abstract. This Essay includes the only empirical analysis of merger agreements entered into after the COVID-19 pandemic was fully underway and with sufficient time that market practice in drafting such agreements could evolve in response. The analysis indicates movement toward providing target companies more flexibility to respond to extraordinary events that may occur between the signing and closing of a merger agreement. The authors emphasize that there is a real potential for extraordinary events to occur pending closing; and that extraordinary events often require extraordinary responses (i.e., actions that are outside the target’s “ordinary course of business”). We acknowledge that targets have skewed incentives in responding to extraordinary events occurring pending closing (as others have argued), but we argue that buyers do as well (possibly even more so) and, thus, reliance on the buyer’s providing consent to the target’s responses is not optimal. The Essay proposes a rethinking of the standard ordinary course covenant and MAE provisions in merger agreements to better balance the needs of the target for flexibility to respond to an extraordinary event with the needs of the buyer to restrict the course of conduct of the company it presumably will soon own.

introduction

Let’s say a pandemic occurs . . . .

And let’s say the parties to a pending merger agreement had contemplated the possibility of a pandemic (or some other specific extraordinary event) occurring between signing and closing, and had decided to allocate to the buyer the risk of that event happening. In other words, their agreement provided that the buyer would have to close even if the extraordinary event occurred and had a “material adverse effect” (MAE) on the target company.

And let’s say that, as would be typical, the parties’ merger agreement had separately provided that, between signing and closing, the target would operate in the “ordinary course of business.” Then, pending closing of the agreement, the pandemic (or some other specified event) occurred and the buyer no longer wanted to close—even though the parties, through the MAE provision, had allocated the risk of that event occurring to the buyer. Finally, let’s say that the parties litigated the issue and a court confirmed that the parties had allocated the risk to the buyer, and thus held that the buyer was not excused from closing on this basis. However, the court also held that the buyer was excused from closing on the basis that the target’s operational responses to the event—although eminently reasonable in light of the extraordinary circumstances—breached the target’s covenant to operate, pending closing, in the “ordinary course of business.”

This was the anomalous result in AB Stable VII LLC v. MAPS Hotels & Resorts One LLC,1 one of only three Delaware decisions2 issued to date addressing whether the COVID-19 pandemic provided a basis for a buyer to walk away from an agreed deal.3 In AB Stable, the Delaware Court of Chancery held that the no-MAE condition to closing in the parties’ merger agreement (i.e., the condition that there had been no MAE on the target company between signing and closing) was satisfied because the parties had defined MAE to exclude “calamities,” which, the court concluded, encompassed the concept of a pandemic.4 However, the court held that the target, which owned and operated a group of luxury hotels, breached the covenant to operate in the ordinary course of business between signing and closing given that, in response to the pandemic, it had closed some of its hotels and operated the others on a bare-bones basis.5 Some of these responses ultimately were required under governmental orders issued, and they mirrored the actions other hotel companies were taking in response to the pandemic.6 Nonetheless, the court held that the seller breached the covenant to operate the target in the ordinary course of business because the target’s postpandemic operations deviated from its ordinary, prepandemic course of business.7 Thus, even though the parties, through the definition of MAE in the no-MAE condition, had allocated the risk of a pandemic occurring to the buyer, the buyer was not obligated to close the merger because the target’s perfectly reasonable responses to the pandemic breached the covenant to operate in the ordinary course of business.

AB Stable’s implications sweep beyond the COVID-19 pandemic. Extraordinary events (albeit oxymoronically) happen with some frequency. There has been an increasing incidence of, for example, national and global financial and political crises, as well as extreme weather events. While the COVID-19 pandemic has been a once-in-a-century kind of extraordinary event, other extraordinary events that are more mundane and more frequent also have given rise to litigation under MAE and ordinary course provisions.8 The paradigm that AB Stable establishes would likely apply in most cases where an extraordinary event occurs between the signing and closing of a merger agreement—because most extraordinary events require extra-ordinary responses (i.e., operational responses that deviate from the ordinary course).

We conclude that the standard ordinary course of business covenant is inherently problematic because, as AB Stable illustrates, it fails to effectuate important aspects of the parties’ intentions with respect to risk allocation for an extraordinary event that occurs pending closing. When parties agree that the occurrence of a particular type of extraordinary event cannot constitute an MAE that entitles the buyer to walk away from the deal, they most likely do not intend to allow the buyer to nonetheless exit through the back door of the ordinary course covenant, as unfolded in AB Stable. Also, when parties agree that the occurrence of a particular type of extraordinary event canconstitute an MAE that would entitle the buyer to walk away from the deal, they most likely do not intend to put the buyer in a position to actually cause the event to have a material adverse effect. However, such is the case when the target company could have avoided the MAE by taking reasonable actions, but could not do so because those actions, however reasonable, were non-ordinary course.

Moreover, say an asteroid hits and destroys one of a company’s ten equally productive manufacturing plants. The event likely would not be an MAE as it affected only one-tenth of the company’s manufacturing capacity—a result that likely reflects what the parties would have intended. However, operating at only 90% capacity, or taking steps to mitigate the damage done, could well be deemed a material deviation from the ordinary course of business (given the relatively low materiality standard for finding breach of a covenant and the extremely high standard for finding an MAE has occurred). The buyer then would have the right to walk from the deal due to a material breach of the ordinary course covenant—a result that seems almost certainly contrary to what the parties likely would have intended and, indeed, patently nonsensical.

Obviously, if an extraordinary event occurs, a target can avoid breaching the ordinary course covenant by obtaining the buyer’s consent to operate, or take specific actions, outside the ordinary course of business.9 Given that it is typically in the buyer’s interest to preserve the target’s business (which it should soon own), one might expect the buyer to consent whenever the seller proposes to take reasonable actions in response to an extraordinary event. In the only other published article we know of examining the interaction between the standard MAE provision and ordinary course covenant in M&A deals, Guhan Subramanian and Caley Petrucci argue that the “negotiation” between a buyer and target that ensues when the target requests consent to take non-ordinary course actions provides the “optimal” framework for resolving these issues.10 As we discuss below, we respectfully disagree with the Subramanian-Petrucci view, in light of the extreme leverage and distorted incentives the buyer has in such a negotiation. By denying consent to the target’s proposed (even if concededly reasonable) responses to an extraordinary event, the buyer would put the target in the position of either risking an MAE if the target does not respond to the extraordinary event, or breaching the ordinary course covenant if it does respond. Either choice would enable the buyer to exit the agreement or to renegotiate it with increased leverage.

This Essay proposes a rethinking of the standard ordinary course covenant and MAE provision in merger agreements, balancing the needs of the target for flexibility to respond if an extraordinary event occurs between signing and closing with the needs of the buyer to retain the ability to restrict the target’s responses. While a postsigning discussion or negotiation between the parties over non-ordinary course responses to extraordinary events that occur pending closing is appropriate, in our view, the target may require more flexibility than would be afforded through a simple consent right of the buyer, even if subject to a requirement that the consent cannot be withheld unreasonably.

We proceed in five parts. In Part I, we provide background on standard MAE provisions and ordinary course covenants in merger agreements and explain why merger parties care so much about these provisions. In Part II, we analyze the key Delaware cases and other judicial decisions addressing whether the COVID-19 pandemic excused a buyer from closing a pending merger agreement under a no-MAE condition or ordinary course covenant. In Part III, we address why a target’s ability to request consent for non-ordinary course actions in response to an extraordinary event does notnecessarily provide a well-balanced framework to address the critical issues that arise relating to the interaction of MAE and ordinary course provisions. In Part IV, we provide an analysis of current market trends in drafting MAEs and ordinary course covenants, as reflected in merger agreements entered into after the pandemic was fully underway. To our knowledge, this is the first study of agreements entered into at a time sufficiently after the pandemic emerged such that market practice in response to the pandemic had a meaningful opportunity to evolve. It is also the first study we know of to focus on the extent to which merger agreement parties have afforded the target company flexibility to respond to the pandemic or other extraordinary events. Finally, in Part V, we outline a new approach to conceptualizing ordinary course and MAE provisions. Crucially, our approach would provide a target with needed flexibility to respond to extraordinary events, while still appropriately protecting the buyer. Merger parties may wish to adopt this approach in light of the nonremote potential for extraordinary events to occur between signing and closing of a merger agreement, as highlighted most recently and vividly by the pandemic.

I. the standard mae condition and ordinary course covenant

In an ideal world, the signing of a merger agreement and the closing of the planned merger would occur simultaneously. That way, the seller would be ensured that no negative event would occur pending closing that could derail the deal, and the buyer could take control of the company’s operations immediately. But a simultaneous signing and closing is usually not possible. Among other reasons, parties must often obtain shareholder and regulatory approvals before the closing can occur. The period between signing and closing varies in duration, but is usually at least thirty to ninety days and can be much longer.11

Traditionally, it is through the “MAE condition” that parties allocate the risk of events occurring during the interim period that may adversely affect the target company in a material way.12 Separately, the purpose of the “ordinary course covenant” is to impose restrictions on the decisions the seller makes in operating the target during the interim period.13 This Part examines how MAE provisions and ordinary course covenants typically are drafted, how they have been interpreted by the Delaware courts, and how they generally have functioned in M&A deals. In Section I.A, we illustrate that because MAE provisions typically impose an extremely high materiality standard, they rarely provide a basis for buyers to walk away from a deal. As we discuss in Section I.B, however, because ordinary course covenants typically provide a much lower materiality standard, they may more readily permit buyers to exit a transaction. Critically, in the context of an extraordinary event occurring between signing and closing, the interaction of the two provisions can produce an unintended and (we would argue) nonsensical result: while, through the MAE provision, the parties may have expressly allocated to the buyer the risk of the particular event occurring, the target’s necessary or reasonable responses to that event may breach the ordinary course covenant and thus permit the buyer to terminate the deal.

