The novel coronavirus (“COVID-19”) triggered unprecedented disruptions in business operations, supply chains, and distribution networks. With such disruptions come considerable challenges to existing and future merger and acquisition (“M&A”) transactions.
We created a series of alerts to educate buyers and sellers about the ways in which COVID-19 may impact the transaction process and the terms of the purchase agreement. We also use a recent broken M&A transaction between Sycamore Capital and Victoria’s Secret as an example of the impact of the COVID-19 business environment on M&A transactions.
This alert (Part I) focuses on the impact of COVID-19 on representations and warranties, pre-closing covenants and MAC clauses. A subsequent alert (Part II) will focus on the impact of COVID-19 on valuation and due diligence.
Victoria’s Secret Broken M&A Transaction
On April 22, Sycamore Capital walked away from its anticipated $525,000,000 acquisition of Victoria’s Secret and PINK from L Brands (“Victoria’s Secret”). Like many retailers around the country, as a result of the COVID-19 business environment, Victoria’s Secret temporarily closed almost 1,600 stores, reduced purchases of new merchandise, furloughed most employees, reduced compensation by 20% for all senior employees and withheld April rent payments.
Sycamore Capital used those fairly common responses by Victoria’s Secret to COVID-19 as justifications to seek termination of the transaction. In court filings with the Delaware Chancery Court on April 22, Sycamore Capital claimed that Victoria’s Secret breached its covenant to operate ‘in the ordinary course of business’, breached multiple representations and warranties and triggered the MAC clause.
The Victoria’s Secret broken M&A transaction not the first and will not certainly be the last broken M&A transaction as a result of the COVID-19 business environment. As a high profile M&A profile transaction, the Victoria’s Secret broken deal highlights the impact of the COVID-19 business environment on common pre-closing covenants. One takeaway from the Victoria’s Secret broken deal is for buyers and sellers to be make sure that the purchase agreement terms reflect the current business realities in light of COVID-19.
In many transactions, compliance with a list of affirmative and negative covenants is required in order to force the other side to consummate the transaction. A common covenant is the ‘ordinary course of business’ provision that Sycamore Capital claimed was breached by Victoria’s Secret. Victoria’s Secret was required to “conduct its business in the ordinary course of business consistent with past practice”. Sycamore Capital claims that those business responses by Victoria’s Secret to COVID-19 constitute a breach of the ‘ordinary course of business’ covenant.
A breach of the ‘ordinary course of business’ provision is intended to enable a buyer like Sycamore Capital to walk away from the transaction or seek indemnity against the seller post-closing. A seller dealing with the continued uncertainty of the COVID-19 business environment will benefit from certain modifications to the ‘ordinary course of business’ provision in the purchase agreement. For example, unlike Victoria’s Secret, a seller should remove any reference to the past practices of seller since the seller will certainly operate different from historical practice during the COVID-19 period. A seller should also be specifically permitted to take actions it takes in response to legal requirements and actions that similarly situated companies take in response to COVID-19. Victoria’s Secret did not benefit from such carveouts.
Representations & Warranties
The impact of COVID-19 extends to representations and warranties that a buyer will expect seller to make in a purchase agreement. The representations and warranties in a purchase agreement serve multiple purposes, including the allocation of risk between parties for the pre-closing operations of seller and as a mechanism to facilitate due diligence.
In the Victoria’s Secret broken M&A transaction, Sycamore Capital claimed that Victoria’s Secret breached a number of representations. Similar to many transactions, the Victoria’s Secret purchase agreement included both MAC and ‘ordinary course of business’ provisions in the representations. In addition, according to Sycamore Capital, the failure to pay April rent constituted a breach of Victoria’s Secret representation that it had not breached any material contract. According to Sycamore Capital, Victoria’s Secret’s various responsive measures breached its representation that it had not taken any action without the consent of Sycamore Capital that would otherwise constitute a MAC.
Looking at future transactions, similar to our discussion in Part II to the impact of COVID-19 on due diligence, sellers should expect buyers to include COVID-19-specific representations and warranties in the purchase agreement. Seller should expect several of the representations listed below. This list includes common representations that are updated to reflect COVID-19 issues.
- Customer termination, quantity reduction, renegotiation, default, force majeure notice, bankruptcy, legal restrictions
- Vendor termination, delivery delay, price increase, quantity reduction, renegotiation, default, force majeure notice, bankruptcy, legal restrictions
- Compliance with applicable laws, including new regulations related to COVID-19
- Adequacy of reserves for accounts receivable
- Quality and adequacy of inventory
- Accuracy of financial statements, adequacy of internal controls and absence of undisclosed liabilities related to COVID-19
- Employment matters, including the provision of safe work environment and compliance with workforce, health and safety policies and procedures
Material Adverse Change (“MAC”) Clauses
One lesson from the Victoria’s Secret broken M&A transaction is for the parties to think through the specific language to include in the MAC clause. MAC clauses generally shift to a buyer the risk for industry-wide and systemic issues and shift to the seller the risk for company-specific issues. This risk shifting to Sycamore Capital for industry-wide and systemic issues did not appear to occur. As a result, Sycamore Capital claimed that all of the preventative measures taken by Victoria’s Secret in response to COVID-19 constituted a breach of the MAC clause.
Buyers prefer broadly-drafted MAC clauses to allow them to terminate prior to closing or seek indemnity post-closing. A buyer-friendly MAC clause covers both material adverse changes to the financial condition or business of seller as well as any change that prevents or materially impedes the performance of seller under the Agreement. A buyer-friendly MAC clause also limits seller carveouts to situations where the impact to seller is not disproportionate to others in seller’s industry.
Among other carveouts, sellers will require COVID-19 related effects to be specifically excluded from the definition of MAC. A seller-friendly MAC exclusion may go beyond COVID-19 and exclude any epidemic, pandemic, disease outbreak or any other public health event.
The MAC clause in Victoria’s Secret specifically carved out pandemics but failed to extend the carveouts to both the prongs of the MAC clause. As a result, Sycamore Capital claimed that the protective measures taken by Victoria’s Secret prevented or materially impaired the performance of Victoria’s Secret under the purchase agreement.
Due to the pervasive impact of COVID-19 to many businesses and industries, sellers may automatically benefit from common MAC exclusions. Common exclusions that are not COVID-19-specific include the adverse changes due to changes in laws, changes that are generally applicable in seller’s industry and changes generally affecting the economy. These exclusions are broad enough that they should be triggered by COVID-19 even though COVID-19 is not specifically referenced.
Buyers and sellers are modifying their approach to M&A transactions in light of the significant impact to date and the uncertain future impact of the COVID-19 pandemic. Some of these changes include including additional representations and warranties, modifying common closing covenants and careful drafting of the MAC clause.