claimed that the seller failed to operate in the ordinary course of business because (1) the seller refused to produce updated financial forecasts for 2020 and beyond, (2) the seller’s sales have decreased amid the shift to remote work, (3) the seller has provided nonstandard discounts to a significant number of its customers and (4) the seller has harmed staff morale by erroneously informing employees that they would be terminated after the deal closes.22 The seller’s complaint asserts that none of these arguments passes muster: (1) the seller has worked closely with the buyer on updated scenario planning in light of the pandemic, and creating an entirely new operating plan would be a deviation from the ordinary course of business; (2) the buyer knew of the seller’s shift to remote work, which was prompted by local government orders, and, in any event, the seller’s sales staff commonly worked from home before the pandemic; (3) the discounts the seller has provided are consistent with discounts it has provided in the past; and (4) the buyer in fact pressured the seller to put in place a transition plan. On the whole, the seller argues, the buyer has approved all but two measures the seller has undertaken in response to COVID-19, and the seller did not undertake the two measures the buyer did not approve.
It is of course too early to determine the success sellers may have in challenging claims that they have failed to operate “in the ordinary course of business.” As some of the prior Delaware Chancery Court decisions discussed above demonstrate, sometimes even a reasonable reaction to extraordinary circumstances might be deemed to violate an ordinary-course covenant depending on the significance of the effect on the target company’s operations. But, at a minimum, the cases filed to date are notable in that they highlight the myriad ways in which sellers may assert that their responses to COVID-19 are part of the ordinary course of business in the circumstances wrought by the pandemic.
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The outcomes of these cases are necessarily uncertain, making it difficult to predict whether the arguments in favor of terminating transactions, or the defenses against them, will prove meritorious. But the cases do provide some initial context for understanding the types of COVID-19-related arguments parties to merger agreements have made to delay closing or terminate strategic transactions and the principal defenses against those arguments made by sellers seeking to force the close of the transactions—arguments that are particularly fact-dependent. Companies that have recently executed merger agreements, that are contemplating strategic transactions amid COVID-19 or that are considering whether to litigate to force the closing of a strategic transaction should consider this context as they continue to navigate strategic transactions amid COVID-19, particularly in light of the burdens of proof the various COVID-19-related arguments require. Sellers contemplating litigation may wish to take note that, as discussed above, the Delaware Chancery Court has denied sellers’ motions for expedited trials in two of the recently filed cases. Accordingly, depending on the circumstances, delay might prove disadvantageous to sellers hoping for a quick resolution to any potential litigation.
WilmerHale is closely monitoring developments in strategic transactions litigation related to COVID-19. If you have any questions, or require assistance with a strategic transactions litigation matter, please feel free to reach out to this alert’s authors or any of your contacts at WilmerHale.