A. No-MAE Conditions

The essential rationale for the no-MAE condition is that the buyer should not be required to close if, between signing and closing, the target company is so damaged by an extraordinary event that it no longer resembles the company that the buyer priced and agreed to buy. The rationale has particular force when an extraordinary event is specific to the target company (rather than reflecting general conditions that affect the company)14 and was unforeseeable by the parties (rather than something that they readily could have contemplated and accounted for in the merger agreement).15 A classic illustration of an event that could constitute an MAE would be the discovery, between signing and closing, that the target’s sole product causes cancer, in a context in which it would take years for the target to develop another product.

The determination as to whether an MAE occurred has potentially momentous consequences for merger parties. An MAE determination would mean that the buyer is entitled to walk away from the deal, likely leaving the target as “damaged goods” (at a time when it has suffered an extraordinary event, no less) and making it more difficult for the target to find an alternative buyer or to continue to operate its business. By contrast, a judicial finding that there was not an MAE would mean that, depending on the terms of the agreement and other circumstances, the buyer could be ordered to specifically perform the merger agreement and close; or, if the buyer had already walked away from the deal, that the buyer could be liable to the target for damages.16

A standard formulation of a no-MAE provision states, first, that the buyer is not obligated to close if, from the date of signing (or, in some agreements, from the date of the last financial statements prior to signing) through the closing date, an event has occurred that has had (or, in many agreements, would reasonably be expected to have) a material adverse effect17 on the business, financial condition, or results of operations of the target company. Second, the provision typically states that the effects of specified types of events (the “MAE Exclusions”) will notbe taken into account in determining whether there has been an MAE.18 Third, however, the provision states that specified events that are MAE Exclusions will be taken into account in determining whether there has been an MAE to the extent that the effect on the target from such excluded event is disproportionate as compared to its effect on others in the same industry.19 Under this triad of clauses, which is often several pages long in a merger agreement (and which Vice Chancellor J. Travis Laster has aptly characterized “verbal jujitsu”),20 the no-MAE condition: (1) allocates to the target the risk of any event occurring between signing and closing that has an MAE on the target (i.e., it protects the buyer against having to close if the target suffers an MAE for any reason); (2) then shifts the risk instead to the buyer if the event is an MAE Exclusion; and (3) then shifts the riskback again to the target if the event is an MAE Exclusion, but disproportionately affects the target.21

MAE provisions thus typically exclude most events from constituting an MAE. Usually, the MAE definition functions such that the only events that could be deemed to constitute an MAE are events that are (a) internal to the company (e.g., the discovery of a major accounting fraud or a major product safety issue), or (b) exogenous (i.e., involving general or industry conditions) but have a disproportionate impact on the target. Indeed, in our experience, many MAE litigations focus on whether a general or industry event that has occurred has had a disproportionate impact on the target.22

If an event occurs that is notan MAE Exclusion (and, if applicable, it does not have a disproportionate impact on the target), the Delaware courts will then determine whether the effects of the event (or, as applicable, the disproportionate effect) had (or, if applicable, would be expected to have) a sufficient impact on the target to constitute an MAE.23 Unless the parties expressly provided otherwise in their merger agreement, courts do not apply a bright-line test to determine whether an MAE has occurred. Rather, they reach a subjective judgment that depends on the specific wording of the MAE clause and all of the facts and circumstances of the particular case.24 Courts have applied a very high standard for finding an MAE, requiring a material adverse effect on the long-term value of the company (i.e., a material effect having “durational significance”).25 Indeed, in only one casehave Delaware courts ever found an MAE that permitted a buyer not to close a merger agreement.26Given this judicial approach, the primary practical function of MAE conditions has been to provide a basis for possible renegotiation of a transaction to reflect a target company’s actual or potential decline in value, rather than to provide a clear basis for terminating the agreement.27 The degree of negotiating leverage, and whether it is sufficient to force a renegotiation of price or terms, will depend on the specific change suffered by the target and the specific wording of the MAE clause at issue.

MAE provisions thus rarely provide a basis for a buyer to walk away from a deal. This is both because the definition of “MAE” in merger agreements (taking into account the various exclusions) typically severely narrows what type of event can constitute an MAE, and because the materiality standard for a judicial finding of a material and adverse effect is so high.28 By contrast, however, as we discuss below, there is a relatively lowmateriality standard for a breach of the covenant to operate in the ordinary course of business.

B. Ordinary Course Covenants

Ordinary course covenants restrict a target’s flexibility in making decisions about how to operate the target company’s business pending closing. Without the buyer’s consent, the target cannot freely make major changes to its operations. The rationale for ordinary course covenants is that the target should not be free to transform itself such that the buyer would be forced to acquire a company that is essentially different from the one it agreed to acquire. For example, without an ordinary course covenant, a target that is a hotel company could decide after signing to become a shoe store instead. Even if the change would not adversely affect the target’s earnings or value, the target would no longer be the company for which the buyer bargained.

An ordinary course covenant typically provides (in the first part of the provision, which we refer to in this Essay as “Clause 1” of the covenant) that, between signing and closing of the merger agreement, the target will operate (or, in some agreements, that the target will use reasonable (or best) efforts to operate), in the ordinary course of business. In some agreements, the obligation is to operate in the ordinary course “consistent with past practice.” Some agreements qualify the obligation by providing that operation in the ordinary course is required only “in all material respects.” In addition, the covenant (in the second part of the provision, which we refer to as “Clause 2”) typically specifies that, pending closing, the target must seek to preserve the business, keep available its employees, and maintain its relationships with employees, suppliers, and others. Finally, the covenant (in the third part of the provision, which we refer to as “Clause 3”) typically specifies certain actions that the target may not take, pending closing, regardless of whether these actions generally would be taken by the target in the ordinary course. Of course, as noted above, the target can always take actions outsidethe ordinary course if it obtains the buyer’s consent. And, in most agreements, the covenant provides that, if such consent is requested, the buyer cannot unreasonably withhold, delay, or condition such
consent.29

Typically, a merger agreement conditions closing on the seller, pending closing, having complied in all material respects with its covenants in the agreement, including the ordinary course covenant. Importantly, the “in all material respects” standard is a “lower standard” than an MAE standard.30 Under the “in all material respects” standard, a judicial finding of noncompliance with the covenant would not require an effect on the long-term value of the company, but only that there was a deviation that “significantly alter[ed] the buyer’s belief as to the business attributes of the company it [was] buying.”31 As the court has further explained, the “in all material respects” standard means that any noncompliance with the covenant constitutes a breach except with respect to “small, de minimis, and nitpicky issues.”32

Courts are thus far more likely to find a breach of an ordinary course covenant than a failure of a no-MAE condition. Indeed, while plaintiff-buyers seeking to abandon pending deals during the COVID-19 pandemic initially focused on claiming that the pandemic caused the no-MAE condition to be unsatisfied, they soon (and particularly after the AB Stable decision was issued) turned to making and emphasizing claims of breach of the ordinary course covenant (or the accompanying specified prohibited actions).33

As in the case of MAE provisions, the ordinary course covenant is often inherently imprecise and subjective, requiring an intensively fact-specific inquiry to determine whether it has been breached. Also, as with MAE provisions, Delaware courts focus on the specific language of the covenant when interpreting it. For example, when an ordinary course covenant is subject to an “efforts” standard (rather than being a “flat” obligation), there may be room for a target to argue that it was no longer reasonable to act in the ordinary course once an extraordinary event occurred.34 When the requirement to operate in the ordinary course is qualified by the phrase “consistent with past practice,” the Delaware courts have looked only at how the business has operated in the past.35 But when that qualifying phrase is not included, the Delaware courts have considered both how the target operated in the past and how companies in the same industry generally operate.36 As discussed below, the AB Stable parties’ inclusion of the “consistent with past practice” phrase in their merger agreement was critical to the judicial outcome. The court stated that, even though the actions taken by the target company in response to the pandemic were similar to those taken by other companies in the industry, the court was restricted by this phrase to considering only whether the actions were similar to the past practice of the target company (i.e., to how it had operated prepandemic).

II. lessons from the covid-19 pandemic

When the COVID-19 pandemic hit the United States in early 2020, virtually every party to a then-pending merger agreement evaluated whether it or its counterparty had a right not to close based on the pandemic. In our experience, most of the then-pending agreements proceeded to closing without incident. Some were renegotiated, with the parties agreeing to a lower purchase price. In other cases, litigation was brought, almost all of which was ultimately settled and withdrawn.37

To many, it seemed that if ever an event should qualify as an MAE, it was the COVID-19 pandemic. It was unprecedented in our lifetimes, arose suddenly and unexpectedly, and had a massive global impact, affecting literally every business and person in the world. Millions of people died and many millions more suffered through grave illness. Governments issued orders requiring almost all businesses to close and almost all people to stay home.38 The stock market plummeted, with many companies seeing precipitous, steep drops in their stock prices.39 If this singular event did not constitute a “material adverse effect” on a company, what ever would? Moreover, if companies could not take the actions necessary to respond to the pandemic and the related cessation of business without breaching the ordinary course covenant, when could a target company ever notbreach the covenant after an extraordinary event?

