COVID-19’S IMPACT ON SIGNED AND FUTURE M&A DEALS — THE VICTORIA’S SECRET EXAMPLE
By Bart Breinin, Partner, Paul Ellis Law Group

A webinar presented by the ABA Business Law Section on March 24, 2020 titled “When COVID-19 Impacts Your Deal: Evolving M&A Practices and Provisions” provided some helpful observations regarding mergers and acquisitions (M&A) in the time of COVID-19. Among the insights discussed by the panel were the “material adverse change/material adverse effect” (MAC/MAE) condition to closing and the “interim operation” covenant contained in virtually all acquisition agreements. A summary of those insights follows:

  1. MAC/MAE:

a. This provision typically provides an out for a buyer if a significant enough event occurs that it fundamentally affects the business to be acquired (similar to a “force majeure” or “Act of God” clause in many contracts). However, these provisions are typically drafted narrowly, have numerous contingencies and exceptions (and exceptions to the exceptions). Thus, they are rarely invoked by buyers.
b. In deals signed after the emergence of COVID-19, sellers will want to insert an additional exception to standard MAC/MAE conditions for epidemics/pandemics including COVID-19. Until recently, very few deals included this sort of MAC/MAE carveout, but most current deals do (and likely will going forward).
c. Buyers will want to require the standard “disproportionate impact” exception to the exception, while sellers will want to limit its application as much as possible by using focused/targeted wording.
d. Importantly, it was noted that only one Delaware case to date has allowed the invocation of a MAC/MAE in a deal, but that was pre-crisis.

  1. Interim operation of business covenants:

a. Going forward, sellers will want to water down the standard requirements to conduct business between execution and closing “in the ordinary course of business consistent with past practice” (including any definition of what the quoted words should mean). For example, they may want to substitute a “reasonable efforts” standard for a strict obligation.
b. Sellers will also want to limit buyers’ typical consent rights for the interim period and include exceptions in light of this crisis (and potential similar ones in the future). The parties may also want to revise the standard wording of cooperation covenants.
c. Importantly, it was noted that these provisions are more susceptible to being breached (albeit inadvertently) as a result of the pandemic than MAC/MAE provisions, and thus could have a very real impact on whether a deal gets closed and on post-closing indemnities.

We are now seeing the foregoing considerations play out in the current crisis. One example involved a deal to acquire a famous U.S. brand. In a Wall Street Journal article published on April 24, 2020 (“Victoria’s Secret Owner Assails Former Suitor”), it was reported that the owner of Victoria’s Secret was litigating with Sycamore Partners, a private-equity firm that was trying to back out of its agreement to buy the business. According to the article, the buyer argued that the decision by L Brands, the seller, “to close the lingerie brand’s U.S. stores, furlough the majority of its workers and skip April rent payments were violations of the proposed transaction, according to a lawsuit filed by Sycamore in a Delaware court.” The seller argued that it believed the termination was invalid, and that “the parties were already aware of the coronavirus pandemic when they negotiated the deal and agreed that Sycamore would bear the risk of any adverse impact,” among other things.

Furthermore, in a New York Times column published on April 29, 2020 titled “The Victoria’s Secret Contract That Anticipated a Pandemic”, James Stewart reported that while most M&A agreements contain MAC/MAE clauses, in this case the seller’s lawyers “carved out specific exceptions to those [clauses], including a pandemic.” It went on to note that “Sycamore’s lawsuit concedes that it can’t invoke the ‘material adverse event’ clause to justify terminating the contract, given the language that specifically excludes a pandemic….Instead, the suit contends that L Brands failed to run the Victoria’s Secret business in a manner consistent with past practices, in breach of the agreement….”

In this case, therefore, the buyer was basing its termination argument not on a MAC/MAE provision, but rather on a purported violation by the seller of interim operating covenants (by closing stores, furloughing workers and not making rent payments). Such an approach makes sense, since (as mentioned above) it is very difficult to establish that a MAC/MAE has been triggered–and all the more so in this case, where the buyer carved out a specific pandemic exception. Whether the court would ultimately have accepted the buyer’s arguments–thus not requiring it to consider issues of material adverse impact under the circumstances–has become a moot point, as both parties have now agreed to terminate the deal (with neither party paying a termination fee), as reported in The Wall Street Journal on May 5, 2020 (“Deal for Victoria’s Secret is Dead”).

The April 24 Wall Street Journal article noted that, “With little precedent to go on, deal lawyers have been poring over merger agreements for vulnerabilities that could give regretful buyers a way out—or leverage to try to recut a deal for a lower price, given that most targets’ share prices have sunk. They have found few loopholes, partly because sellers began making it harder for buyers to back out following the financial crisis when many private-equity firms tried to walk away from deals.” The New York Times column quoted Charles Elson, a corporate governance expert: “’In a pandemic, you respond to a pandemic….Unless there was fraud or misconduct by L Brands management, it’s going to be very hard for them to get out of the deal.” It is true that it has been difficult historically for buyers to walk away from signed M&A deals, but Sycamore was apparently able to do that without having to agree to any penalty (though it is unclear based on the reporting why L Brands agreed to drop the deal). It will be interesting to see whether other buyers will try during the current crisis to make the same types of “breach of covenant” arguments that Victoria’s Secret’s buyer made, and whether those arguments will have a better chance of success than termination based on a MAC/MAE (especially if that clause includes a specific pandemic exception).