Claiming a material adverse event is suddenly more acceptable than ever, but proving one remains an extraordinary feat.
Instead, private equity buyers are testing MAE’s traditional definition and pivoting to a clause that calls for businesses to operate in the ordinary course between the signing and closing of a transaction, according to several litigators who spoke with PE Hub.
Even prior to covid-19, anyone filing a material adverse event lawsuit was on the wrong side of case law, said Josh Margolin of Selendy & Gay. Margolin previously clerked for the chancellor and vice chancellor of the Delaware Chancery Court, where such cases are litigated.
“It’s always a long shot, but it’s a long shot that can lead to renegotiations and that’s a good thing if you’re a buyer. If you can make your acquisition a little cheaper now –especially one that looks a little less appealing now – all the better,” said Margolin, a partner at the law firm.
“The cases aren’t necessarily indicative of desire to terminate a transaction as much as it is to use it to renegotiate price,” added Daniel Peters, partner at Winston & Strawn.
“This is primarily about valuation,” he said, pointing to the massive resurgence of earnouts negotiated into transactions.
Sponsors considering invoking MAEs are likely keeping close tabs on Advent International and Forescout Technologies, who are set to meet in court in mid-July over their pending $1.9 billion deal. As things stand today, it will be the first MAE case litigated in the era of covid-19.
Similar to some other situations, the MAE clause in the Advent-Forescout suit explicitly excluded ‘pandemic’, meaning a buyer cannot cite pandemic as a trigger for an MAE. MAE clauses typically have a long list of what does not constitute an MAE.
At the core of Advent’s argument was the disproportionate financial impact that the company suffered in relation to its peers, while also arguing the cybersecurity company failed to operate in the ordinary course. But Forescout argued that its deteriorating performance was caused by covid-19.
“I’m surprised that there are people that have negotiated covid into the MAE, taken the risk, and are still willing to plea covid,” Margolin said. “That to me is really bold and pretty incredible, but as you pair it with other claims, it’s a good flavor for the complaint.”
Advent is among a number of buyout shops that have already invoked MAE clauses, including Sycamore Partners, Carlyle Group, Singapore sovereign wealth fund GIC, Kohlberg & Co and Madison Dearborn Partners.
“I think we’re going to continue to see more [MAEs],” said Travis Wofford, partner at Baker Botts. “We have a lot of time to go through the rest of the year for buyers to assert their inability to close.”
Winning an MAE argument based on covid-19 alone doesn’t seem likely, litigators told PE Hub.
Unless both parties agreed that a pandemic could constitute an MAE in the original contract, “it’s going to have to be covid plus plus plus other factors,” Margolin said. “Otherwise, I just don’t think covid cuts it. You have to differentiate the target business from every other business in the industry and that’s a tough ask right now.”
If there’s no mention of pandemic in a contract, the buyer is still at a disadvantage because it would likely fit under ‘act of god’ or ‘social/political upheaval’ – common exclusions from MAE clauses, he said.
That’s not to say buyers don’t have any leverage.
“The leverage right now is time and money,” Margolin said. “If you can hold up the closing of a deal during litigation, the target probably now needs money more than ever. You’re probably going to run into a lot of sellers who are willing to negotiate rather than take it to the mat.”
At the same time, the definition of a material adverse cause (MAC)/MAE is becoming less boilerplate. It used to be that you had a fairly bare-boned definition, and now, the exceptions are often far longer than a MAC/MAE definition, lawyers said.
That could have a counter-intuitive effect, making a MAC/MAE potentially easier to show, said Matthew DiRisio, a partner at Winston & Strawn.
“If a party sat there and contemplated 20 things that wouldn’t be MACs, if they thought of all these permutations and chose not to [exclude] A, B or C, that might suggest that this is something that could be considered a MAC,” DiRisio said.
While MAEs are being challenged more than ever, private equity buyers are spending more time testing out another strategy as a means to scrap or renegotiate a deal: the interim operating covenant.
That is where the focus is – more than trying to fine tune the MAE definition, Peters said.
“Buyers recognize the probable futility in showing that one company is a special snowflake when it comes to the covid effects,” DiRisio said. “That’s turned attention to the theory that there has been a breach of the ordinary course covenant between signing and close.”