Notwithstanding the singular nature of the COVID-19 pandemic, the Delaware Court of Chancery has applied its traditional approach when determining whether target companies suffered an MAE due to the pandemic. In the three cases it has decided on this issue, AB Stable, Snow Phipps, and Level 4 Yoga LLC v. CorePower Yoga LLC,the court reached its usual determination that there was notan MAE. The court also applied its traditional framework for determining whether the target companies in these cases breached the ordinary course covenant in responding to the pandemic. While the analysis was the same in the three cases, on this issue the result was not uniform. In AB Stable, the court found that the seller breached the covenant and the buyer therefore was not obligated to close. In Snow Phipps, where the court viewed the target’s pandemic responses as having been much more minimal. And in Level 4 Yoga, where the target’s pandemic responses were directed by the buyer and the target was contractually obligated to follow them (as the buyer was also the target’s franchisor), the court found that the target did not breach the covenant and that the buyer therefore had to close.40

We note that the Court of Chancery’s approach in these three cases, although consistent with its usual insistence on a “plain reading” interpretation of contract provisions,41 was neither self-evident nor preordained. Indeed, in our experience, the view among many legal practitioners was that the alternative approach taken by a Canadian court—in the two cases it decided addressing the issue, Fairstone Financial Holdings Inc. v. Duo Bank of Canada42and Cineplex Inc. v. Cineworld Group Plc43—was more appropriate in light of the extreme circumstances of the pandemic. The Ontario court interpreted the “ordinary course” covenant to mean, in the context of the pandemic, what was “ordinary course” in extraordinary times.44 Under that approach, the court considered reasonable responses to the pandemic to be in the ordinary course of business (and not a breach of the covenant).45 Below, we discuss AB Stable, Snow Phipps, Level 4 Yoga, Fairstone, and Cineplex in greater detail.

A. The AB Stable Decision

AB Stable involved the planned $5.8 billion acquisition, by Mirae Asset Financial Group (Mirae), from AB Stable VIII LLC (AB Stable), of Strategic Hotels & Resorts (Strategic), a Delaware corporation that owned fifteen luxury hotels in the United States.46 The parties signed the merger agreement in September 2019 (a few months before the COVID-19 pandemic emerged) and scheduled the closing for mid-April 2020 (by which time the pandemic was fully underway in the United States). In early April, Mirae stated that it would not close and was terminating the agreement.47 Mirae argued that it was entitled to terminate for two reasons. First, it claimed that the no-MAE condition would not be satisfied in light of the pandemic.48 Second, it argued that the operational changes Strategic had made in response to the pandemic constituted a breach of the ordinary course covenant.49

AB Stable filed an action in the Court of Chancery seeking specific performance of the merger agreement.50 The court did not accept Mirae’s first argument: Vice Chancellor Laster found that there was not an MAE because the MAE definition in the merger agreement excluded the effects of pandemics.51 Although the agreement did not use the word “pandemic,” it specifically excluded the effects of “natural disasters or calamities.”52 In the Vice Chancellor’s view, these terms, by their “plain meaning” (based primarily on dictionary definitions), encompassed the concept of a pandemic.53 The Vice Chancellor reasoned that the pandemic was a “calamity” because “[m]illions have endured economic disruptions, become sick, or died from the pandemic,” with “suffering and loss on a global scale, in the hospitality industry, and for Strategic’s business.”54 He reasoned that the pandemic also was a “natural disaster” because it was “a terrible event that emerged naturally in December 2019, grew exponentially, and resulted in serious economic damage and many deaths.”55

The Vice Chancellor also reasoned that a broad interpretation of the MAE exclusions to encompass pandemics likely was consistent with the parties’ intentions, as merger parties generally allocate to the buyer “exogenous” risks (i.e., risks not specific to the company).56 Finally, he viewed the policy considerations as favoring a broad interpretation of MAE exclusion terms, as only a broad interpretation permits merger parties to allocate the risk of “unknown unknowns” (i.e., things we don’t know we don’t know).57 The Vice Chancellor therefore ruled that Mirae was not excused from closing under the no-MAE condition.

However, the court accepted Mirae’s second argument: the Vice Chancellor found that Mirae was excused from closing on the basis that Strategic had breached the ordinary course covenant.58 The parties had provided that, between signing and closing, Strategic had to be operated, in all material respects, only in the ordinary course of business, consistent with past practice.59 The Vice Chancellor readily found that Strategic’s “extraordinary” and “massive” changes to its business in response to the pandemic were not in the ordinary course of business consistent with Strategic’s past practices.60 Strategic had closed two of its fifteen luxury hotels and had operated the others on a bare-bones basis with “skeleton staffing.”61 It had also slashed employee headcount, reduced the remaining employees’ hours and deferred pay increases until further notice, minimized marketing expenditures, and put on hold all nonessential capital expenditures and the replacement of furnishings, fixtures and equipment.62

The Vice Chancellor expressly rejected Strategic’s arguments that an ordinary course covenant permits a target company to engage in “ordinary responses to extraordinary events” and that Strategic had not breached the covenant because it had “operated in the ordinary course of business based on what is ordinary during a pandemic.”63He stated that “the weight of Delaware precedent” supported the contrary view: that “ordinary course” means “how the business routinely operates under normal circumstances” or, put differently,“the customary and normal routine of managing a business in the expected manner.”64 This approach is consistent with the provision’s purpose to “reassure a buyer that the target company has not materially changed its business or business practices during the pendency of the transaction” and that “the business [the buyer] is paying for at closing is essentially the same as the one it decided to buy at signing,” the Vice Chancellor concluded.65It was thus irrelevant, he stated, whether Strategic’s responses to the pandemic were reasonable or were similar to the buyer’s or other companies’ responses—which, he acknowledged, they were.66

The Delaware Supreme Court affirmed the Court of Chancery’s holdings, reiterating that the target’s actions in response to the pandemic were reasonable and consistent with industry-wide responses to the pandemic.67 It also held, however, that the ordinary course covenant, as drafted, requiring the target to operate “only in the ordinary course and consistent with past practice in all material respects,” required that the target operate in the ordinary course of its own business practices, “measured by its operational history, and not that of the industry in which it operates.”68 In so holding, the Supreme Court reasoned that looking to the actions of other hotels to judge the target’s pandemic responses was “more analogous to a commercially reasonable efforts provision” rather than a covenant to operate in the ordinary course.69

Addressing the interaction of the ordinary course covenant with the MAE provision that allocated the risk of a pandemic to the buyer, the Supreme Court emphasized their distinct purposes. “[W]hile the MAE provision shifts systemic risks like the pandemic and its effect on valuation to the Buyer, the Ordinary Course Covenant, consistent with its purpose, ensured that the [target] could not materially alter its course of business without the Buyer’s notice and consent,” the Supreme Court wrote.70 The Supreme Court concluded that the parties intended the two provisions to act independently, as they contained different materiality standards and there was no reference to the MAE provision in the ordinary course covenant. The Supreme Court also stressed the importance of the consent mechanism in the merger agreement. The target was not “hamstrung”71 by the ordinary course covenant, the Supreme Court reasoned, because the merger agreement provided that the target could seek consent of the buyer for actions outside the ordinary course of business and the buyer was prohibited from unreasonably withholding such consent. The target could (and should) have sought consent and then, if consent was withheld unreasonably, challenged the refusal.72

B. The Snow Phipps Decision

Snow Phipps was decided in late April 2021, over a year after the start of the
pandemic.73 At that time, vaccinations were in full swing, cases of infection were down, and businesses were beginning to resume more normal operations.

Early in the pandemic, Kohlberg had entered into an agreement to acquire DecoPac, Inc., for about $550 million, from private-equity firm Snow Phipps.74 The purchase price reflected a last-minute renegotiation by Kohlberg of its prior $600 million offer, based on concerns about the emerging pandemic.75 DecoPac’s business was the sale of cake decorations and cake-decoration equipment to grocery stores for use by their in-store bakeries.76 Soon after the parties entered into the agreement, stay-at-home orders were issued around the country and celebrations of all kinds were canceled, causing a “precipitous decline” in DecoPac’s weekly sales numbers.77

Kohlberg claimed that the pandemic constituted an MAE on DecoPac, and that DecoPac’s responses to the pandemic constituted a breach of its covenant to operate, pending closing, in the ordinary course of business consistent with past practice.78 Then-Vice Chancellor (now Chancellor) Kathaleen St. J. McCormick found that the pandemic did not have a sufficiently material impact with durational significance on DecoPac to constitute an MAE. Indeed, by the time of trial, the company’s business and financial results had already rebounded.79 She also found that, in any event, the effects of a pandemic were excluded from an MAE based on the broader terms the parties had specified as exclusions from the MAE definition.80

But unlike in AB Stable, the Chancellor found that the target company’s responses to the pandemic did not constitute a breach of its ordinary course covenant.81 The agreement provided that, between signing and closing, DecoPac would be operated, in all material respects, in the ordinary course of business, consistent with past
practice.82 The Chancellor found that DecoPac’s operational responses to the pandemic were both “de minimis” and, indeed, consistent with how DecoPac had operated in the past when sales had declined.83

