The pandemic-induced downturn has undoubtedly created uncertainty for mergers and acquisitions across the globe. Deals that once seemed to offer buyers a clear path to growth have become suddenly unpalatable, resulting in several failed acquisitions. One notable instance is the recent termination of Sycamore Partners’ acquisition of Victoria’s Secret, which reveals a unique perspective into a couple common clauses found in M&A agreements: the Material Adverse Effect (MAE) and the Ordinary Course (OC) clauses. For middle market business owners and investors looking to close clean transactions, these two seemingly benign clauses may be the proverbial fly in the ointment.
On February 20, 2020, Sycamore Partners announced its agreement with L-Brands to purchase a 55% interest in Victoria’s Secret for approximately $525 million. Within the transaction’s governing documents was an MAE clause specifically carving out “pandemics” as an exclusion, which presumably obligated Sycamore to complete its acquisition of Victoria’s Secret regardless of the existence or effects of a pandemic. Shortly after signing the agreement, COVID-19 spread across the globe causing massive economic damage as businesses were shuttered. By mid-March, Victoria’s Secret had closed most of its retail stores, ceased rent payments, and furloughed most of its employees and/or reduced salaries. On April 22, 2020, Sycamore terminates the deal and, by early May, was accepted by L-Brands with no termination fees owed by Sycamore.
Credit should be given to L-Brands for including a carveout for the COVID-19 pandemic, which was considered a minor threat to the United States at the time they drafted and signed the transaction agreement (recall that the World Health Organization declared COVID a pandemic on March 11, 2020). So how was Sycamore able to exit the transaction without penalty?
Interestingly, Sycamore found refuge in one of the most common clauses in an M&A transaction and was able to effectively terminate its acquisition. Nearly every transaction’s definitive agreement includes a pre-closing requirement for the seller to continue to operate the business in the ordinary course “consistent with past practices” and to use “reasonable best efforts” to preserve intact the business until the transaction closes, unless otherwise consented to by the buyer.
Sycamore’s ability to terminate its acquisition was preserved by L-Brand’s inability to maintain the business consistent with past practices, which was evident when it closed its stores and terminated its workforce without consent from Sycamore. In effect, Sycamore was no longer purchasing the same operating capabilities it agreed to when it signed the transaction agreement. Arguably, L-Brand’s actions were required in order to save the business during an extraordinary time. In fact, there were probably no businesses or industries, let alone the consumer retail industry, still operating in a manner consistent with past practices at that time, so drastic measures may have been the only course of action. However, the agreement’s language was clear: L-Brands was to operate the business as it had done in the past and with reasonable best efforts.
After Action Report
So how can a seller (or inversely the buyer) protect its transaction during extraordinary times like a COVID-19 pandemic? What lessons can be learned from L-Brand’s failed transaction? Below are a few considerations.
MAE Carveouts: Look at including carveouts within the Material Adverse Effect clause beyond those that are typical. L-Brands was able to foresee the possible effects of the pandemic and pro-actively included a carveout in the agreement, presumably assuring the pandemic would not serve as a reason to terminate the agreement.
Direct or Indirect Causes: Consider addressing a direct or indirect relationship between the causes and effects for the MAE carveouts. How closely can the impact be associated with the cause of the MAE?
Ordinary Comparison: Consider what is ordinary course and incorporate an industry standard or key metric that can be used to determine deviations from what is considered ordinary. The actions of and impact on an entire industry may provide an example of what is considered normal.
Reasonableness: Refine the use of “reasonable best efforts” to include stricter limitations (i.e. commercially reasonable) which may allow for actions to be taken outside ordinary course if the action was in pursuit of the best economic outcome (i.e. proper value).
Past Practice: Consider the use of “consistent with past practices” and limiting its application to a period of normalcy. Alternatively, apply OC carveouts that allow for specific deviations during extraordinary times.
Communication/Negotiation Process: Include a clear process to resolve deviations from ordinary course via negotiations between the buyer and seller (to which responses cannot be unreasonably withheld or delayed). Careful thought, however, should be given to the control and authority shifted to the buyer when requiring such consent (i.e. avoid two chefs in the kitchen).
It’s likely the MAE and OC clauses will come under the microscope by many attorneys in the coming months (if they aren’t already). Business owners and investors should be aware of the risks embedded in the aforementioned common clauses and how those risks shift between the buyer and seller during the drafting of the transaction’s definitive agreement. Never take for granted “boilerplate clauses” or “template” agreements. When in doubt, engage forward thinking attorneys and M&A experts for your transaction.