The COVID-19 pandemic sweeping the globe has created massive personal, financial, and economic dislocation. The way in which business is conducted has fundamentally changed, perhaps permanently. Actions that were commonplace only a few months ago, such as commuting to an office, having an in-person meeting, or going to a restaurant, are now anathema. Many businesses and individuals are confronting the question of whether they are (or should be) bound by contracts made prior to the time of COVID-19 in the post-pandemic world. In this post, I will address some of the issues that arise in acquisition agreements. In the next post, I will address some of the issues that arise in more general contracts, such as leases, purchase orders, and supply contracts.
The starting point of any contractual analysis is the wording of the contract itself. This post addresses general principles that may not be applicable to the words of a particular contract and does not constitute legal advice.
Acquisition Contracts and the Interim Period
Most sizable acquisition contracts provide for a delay between the signing of the agreement governing the acquisition and the closing of the transaction. This delay can be caused by a number of factors, including the need to obtain stockholder or regulatory approval and/or raise financing. The period of the delay is referred to as the Interim Period.
During the Interim Period, the parties are exposed to changes in the marketplace in general and in the company being acquired, aka the “Target.” The price a buyer is willing to pay for the Target on the signing date (and the price at which the seller is willing to sell the Target for on that date) is likely different than the price at which the buyer is willing to buy (and the seller is willing to sell) on the closing date. This is particularly true when there has been an intervening event, such as the global pandemic experienced over the past several months. Over time, market practice has developed to govern the allocation of this risk during the Interim Period.
Allocation of Risk During the Interim Period
In general, there are two means of allocating risk during the Interim Period. First, there may be a purchase price adjustment based on factors that arise between signing and closing. These purchase price adjustments, which are subject to very limited exceptions, are only present in private deals and are usually based on changes in working capital or net assets. Because these adjustments are retrospective and accounting-based, pre-pandemic provisions generally would not be adequate to compensate a buyer for a dramatic decrease in the prospective value of the Target. For example, if one were buying a cruise company based on a pre-pandemic agreement, the working capital and/or net assets might be down due to the stay-at-home orders to date, but that decrease (in the mind of the buyer) likely would not be sufficient to compensate it for the fundamental change in the nature of the Target arising out of the pandemic.
The second protection for changes arising in the Interim Period is closing conditions. In general, a buyer will not have to consummate an acquisition if certain specified closing conditions have not been met. However, a seller is not protected against the circumstance where the value of the business being sold increases between signing and closing and will be obligated to close so long as the buyer has the purchase price and all regulatory consents have been obtained. The two most relevant closing conditions to a buyer that has signed a pre-pandemic contract are: (1) the absence of a Material Adverse Effect closing condition, and (2) compliance with the Interim Operation of the Business covenant.
The Material Adverse Effect Closing Condition
Substantially all business acquisition agreements with an Interim Period are subject to a condition that the buyer does not have to close the acquisition if a “Material Adverse Effect” has occurred. What constitutes a Material Adverse Effect is one of the most hotly negotiated provisions in most acquisition agreements, and historically courts have been loath to find that a Material Adverse Effect has occurred. In general, the market and courts have centered on a two-tiered concept of Material Adverse Effect. First, there has to be an adverse effect on the Target that is significant in magnitude and duration; for purposes of this post, I refer to that as a “MAC.” Second, the MAC must not be due to generally applicable causes, unless there has been a disproportionate effect on the business being acquired, a “Universal Cause.” Using the previous example, one can certainly see an argument that the pandemic has caused a MAC to a cruise company. However, that MAC is likely not a Material Adverse Effect as it is due to a Universal Cause, the pandemic, and not a cause that is specific to the Target. Thus, the buyer would not be excused from closing the acquisition because of the Material Adverse Effect clause, unless the buyer could show that the cruise company was disproportionately and adversely affected by the pandemic when compared to other cruise companies.
The Interim Operation of the Business Covenant
A buyer that signed an acquisition contract pre-pandemic may, however, be able to rely on a second closing condition. In general, acquisition agreements require a seller to operate the Target in the ordinary course of business consistent with past practice, to use some form of efforts to keep its business intact, and to not engage in certain specified actions. These obligations are referred to as the “Interim Operation of Business Covenant,” and it is typically a condition to the buyer’s obligation to close the acquisition that the seller has performed the Interim Operation of Business Covenant in all material respects. In the cruise company example, if the cruise company has canceled all of its sailings due to stay-at-home orders, a buyer could argue that even though the cancellations didn’t constitute a Material Adverse Effect because it was due to a Universal Cause, a Universal Cause is not an excuse for the shutdown of the Target’s business (which violates the Interim Operation of the Business Covenant), and thus the buyer does not have to close the acquisition.
Is the buyer’s argument correct? Should the buyer be let out of the contract on that basis? At least one case appears to have settled on the basis that the seller believed that the buyer would prevail. Does your view change if the seller specifically negotiated as a Universal Cause (i.e. something not triggering a Material Adverse Effect) the effect of the pandemic? Several lawsuits have been filed, and we will not know the answer until those cases are resolved.
A Contract Is Not Necessarily a Promise
In the classic Western Rio Grande, John Wayne tells his wife that their son must learn to honor his word, in this case, his enlistment contract in the United States Cavalry, even if it means his own destruction. The concept of being bound to honor one’s contract is referred to as “Contract as Promise.” Today, for the most part, we do not follow the model of Contract as Promise. Instead, we are allowed to break our contracts, so long as we pay the resulting damages (although that rule still doesn’t apply to military enlistment or for contracts in which damages don’t provide the other party with an adequate remedy). As such, even if one is bound by a pre-pandemic contract, performance is not required, but a party may be exposed to damages if it doesn’t perform. A buyer that is obligated to buy a Target may simply refuse to close the acquisition. That buyer would be liable to the seller for damages, which as a theoretical matter would be equal to the difference between the agreed-upon purchase price in the acquisition agreement and the value of the business on the date the buyer was obligated to close but failed to do so. Given the costs, uncertainty, and delay faced by a seller in pursuing a remedy, the practical recovery is likely to be a lot less than the true injury suffered.
Maurice M. Lefkort W86 is a partner in the Corporate & Financial Services Department of Willkie Farr & Gallagher LLP and the former Chairman of the Corporation Law Committee of the Association of the Bar of the City of New York.
Editor’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, please note that this post may constitute attorney advertising.