Kohlberg contended that DecoPac’s $15 million drawdown of its $25 million credit revolver soon after the merger agreement was signed breached the ordinary course covenant.84 The court disagreed, noting that, although this was the company’s largest drawdown, it had drawn on the revolver five times since late 2017 (when Snow Phipps had acquired the company).85 Further, there was credible testimony that the drawdown “was driven solely by a Snow Phipps policy [that was] implemented broadly among its portfolio companies to address counterparty risks and was not in response to liquidity issues at DecoPac.”86 Kohlberg also contended that DecoPac, in response to the pandemic, had taken “severe cost-cutting measures” and had made “radical shifts in the ways in which it dealt with customers and suppliers.”87 Kohlberg pointed to DecoPac having “minimized marketing, capital expenditures, and labor costs; halted spending ‘on all outside consultants’; and instructed its vendors to halt or delay production and shipments.”88

The Chancellor found, however, that “decreasing labor costs in line with decreased production was in fact a historical practice of DecoPac.”89 With respect to the other cost-cutting measures, she found that reducing costs “in tandem” with sales declines was DecoPac’s standard practice, as reflected in prior times of declines in sales.90 Moreover, the cost-cutting reflected spending that “varied only in expected and de minimis ways from prior years with higher sales.”91 The Chancellor therefore ruled that DecoPac did not breach the ordinary course covenant and Kohlberg had to close the acquisition.92

C. The Level 4 Yoga Decision

Level 4 Yoga93was decided well after the pandemic had begun to recede, businesses had reopened, and a return to normal life and business was underway. Vice Chancellor Slights ordered CorePower Yoga, LLC to close the agreement it had entered into, prepandemic, to acquire the yoga studios owned by its franchisee, Level 4 Yoga, LLC. It also ordered that CorePower pay compensatory damages for its delay in closing.94

CorePower was the franchisor of Level 4’s studios, under a longstanding franchise agreement. The franchise agreement included a call right pursuant to which CorePower was entitled to acquire all of Level 4’s studios in a single transaction. CorePower wanted to acquire the studios, but (to avoid integration problems) it wanted to acquire them in tranches rather than all at once.95 In an asset-purchase agreement that Level 4 and CorePower entered into in October 2019 (the APA), Level 4 agreed that CorePower could acquire the studios in three tranches and that the first closing would occur on April 1, 2020.96 In late March 2020, CorePower asserted that it was no longer obligated to close the almost $30 million transaction due to the pandemic having emerged in the United States and businesses across the country, including Level 4’s studios, having shut down.97 CorePower claimed that the pandemic constituted an MAE and that the closure of Level 4’s studios constituted a breach of Level 4’s covenant to operate, pending closing, in the ordinary course of business.98

With respect to the MAE issue, the APA, unusually, provided no exceptions to the MAE definition. The court, applying its traditional MAE analysis, found that the pandemic did not constitute an MAE because, at the time CorePower asserted it had a right not to close, it had no basis to believe that the effects of the pandemic would have “durational significance.”99 Contemporaneous evidence introduced at trial indicated that CorePower believed at that time that the studios would be closed for only six weeks.100

With respect to the ordinary-course-covenant issue, the APA again was unusual. While the APA set forth a representation and warranty by Level 4 that it was operating in the ordinary course of business consistent with past practice and contained a covenant that it would continue to so operate pending closing, there was no closing condition that the representations or covenants had to be true. Level 4 explained that it had insisted on the APA being drafted as a “one-way gate to inevitable closings” in exchange for agreeing to CorePower’s desire for staggered closings. Level 4 argued that, therefore, CorePower’s only recourse, even assuming a breach of the ordinary course covenant, was through post-closing indemnification. The court agreed with Level 4, given the unusual structure of the APA, which suggested that the parties had intended that the closings would occur even if a party had breached the agreement. Moreover, the court held that Level 4 had not breached the ordinary course covenant because it had closed the studios in response to a directive from CorePower (as the franchisor) to do so. While the closure of the studios may have been “extraordinary,”101 the court reasoned, Level 4, as a franchisee, was contractually obligated under the franchise agreement to follow CorePower’s directives and its doing so was entirely consistent with its longstanding past practice.

Given the unique factual context, and the unlikelihood of similar facts in another case, the decision offers little predictive value as to future rulings on a buyer’s failure to close based on an extraordinary event occurring between signing and closing.

D. The Fairstone Decision

A Canadian court took an opposite approach to Delaware’s on the issue of whether responses to the COVID-19 pandemic constituted a breach of a typical ordinary course covenant. In Fairstone,102 the Ontario Superior Court interpreted a typical ordinary course covenant in light of the extraordinary circumstances relating to the pandemic. On that basis, the court found that the target company had not breached the ordinary course covenant.103 And because the pandemic was excluded from constituting an MAE,104 the court ordered the buyer to close the merger.105

The parties’ agreement provided that Fairstone, one of Canada’s largest consumer-finance companies, had to act in the ordinary course of business between signing and closing. The “ordinary course of business” was defined as acting “consistent with the past practices” and “in the ordinary course of [the company’s] normal day-to-day operations.”106 The agreement provided that Fairstone could request consent to act outside the ordinary course of business, and that the buyer, Duo Bank of Canada, could not unreasonably withhold such consent.107 In response to the pandemic, without seeking consent from Duo Bank, Fairstone made changes to its branch operations model, its collections process, its employment policies, its expenditures, and its accounting methodology.108

The Ontario court viewed it as appropriate to consider what would be considered ordinary course in the context of extraordinary circumstances. The court interpreted the covenant to permit the target company to operate as would be the ordinary course for responding to a disaster, and not to permit the buyer to use the covenant to trump operation of the no-MAE condition.109 In doing so, it emphasized that Fairstone’s actions were taken in good faith for the purpose of continuing, rather than changing, its business. It observed that the company’s responses to the pandemic were not related to economic challenges that were unique to the company, that they were designed to preserve the company’s normal operations to the extent practicable, and that they did not fundamentally change the company’s business.110 Moreover, the court held that, even if Fairstone’s conduct had fallen outside the ordinary course of business, Fairstone would not have needed to obtain Duo’s prior consent for its actions, as it would have been unreasonable for Duo to withhold consent under the circumstances.111

The Fairstone approach thus avoided the problematic result reached in AB Stable that, as a practical matter, the target company could not respond to the pandemic or other extraordinary event without breaching the ordinary course covenant, even though the pandemic or other event was excluded from the MAE condition. It also relied on a framework of analysis that was rooted in the factual context of the case. In other words, it recognized that there was nothing “unordinary” about a company adjusting its operations in response to plunging demand and revenues caused by an external extraordinary event—that this is, in fact, what any company would do in the ordinary course of business. Given Delaware’s very different interpretation of a typical ordinary course covenant, targets negotiating merger agreements who wish to ensure that they have flexibility to respond to an extraordinary event should consider seeking a reformulation of the standard covenant.

E. The Cineplex Decision

In Cineplex,112 the Ontario Superior Court reaffirmed the approach it took in Fairstone—and awarded the target a whopping almost CA$1.24 billion in damages for the buyer’s wrongful termination of the merger agreement based on the target’s pandemic responses allegedly having breached the ordinary course covenant.113

The Ontario court found that Cineplex Inc., a movie theater chain, had not breached the ordinary course covenant in the merger agreement pursuant to which it was to be acquired by Cineworld PLC. In response to the pandemic, Cineplex closed all of its theaters worldwide, and reduced spending and deferred payments to landlords, film companies, and others to save cash.114 The court’s reasoning proceeded in four steps. First, the court determined that the concept of “ordinary course” had to be read in the context of the whole merger agreement, which allocated systemic risks (including, specifically, the risk of “outbreaks of illness”) to the buyer.115 Second, the court noted that the actions taken by Cineplex were designed to preserve the business the buyer was to acquire—and, indeed, that the merger agreement (in the second clause of the ordinary course covenant), as is usual, required that the target take actions to seek to preserve the business.116 Third, the court observed that Cineplex’s pandemic responses were “temporary” and consistent with actions the company had taken in the past to manage liquidity issues when they arose.117 And finally, the court noted that provincial-government orders required that theaters be closed during the pandemic, and reasoned that Cineplex could not be “held in default of the Ordinary Course covenant when it was prevented from conducting its normal day-to-day operations by government mandate.”118

The Ontario court also distinguished Delaware precedent, emphasizing that, in AB Stable, Akorn, and Cooper Tire, the measures the target took were a substantial departure from the practices of the seller, as well as other companies in the same industry.119 The court’s analysis in this respect appears to leave room for some harmonization in future cases of the Delaware and Canadian approaches to ordinary course covenants. For now, however, Delaware’s approach, as reflected in AB Stable, Snow Phipps, and Level 4 Yoga, is that “ordinary course of business” (at least when modified by “consistent with past practice”) means the ordinary course as the company operated previously, during ordinary times. Canada’s view, as reflected in Fairstone and Cineplex, is that “ordinary course of business” means the ordinary course taking into account the occurrence of an extraordinary event. Importantly, of course, under either regime, if the parties’ intentions are otherwise, the court will follow them if they have been expressly stated in the agreement.