“What happens when you’re a company that had 1000 retail stores and now you’re all the sudden down to 250 [stores]?” added Margolin. “Maybe the MAE won’t allow you to point to covid. But maybe you have the argument that you’re no longer conducting business in the ordinary course.”
The ordinary course covenant is potentially easier to prove, but there are challenges, Wofford said.
“How do you operate ‘in ordinary course’ in the context of a pandemic?” Wofford said.
Targets are drawing down on revolvers to shore up their balance sheets and commonly that conflicts with the interim operating covenant, he said. But that alone won’t be enough to terminate a deal, Wofford said.
In perhaps the most high profile of cases, Sycamore in an attempt to break its agreement to acquire Victoria’s Secret from L Brands claimed an MAE through a less standard definition. Sycamore argued the steps the company was taking in the pandemic downturn materially impeded its ability to perform its obligations under the transaction agreement. It concurrently argued an ordinary course breach.
L Brands, however, asserted that actions including closing stores, furloughing employees and dealing with inventory issues were similar in nature to its response during the financial crisis. It argued that all other retailers were doing things like not paying rent.
The lawsuit never went to trial, but L Brands in early May called off Sycamore’s $525 million agreed deal for a 55 percent stake.
To embrace the ordinary course argument, a Delaware judge would have to say: “You get to get out of an agreement simply because the company was taking steps it never had to take before – but it was faced with circumstances that it never faced before,” explained a M&A litigation partner at a global law firm, requesting anonymity.
No reputational harm
Historically speaking, private equity firms haven’t been willing to take an MAE case to trial to break a deal agreement.
But the sudden and widespread impact of covid-19 has over the last three months led to a handful of disputes already. So what gives?
When Louis Lehot, founder and managing partner of boutique law firm, L2 Counsel, was at Simpson Thacher during the Global Financial Crisis, the mantra was: If you sign, you don’t walk from that deal.
“I was ensconced with the theory that you couldn’t walk because your reputation was ruined,” he said.
In Lehot’s view, the change in thinking is driven by GPs’ much closer relationship to their LPs today.
“The big difference is PE firms are constantly fundraising with LPs today. GPs are trying to say to LPs: ‘Invest in me, I’m not going to go down with covid.’ It’s much more about [a firm’s] reputation with LPs.”
Besides Advent-Forescout and Sycamore-L Brands, other suits have involved Realogy, who sued SIRVA Worldwide and Madison Dearborn Partners over their plans to call off a $400 million business unit sale over the pandemic.
In May, the Delaware court denied American Express GBT’s request for an expedited trial to litigate their $1.5 billion deal, effectively letting the buyers Carlyle and GIC walk, PE Hub reported.
Elsewhere, Snow Phipps Group sued Kohlberg & Co for attempting to get out of its $550 million deal to acquire DecoPac, a wholesaler of cake decorations.
All this despite only one successful MAE claim of significance in recent years.
In 2018, Delaware Chancery Court found that an MAE occurred within the proposed sale of US generic drug maker Akorn to German pharmaceutical giant Fresenius KabiAcorn.
The Delaware judge found that “Akorn’s business performance fell off a cliff,” even though “Akorn had reaffirmed its full year guidance” after the deal agreement. In addition, Fresenius received letters from anonymous whistleblowers accusing Akorn of regulatory breaches and, in the course of follow-up investigations, uncovered what the court found were “serious and pervasive data integrity problems,” the judge said. The latter, which involved the submitting of falsified product data to the FDA, constituted a regulatory MAC.
In DiRisio’s view, Akorn is almost meaningless because the facts were so egregious: “It’s viewed as a test case for: if this isn’t a MAC, there is never going to be one. People stopped putting a lot of stock in the Akorn comparison because it was just so out there.”
Others disagreed. “You have to look at Akorn,” said Margolin. “If you’re filing one of these suits, you want to tie yourself to Akorn as closely as you can. Because that’s the success story. As close as you can mimic to Akorn the better off you are.”
Akorn isn’t the only MAE to ever occur, Wofford argued.
“It’s a misnomer to say there has never been an MAE [besides Akorn]. In 2008 and 2009 deals were getting terminated, they just weren’t going to trial,” he said.
Update: This story was updated to clarify Advent’s argument in the Forescout case.