* * *

The Delaware Court of Chancery’s more narrow interpretation of a typical ordinary course covenant—requiring a comparison of the precise way that the company operated before and after an extraordinary event has occurred, removed from the context of the circumstances presented by the extraordinary event—most often will not reflect the likely intentions and expectations of the parties, in our view. For example, if a hotel company, in the five years prior to the pandemic, had flat employee expenses, would the parties really intend that, to operate in the ordinary course of business, employee expenses would have to continue to be flat no matter what? Or would the parties expect that, if demand for the company’s product and the company’s revenues were to fall dramatically, the company would reduce its employee expenses accordingly?

The Court of Chancery, in AB Stable, expressly rejected Strategic’s argument that it is inherently within any company’s ordinary course of business to cut back in the face of declining revenues even if the company had never had to do so before. In Snow Phipps, which generally followed the AB Stable approach, the court found that it was the target’s ordinary course of business to cut back in the face of declining revenues, given that the company had in fact done so previously when its revenues had declined. In our view, the Fairstone approach has the virtue of eliminating as a sine qua non the serendipitous question whether the specific situation had arisen previously for the company. Instead, the Fairstone approach recognizes the real-world practicality that there is nothing unordinary about companies cutting back when demand and revenues plunge.

III. consent (and other paradigms) do not provide sufficient flexibility for target responses to extraordinary events

A mainstream view is that a target’s ability to seek consent to operate outside the ordinary course of business saves it from being “trapped” by the ordinary course covenant in a situation where operating in the ordinary course does not make commercial sense (or conflicts with the target’s obligation under Clause 2 of the ordinary covenant to seek to preserve its business).120 A target can always request consent, and most agreements specifically provide that the buyer cannot unreasonably withhold, condition, or delay consent if it is requested.121

The Delaware Supreme Court, in its affirmance of AB Stable, effectively endorsed the consent mechanism as a productive route to resolving the dilemma a target faces when it is subject to an ordinary course covenant but it does not make commercial sense to operate in the ordinary course because an extraordinary event has occurred. The Delaware Supreme Court stressed that, as a target can seek consent from the buyer to depart from the ordinary course, the target is not forced to “run the business into the ground by continuing to operate in the ordinary course of business.”122 The court wrote:

The Ordinary Course Covenant involves the Buyer in the Seller’s response to disruptive events. The Buyer might have wanted to respond to the pandemic in different ways, to ensure the long-term profitability of the business or to prioritize one area over another. The Seller was not hamstrung by the Ordinary Course Covenant—it was simply required to seek consent before making the changes, and if consent was “unreasonably” denied, the Seller could have challenged the Buyer’s unreasonable denial of consent.123

The Delaware Supreme Court thus rejected the seller’s argument that its taking reasonable non-ordinary course actions did not violate the covenant, given that the buyer was prohibited under the agreement from unreasonably withholding consent and a withholding of consent would have been unreasonable under the circumstances. Instead, the Delaware Supreme Court appears to have been promoting negotiation between the parties as the appropriate mechanism for addressing the target’s perceived need for non-ordinary course responses to the pandemic.

Similarly, in the only other published article we know of examining the interaction between the standard MAE provision and ordinary course covenant in M&A deals, Deals in the Time of Pandemic,124 Subramanian and Petrucci observe that a merger agreement requirement for the buyer’s consent for non-ordinary course conduct pending closing has the effect of “forc[ing] the negotiation between buyer and seller over a mitigation strategy” after an extraordinary event occurs.125 Subramanian and Petrucci submit that this forced negotiation provides the “socially optimal” approach as a policy matter.126 Although they concede that the buyer has control in this situation, they assert that it is well-placed because a buyer has “correct incentives” to mitigate the damage from the occurrence of an extraordinary event, given that the buyer will own the company post-closing.127 Conversely, they assert, a target company’s “incentives are distorted,” because the target “would be, in effect, playing with the buyer’s money” as the buyer will own the company post-closing.128 They concede that they cannot predict “the directional effect of the distortion in the [target]’s incentives” (i.e., what kind of result would follow from the distorted incentives), but they propound that a target “could take actions that are too risky, too cautious, or simply opportunistic with respect to the buyer.”129

We respectfully disagree that the negotiation that ensues when a target seeks consent to take non-ordinary course actions in response to extraordinary circumstances is an appropriate mechanism for resolution of the fundamental dilemma that the target faces in this situation. A target’s agreement to sell the company for cash reflects, for the target, an exchange of an asset of uncertain value (the company) for an asset of certain value (the cash price). After the agreement is signed, and pending closing, the target ceases to have incentives with respect to the company other than to ensure that the deal closes. The target may have more incentive to be inactive than the buyer would, as the target will no longer benefit from a maximization of value of the company. But, certainly, the target does not have a “distorted” incentive to take action that would destroy value. After all, destroying the target’s value would risk an MAE that could provide a basis for the buyer not to close, and damage to the target that would be continuing as a standalone company if the transaction did not close (due to an MAE or any other reason). The buyer’s agreement to buy the company, on the other hand, reflects for the buyer an exchange of an asset of certain value (the cash price) for an asset of uncertain value (the company). The buyer, therefore, may well be incentivized to cause mischief after an extraordinary event occurs, as it may want to avoid closing or to renegotiate the deal. In the case of an agreement to sell a company in a stock deal, the target and buyer have equivalent incentives to maximize the value of the company pending closing, as they both would profit therefrom postclosing. But, depending on the circumstances, the buyer still may have the distorted incentives that arise from a preference not to close or to renegotiate.

Put differently, after the occurrence of a material, extraordinary event, a buyer may wish to proceed with the deal on the agreed terms, but very well instead may wish (a) not to proceed with the deal (either based on the actual or potential impact of the extraordinary event, or for reasons having nothing to with the event but using it as a pretext to exit the agreed transaction), or (b) to renegotiate the price or terms based on the extraordinary event having occurred. By contrast, the target arguably has an incentive in every case to preserve the business—both (a) to avoid any problem with the deal closing and (b) to keep the business intact in case the deal does not close.130

By denying consent to a target’s proposed (even eminently reasonable) responses to an extraordinary event, the buyer can put the target in the position of either risking an MAE if the target does not respond to the extraordinary event, or breaching the ordinary course covenant if it does respond. Either choice would enable the buyer to exit (or increase the buyer’s leverage to renegotiate) the agreement. Thus, in our view, a buyer-consent mechanism does not resolve the issue that a target may need more flexibility than the typical merger agreement currently provides to respond reasonably to extraordinary events.

The Snow Phipps decision suggests a different possible route—that is, a route not involving the buyer’s consent—to providing a target with the flexibility it needs under a standard ordinary course covenant. As discussed above, Snow Phipps established that, if a company takes actions in response to an extraordinary event that are similar to the actions it took to a similar extraordinary event in the past, then the responses would have been taken in the company’s ordinary course and would not violate the
covenant.131 One would then expect, for example, that now that most companies have experienced the COVID-19 pandemic, any future pandemic could be met with similar responses by a company without violating an ordinary course covenant. While this approach affords a target with some flexibility under the ordinary course covenant, it remains a problematic framework. For example, could similar actions be taken in the future without violating the covenant only if there is another pandemic, but not another type of extraordinary event? And must the future pandemic resemble this one, in terms of government-ordered shutdowns, global impact, and so on? Or does the approach provide flexibility in the event of any viral outbreak affecting the company, any public health emergency, or even any event causing a decline in earnings? Beyond these interpretive difficulties, the fundamental problem is that a target’s flexibility to respond reasonably to an extraordinary event should not depend upon the serendipity that the company happened to face, or not to face, the same (or a similar) event in the past.

IV. how the drafting of maes and ordinary operating covenants has changed in response to the covid-19 pandemic

Market practice in drafting MAE and ordinary course provisions has evolved in a number of respects in response to the pandemic. Our conclusions, discussed below, are based on our analysis of the 86 publicly available merger agreements that were entered into during the second half of 2021 and through the end of January 2022, for a U.S. target company, with a transaction value of at least $100 million, and not involving an affiliated transaction or spinoff.132

Our study is the first to analyze MAE and ordinary course provisions in merger agreements that were entered into after the beginning of the second half of 2020—when M&A activity (which had paused early in the pandemic) had resumed in force and when sufficient time had passed from the beginning of the pandemic so that market practice could evolve in response. In addition, our study is the first to focus specifically on the issue of the flexibility provided for target responses to the pandemic or other extraordinary events.

As we discuss below, while we observed changes in the drafting of MAE clauses, the most important changes related to the drafting of ordinary course covenants. In a solid majority (65%) of the agreements we surveyed, based on the ordinary course covenant, the target is prohibited, absent buyer consent, from taking non-ordinary course actions relating to the pandemic except to comply with legal requirements and/or guidance issued by governmental authorities relating to the pandemic. However, in a meaningful minority (33%) of the agreements we surveyed, the target is permitted to take any reasonable action in response to the pandemic (and, in some cases, future pandemics or public health events), without further restriction or definition. Moreover, in 29% of the agreements that permit reasonable action in response to the pandemic, reasonable action also is permitted in response to “exigent circumstances” (or “extraordinary events”) other than the pandemic (or future pandemics). The agreements thus reflect meaningful movement toward providing flexibility to respond to the pandemic—the extraordinary event that had occurred and was ongoing at the time the agreement was entered into—and even some considerable movement toward providing flexibility to respond to future extraordinary events that might occur.133

We also observed a meaningful increase in “target-friendly” clauses in the general formulation of the ordinary course covenant that should provide (albeit indirectly) some additional flexibility to respond to extraordinary events of all kinds. For example, as described below, the agreements reflect a notable uptick in inclusion in the covenant of a requirement that the buyer cannot unreasonably withhold consent to the target’s request to take non-ordinary actions; an efforts standard (rather than the covenant being stated as a flat obligation); a materiality standard; and less frequent inclusion of a “consistent with past practice” standard. While these target-friendly general clauses do not provide any clear definition, or even rough parameters, as to what types of actions would be permissible, these drafting changes reflect an evolution in market practice indicating that merger parties recognize that targets need more flexibility to respond to extraordinary events than is provided by the sole reliance on buyer consent that has been advocated by Subramanian and Petrucci and endorsed by the Delaware courts.134

A. Related Studies

In our discussion, we note data from the following other recent studies on MAEs and ordinary course covenants:

ABA Study. The 2021 American Bar Association Deal Points Study135 surveyed the most recent set of agreements other than ours. The ABA reviewed 138 publicly available merger agreements, for transactions that closed in 2021 and involved deal consideration over $200 million.136 It therefore covers agreements entered into roughly from the beginning of the third quarter of 2020 through the third quarter of 2021. Our study updates these results based on more current data for a time during which market practice was further evolving. As discussed below, our results reflect an acceleration of the trends identified in the ABA Study.

Subramanian-Petrucci Study. In their article, Deals in the Time of Pandemic,137 Subramanian and Petrucci analyzed the 1,293 publicly available merger agreements announced between January 2005 and April 2020 with a deal value of at least $1 billion.138 Their sample set thus covered agreements entered into before, or in just the first few months after, the pandemic’s emergence in the United States, when M&A activity was largely on pause.

NP Survey. In the 2020 edition of their annual survey on MAE clauses, the Nixon Peabody law firm (NP) reviewed 220 publicly available M&A agreements entered into between June 1, 2019 and May 31, 2020, for transactions with a value over $100 million.139 The survey looked only at MAE clauses and, as NP noted, “the majority of deals [reviewed] were entered into before the pandemic,” with a portion of them “entered into at the height of [the pandemic-related] lockdown” when M&A activity had virtually ceased.140

Coates-Davidoff Solomon Studies. These studies, by John C. Coates IV and Steven Davidoff Solomon, respectively, were part of the expert testimony submitted to the court in the AB Stable litigation.141 Both professors surveyed the same set of 144 merger agreements, with values above $1 billion, entered into during the year prior to the merger agreement (dated September 10, 2019) that was at issue in the case.142 The agreements that they surveyed thus preceded the emergence of the pandemic. The focus of their study was on the various articulations of MAE Exclusions that specified or potentially related to pandemics.

Based on the time periods during which the agreements reviewed in these various studies were entered into, the ABA Study serves as a check on our survey of an updated sample set. The Subramanian and Petrucci Study (with respect to the early 2020 agreements in that survey) provides a reference point for determining whether our results reflect any evolution of practice since the outset of the pandemic. And both the NP Survey and the Coates-Davidoff Solomon Studies provide recent historical context with respect to MAE clauses.

B. Key Findings Regarding MAE Provisions

The key relevance of our findings with respect to MAEs is that the specific mention of “pandemics” and COVID-19—as well as the increased (albeit modest) incidence of some parameters with respect to the target’s “industry” for purposes of the “disproportionate effect” clause—reflect a market instinct to grapple with and address the extraordinary event (the pandemic) that was ongoing at the time the agreements were entered into.

Universal exclusion of “pandemics.” All of the agreements in our survey specify “pandemics” as an MAE Exclusion. All of the agreements surveyed also specifically reference “COVID-19” and/or “COVID-19 Measures” (defined generally as COVID-19-specific laws and/or government-issued guidelines) in the MAE clause.

This result is consistent with (and shows an increase from) the findings of the ABA Study (the most recent study other than ours), which reported that 97% of the agreements in that survey sample contained an MAE Exclusion for “pandemics” or other public-health events.143 Earlier studies reflect a lesser incidence of specific mention of “pandemics” as an MAE Exclusion. Subramanian and Petrucci reported that the incidence was 60% in the early 2020 agreements they surveyed.144 The Coates Report, which studied a set of agreements entered into just before the pandemic emerged, indicated that just 33% of the agreements specifically mentioned pandemics, epidemics, public health crises, or influenzas (while 87% contained exclusions for natural disasters, crises, or calamities).145

We note that while the now-universal specification of “pandemics” in the list of MAE Exclusions provides some additional clarity, it is of little moment as a substantive matter. Given the Delaware courts’ holdings in AB Stable and Snow Phipps (discussed in Part II, supra), pandemics generally would be excluded in any event under the broader terms (such as “calamity,” “natural disaster” or “Act of God”) that have been commonly included in the list of specified MAE Exclusions. Every one of the agreements we surveyed includes broad terms that, under the reasoning in AB Stable and Snow Phipps, would encompass the concept of pandemics (thus counting pandemics as MAE Exclusions even if the word “pandemic” had not been used).

Frequent use of a “disproportionate effect” exception to the “pandemic” MAE Exclusion. In 81% of the agreements we surveyed, there is an exception to the MAE Exclusion for COVID-19 and/or other “pandemics” if (or, in many cases, only to the extent that) the pandemic has a disproportionate effect on the target as compared to other companies in the same industry (i.e., if, or to the extent that, there is a disproportionate effect on the target, the pandemic is not then excluded from constituting an MAE).

Our finding is consistent with the ABA Study’s observation that pandemic-related MAE Exclusions were subject to the disproportionate effect exception in 80% of the agreements in that survey.146 The Subramanian-Petrucci Study noted a general rise in the use of disproportionate effect exceptions—with an average of two MAE Exclusions per deal subject to the disproportionate effect exception in the 2005 agreements surveyed, increasing to an average of six per deal in the 2020 agreements.147

Significant increase in (but still infrequent) inclusion of a definition of the “industry” in disproportionate effect clauses. 28% of the agreements we surveyed provided some limitation on or definition of the companies to be used as the comparison group to determine if there was a disproportionate effect on the target. Of these agreements, more than one-third provided an actual definition of the industry;148 one-quarter referenced companies in the same “geographic region” in which the target operates; almost one-third referenced companies of “similar size” in the same industry; and approximately one-fifth referenced “similarly situated” companies in the same industry.149

Thus, there was a substantial increase in—although still a low incidence of—efforts by merger agreement parties to provide some definition around the peer group of companies to be considered when determining disproportionate effect. Subramanian and Petrucci reported that only “a handful” of the agreements they surveyed (less than 1%) provided a definition of the industry in which the target operated.150

We note that this issue has become more relevant in light of recent judicial decisions highlighting both the difficulty that courts have had in identifying the relevant companies to be considered to determine whether there was a disproportionate effect on a target, and the potentially determinative effect of that determination on the judicial result with respect to disproportionate effect.151 Accordingly, we expect that, going forward, more agreements will include some definition of or parameters with respect to the relevant peer group for purposes of the disproportionate effect clause. The geographical region modifier also may appear more frequently in the future, as COVID-19 developments over time may highlight the fact that extraordinary events with wide impact can affect different parts of the country or world very differently at various points in time.

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MAE clauses receive an inordinate amount of attention from academicians and often consume a significant amount of time in the negotiation of a merger agreement. However, given the high standards applied by the courts for a finding of an MAE, the now-common extensive list of MAE Exclusions, and the rarity of disproportionate impacts from extraordinary events that are typically included as MAE Exclusions, it is unusual for an MAE provision to provide a strong basis on which a buyer would be entitled to terminate an agreement or could renegotiate a significant price
reduction.152 Therefore, the changes in drafting of MAEs we have discussed ultimately have little substantive importance, and our findings in the following Section regarding ordinary course covenants are of greater interest.

C. Our Key Findings Regarding Ordinary Course Covenants

Since the issuance of AB Stable, more attention has been paid to ordinary course covenants. Nonetheless, studies analyzing these covenants remain sparse.

Our study indicates that there have been meaningful changes to the drafting of ordinary course covenants over the past year that reflect an effort to address a target’s need for flexibility to respond to extraordinary events. These include a higher incidence of general target-friendly clauses and some specific flexibility to respond to the COVID-19 pandemic (and, in some cases, future pandemics as well). While the flexibility in most cases is limited to responding to pandemic-related legal requirements and governmental guidance rather than actions relating to preservation of the business, a significant minority of the agreements permit the target to take any reasonable action in response to the pandemic, and a smaller (but notable) minority of the agreements provide flexibility for the target to take reasonable actions to respond to extraordinary events beyond this or another pandemic.

Our key findings are as follows:

Increase in (target-friendly) prohibition on the buyer “unreasonably” withholding consent for the target to act outside the ordinary course. The incidence of this provision has increased.153 In 93% of the agreements we surveyed, there is an express requirement (with respect to Clause 1 of the covenant—which, as discussed in Part I, is the general affirmative covenant to operate in the ordinary course) that the buyer not “unreasonably” withhold, condition or delay consent to a request by the target to act outside the ordinary course of business. The ABA Study found that 89% of the agreements in that database so provided.154 Subramanian and Petrucci reported that, across their database, 79% of the agreements that included an express consent exception to Clause 1 of the ordinary course covenant provided that the buyer could not unreasonably withhold such consent.155 Of note, none of the agreements we surveyed provides any definition or parameters with respect to what would constitute unreasonableness in withholding consent (either in the context of the pandemic or otherwise).

Increase in use of a (target-friendly) “efforts” standard rather than a “flat” obligation to operate in the ordinary course. Use of an efforts standard156 has increased significantly. In our survey, 49% of the agreements provide for an efforts standard (in Clause 1 of the covenant). Our finding is consistent with the ABA study’s finding that 49% of the agreements in that study included an efforts standard (for the target’s obligation in Clause 1 of the covenant).157 Subramanian and Petrucci reported only a 30% incidence of an efforts standard in the early 2020 agreements surveyed in their study (up from 10% in the 2005 agreements
surveyed).158

Increase in use of a (target-friendly) “materiality” qualifier to the ordinary course obligation. Use of a “materiality” qualifier159 has increased significantly. 59% of the agreements we surveyed contain (in Clause 1 of the covenant) a materiality qualifier.160 This represents a significant increase in the use of a materiality qualifier from the 40% incidence reported in the Subramanian-Petrucci article for the early 2020 agreements they surveyed.161

Decrease in use of a (buyer-friendly) “consistent with past practice” qualifier. There was a notable decrease in qualifying “ordinary course” with the phrase “consistent with past practice.”162 53% of the agreements we surveyed contain the “consistent with past practice” qualifier. This result shows a decrease from the 68% incidence reported in the ABA Study;163 and a further decrease from Subramanian and Petrucci’s finding that the qualifier declined from an 80% incidence in the 2005 agreements to 60% in the early 2020 agreements they surveyed.164

Flexibility to respond to the COVID-19 pandemic. As would be expected, almost all (98%) of the agreements we surveyed expressly provide that the target can take actions required to comply with laws. In a clear majority (64%) of the agreements we surveyed, the target’s flexibility to respond to the pandemic is tied directly to laws or COVID-19 measures issued by governmental authorities. In these agreements, the target can take an action outside the ordinary course of business (without the buyer’s consent) only if the action is required by, or (in some agreements) the action is reasonably taken in response to, a law or a COVID-19 measure.165 However, in a meaningful minority (34%) of the agreements surveyed, the target can take any reasonable action in response to the pandemic.166

Flexibility to respond to extraordinary events other than the COVID-19 pandemic. 10% of the agreements surveyed provide that the flexibility provided to the target to respond to the COVID-19 pandemic also applies with respect to future pandemics (or, in some agreements, epidemics, public health events, viruses, and/or disease outbreaks). Notably, 9% of the agreements surveyed provide that the target is permitted to take reasonable actions in response to any “exigent circumstances” or “extraordinary events” other than pandemics.167

Interrelationship of Clauses 1, 2 and 3.As discussed in Part I, in the ordinary course covenant, what we have labelled “Clause 1” provides that the target will operate in the ordinary course; “Clause 2,” that the target will seek to preserve its business and relationships; and “Clause 3,” that the target will not engage in a list of specified actions.168 In Cineplex, as discussed in Part II above, the Canadian court noted the inconsistency of a target’s being required under Clause 1 to operate in the ordinary course yet being required under Clause 2 to seek to preserve the business when doing so required it to operate outside the ordinary course. In the agreements we surveyed, almost every agreement provides the same pandemic-related exception to the obligations under both Clauses 1 and 2 (thus resolving this issue).169

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One can only speculate whether, as the pandemic ultimately endures or recedes, the perception of a need for flexibility to respond to extraordinary events will increase or fade. In a world with ever-increasing occurrences of events once thought remote, we suspect that the need for greater flexibility for targets (while preserving appropriate protection for buyers) in these types of circumstances will become increasingly apparent.

V. rethinking and redrafting ordinary course covenants and maes

To recap, after signing and prior to closing, a buyer will soon own the company—that is, assuming the deal closes. The target company’s operations during the interim period are thus effectively for the buyer’s account. As a result, the buyer will want, and seemingly should be entitled, to restrict the target to its ordinary business operations unless the buyer otherwise consents. The typical interim covenant reflects this paradigm.

At the same time, however, the target will continue its existence if the closing does not occur and will therefore want to preserve its business during the interim period.170 Moreover, if an extraordinary event occurs during this interim period, it could negatively affect the company—potentially (albeit rarely) rising to the level of an MAE, which could give the buyer the right not to close. The target may thus want, and arguably needs, the flexibility to respond to extraordinary events, which often will require responses that depart from the ordinary course of business. Without contractual authority to respond reasonably to an extraordinary event that occurs during the interim period, if the buyer will not consent to the response, the target could be in the position of damaging the business and risking an MAE if it does not take action or breaching the ordinary course of business if it does take action—either of which could entitle the buyer to terminate, or provide the buyer with leverage to renegotiate, the agreement.

When parties enter a merger agreement amid an ongoing or actively anticipated extraordinary event, they usually consider the target’s need for flexibility to respond to that event171—as has occurred in the case of the COVID-19 pandemic. However, the flexibility that has been provided with respect to the pandemic, in the majority of cases, has been limited to responses to laws and COVID-19 Measures issued by governmental authorities. Moreover, the flexibility largely has not extended to other extraordinary events, including those for which parties have allocated risk to the buyer through the MAE provisions. The greater the uncertainty of closing, and the longer the expected duration of the interim period, the greater the target’s need for flexibility to respond to extraordinary events.

There must be a balance, of course, between a target’s desire to have full flexibility to respond to significant, negative extraordinary events that arise, and a buyer’s desire to limit to the ordinary course of business the target’s actions pending closing even (or, perhaps, particularly) if extraordinary events arise. The typical interim covenant, however, leaves it to the discretion (albeit the reasonable discretion, in most cases) of the buyer whether the target can take any action outside the ordinary course of business in response to an extraordinary event. Although most agreements provide that the buyer’s consent to such responses cannot be unreasonably withheld, they do not provide parameters as to what would be reasonable, leaving the parties with significant uncertainty as to what actions can be taken in these difficult circumstances.

As discussed above, a buyer that wants to close would be expected to want to consent to a reasonable response by the target. But a buyer that would rather not close (or would want to renegotiate the price or terms) could deny consent with the objective of increasing the likelihood of an MAE or forcing the seller to breach the ordinary course of business covenant in order to avoid an MAE. Moreover, as most MAE provisions prevent most circumstances from rising to the level of an MAE unless there is a disproportionate impact on the target, to the extent a buyer may tie a target’s hands in responding reasonably to an extraordinary event, the buyer may increase the likelihood of a disproportionate impact as compared to other companies whose hands are not tied.

A. A New Approach to Ordinary Course Covenants

Merger parties should consider extending the trends that have evolved over the course of the pandemic, to provide greater flexibility to targets to response to extraordinary events, while constraining the skewed incentives of both the buyer and the target. While the Delaware courts, as reflected in AB Stable, Snow Phipps, and Level 4 Yoga, have adopted a narrow approach to interpreting standard ordinary course covenants (based on a plain reading of the typical language), the court will respect the parties’ intentions to the contrary to the extent clearly set forth in their merger agreement. Taking the approach outlined by the Canadian court in Fairstone and Cineplex, merger parties could embed in the ordinary covenant a concept of reasonableness, with the parameters for reasonableness set forth in the agreement. This approach would limit the improprieties that flow from arguably skewed incentives on both sides and would provide greater certainty for the parties than under the current typical framework.

We suggest that merger parties consider one or more of the following possible approaches:

Following the current, more target-friendly trends in respect of ordinary course covenants. These would include, as discussed in Part IV above, a “not unreasonably withheld” requirement for the buyer’s consent, an “efforts” standard, a “materiality” modifier, and/or elimination of a “consistent with past practice” modifier.

Defining “reasonable” responses the target would be permitted to take in response to an extraordinary event. The inclusion of an express requirement that the buyer not unreasonably withhold consent to a request by the target to take a non-ordinary course action goes a long way towards providing the target with needed flexibility to respond to an extraordinary event. However, the result, arguably, is less than optimal, as the buyer (based on potentially skewed incentives to terminate or renegotiate the transaction after the occurrence of an extraordinary event) may stall in providing the consent or even refuse it, which then would require that the target bring litigation to challenge the delay or refusal. Instead, it may be preferable to provide some definitional parameters as to what would constitute unreasonable withholding of consent. Such parameters could include, for example, reference to actions that are (a) reasonably required to comply with law; (b) reasonably taken to comply with or in response to nonbinding government-issued guidance or recommendations; (c) consistent with (i) actions taken by the target in the past in response to the event, similar events, or any other extraordinary events; (ii) responses that other companies in the same industry (or “similarly situated” companies in the same industry) are taking or have taken; and/or (iii) responses that are being taken to the same event (or were taken in response to similar events in the past) by the buyer (and/or, if the buyer has portfolio companies, by its portfolio companies); and/or (d) reasonably necessary (or advisable) to mitigate business disruptions, revenue declines, and/or other specific issues (such as the health and safety of employees, customers, or others) arising from the extraordinary event.172

The provision could also define the types of extraordinary events to which it would apply. For example, it could apply to any event that is unusual or remarkable, only to specified events, or only to specified categories of events. Such specified events or categories could include events exogenous to the company but unknown to the parties at the time of signing or not reasonably anticipatable at the date of the agreement, or events with risks that the parties have allocated to the buyer through the MAE Exclusions.

Alternatively, to address the timing and other issues that would arise if the buyer unreasonably withholds, conditions or delays consent, the agreement could provide that the target in that circumstance could act reasonably (as defined) without the buyer’s consent. Under this scenario, it would be left to the buyer to challenge the unreasonableness of the actions taken (rather than requiring the target to challenge an unreasonable withholding, conditioning or delay of consent).

Specifying a process for the target to consult with the buyer in advance of taking any non-ordinary course action in response to an extraordinary event. A notice and consultation requirement provides the same opportunity for input from and discussion with the buyer as a buyer consent provision does, but without the buyer having total control over the result. We note that, as we have proposed, the target would not have total control either, as the parties would specify the parameters for reasonable action in the agreement. The consultation obligation could be made inapplicable when not practicable or in “emergency” circumstances (in which cases prompt notice would nonetheless have to be provided). A detailed consultation process could be outlined with specificity to ensure appropriate timing and certainty—both for the buyer to consider its response and for the target to be able to move quickly when required in the face of an extraordinary event.173

Providing for an expedited arbitration process in real time. Merger parties could also consider providing for an expedited arbitration mechanism to determine, within a quick timeframe, whether a proposed action by the target that may be outside the ordinary course (or the withholding of consent thereto by the buyer) meets the parties’ defined parameters for reasonableness. An expedited arbitration framework, invocable by either party, would help to incentivize both parties to act reasonably with respect to possible non-ordinary course actions the target may seek to take (and as to which the buyer may seek to withhold consent). By providing that an independent, objective party will make a determination as to reasonableness of the action (or unreasonableness of the withholding of consent) before such action is taken, the game theory relating to the transaction more broadly should be largely eliminated. In other words, the parties would be incentivized to focus narrowly on the issue of reasonableness of the proposed action, and not to use the target’s desire to engage in the action as an opportunity for unrelated delay, derailing, or renegotiation of the transaction.

Providing for waiver by the buyer of the no-MAE (and possibly other) closing conditions. An alternative formulation, which would provide some additional protection for the buyer as compared to those listed above, would be for the buyer’s consent to be required for non-ordinary course actions, and for the buyer to be entitled to grant or withhold such consent in its discretion but only if, in the context of an extraordinary event having occurred, the buyer waives the no-MAE condition with respect to that event. Depending on the circumstances, it may be more appropriate in this situation for the buyer to waive the MAE condition entirely, or even to waive all remaining conditions to closing (other than those legally required such as regulatory approvals). The target’s need for flexibility would be greatly reduced in light of the buyer’s waiver of its right to claim an MAE based on the event that occurred. Correspondingly, the buyer’s entitlement to control over the target’s responses (subject to any applicable antitrust limitations) would be cabined in light of the greater certainty of closing the waiver would afford.174 This approach might be coupled with a reverse termination fee payable by the buyer if for any reason the transaction does not close after the buyer has obtained such control.

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Of course, the value of any one or more of the foregoing formulations of the ordinary course covenant will depend on the particular facts and circumstances in any given case. Variables to be considered would include, among many other factors, the nature of the parties’ respective businesses, the perceived likelihood of closing, the perceived relative negotiating leverage of the parties, the extent of the buyer’s commitment to closing, and the level of confidence each of the buyer and the target has in the other’s management to make good business decisions. Moreover, any modification of the standard formulation of the covenant would be subject to at least some degree of uncertainty with respect to the judicial interpretation and result.

In all cases, the new focus on, and recent Delaware decisions addressing, ordinary course covenants underscore the need for targets to pay special attention to various factors relating to the covenant. To begin, targets should be mindful of the precise drafting of the ordinary course covenant in a merger agreement, and its interaction with the MAE provision, with a focus on the risk of the buyer using the ordinary course covenant as a back-door to escape closing under a lesser standard than an MAE. Additionally, targets should seek to ensure that they comply precisely with notice and consent provisions in the ordinary course covenant before taking an action that may be outside the ordinary course of business. Also, targets should build a record establishing, with respect to actions taken pending closing that may be outside the ordinary course, the need for such actions and the extent to which they are consistent with the company’s own and other companies’ operations and responses to the event or to similar events in the past.

B. A New Approach to MAE Conditions

While less critical, merger parties should also consider tailoring of the standard MAE condition if there are special circumstances present. For example, subject to its negotiating leverage and the specific facts, circumstances, and concerns, a buyer might seek to provide in the MAE definition that a specified significant short-term trend at the target company would be a basis for an MAE—that is, to eliminate the judicial requirement for “durational significance” of a decline.175 For companies that are startups, that are going through cash quickly (a high “burn” rate), that are suffering continuing losses, or that are in a deteriorating financial position, an MAE might be defined as an increase in the present rate of losses or decline in revenues. In a deal subject to regulatory approval and significant delays, the parties could consider having the MAE condition drop out after the shareholder vote or after obtaining regulatory approval. Under certain circumstances, including where the target has unusual leverage, perhaps eliminating the no-MAE condition entirely would be appropriate.

In addition, rather than simply listing “general industry-wide conditions” as an MAE Exclusion, the parties may wish to provide separate and specific treatment for certain conditions that could reflect either industry-wide or company-specific conditions, and which could or could not have a disproportionate effect on the target. For example, the parties might consider dealing specifically with an event such as the emergence of new competition or the development of new regulatory conditions. If a “disproportionate impact” exception is provided, the parties should consider whether a disproportionate effect on the target would have to be “material” to be considered and whether the industry relevant for the comparison should be specified (or, alternatively, whether the comparison should be to a subindustry or a list of specified “peer companies”).

Still other arrangements may be appropriate for situations like the one seen in Snow Phipps, where the buyer has already successfully negotiated a reduction in the anticipated price because an extraordinary event occurred or was anticipated before the merger agreement was signed. In this context, in light of the price reduction, depending on the circumstances, the target should consider seeking a corresponding carveout from the MAE definition, otherwise scaling back the MAE, or even eliminating the MAE condition entirely.

Finally, it should be appreciated that Snow Phipps and Level 4 Yoga highlighted an essential timing difficulty relating to the no-MAE condition—namely, that at the time a target company asserts an MAE and the agreement may be terminated, it is unknown, if litigation ensues, what the target’s financial situation will look like when a court considers, in hindsight, whether an MAE occurred or was reasonably expected. As a practical matter, if the company has recovered or is well on its way to recovery, the court is more likely to conclude that an MAE was not reasonably expected when the buyer asserted it. Merger parties may want to consider providing that termination based on an MAE or an ordinary course covenant could not occur for at least a specified period of time after the buyer provides notice of its intention to terminate. This time period would provide at least some opportunity for further development of the company’s financial situation, time to consider renegotiation of the price without the termination being absolutely imminent, or time for an opportunity to cure the issue.

Conclusion

The COVID-19 pandemic has provided a dramatic reminder that extraordinary events can arise between signing and closing a deal. Although the pandemic has been a truly exceptional event, extraordinary events come in many less spectacular forms, actually occur with some frequency, and almost always necessitate extraordinary responses. The Delaware decisions issued to date relating to the pandemic—AB Stable, Snow Phipps, and Level 4 Yoga—highlight that the typical formulations of MAE conditions and ordinary course of business covenants do not necessarily operate to reflect the parties’ intentions with respect to risk allocation for extraordinary events. Importantly, however, these decisions also underscore that there is no predetermined definition of an “MAE” or of “the ordinary course of business.” These terms simply mean whatever the parties say in their merger agreement that they mean.

To be sure, certain features of these provisions have become common. In addition, Delaware precedent has firmly established a generally narrow judicial interpretation of MAE clauses—as a result of which the Court of Chancery decided in AB Stable, Snow Phipps, and Level 4 Yoga (as well as every other MAE case but one that it has ever decided) that an MAE did not occur. Delaware has now confirmed a similarly narrow interpretation of ordinary course covenants, holding that “the ordinary course of business consistent with past practice” is determined based on a simple comparison of how the company was operated before and after an extraordinary event, without taking into consideration the context that an extraordinary event has occurred. As a result, in AB Stable, the court held that the target’s responses to the pandemic, although perfectly reasonable and expected in light of the pandemic, breached the ordinary course covenant. (And the result would have been the same in Snow Phipps, except that the target’s responses were de minimis and mirrored actions the target happened to have taken previously during periods of decline in its revenues. Likewise, it would have been the same in Level 4 Yoga, except that the buyer, as the franchisor, had directed the target’s responses and the target, as the franchisee, had followed the franchisor’s directives in the past.)

Nonetheless, as noted, merger-agreement parties can agree to draft these provisions in a tailored way to reflect the particular issues and concerns relevant to the specific transaction, company, industry, and times. This Essay urges that, where appropriate and feasible, the parties consider doing so—particularly given that extraordinary events are not all that extraordinary in terms of their frequency, and that they often, as a reasonable business matter, call for extraordinary (that is, non-ordinary course) responses. Moreover, arguably, it is actually in a company’s ordinary course of business to respond to extraordinary events with reasonable actions otherwise outside the ordinary course. In other words, responding to a major crisis by conducting business as usual in most cases would be extraordinary, not ordinary. Further, we believe it is socially and economically optimal not to leave it solely in the buyer’s discretion whether those actions can be taken. Rather, providing a target with flexibility to respond in reasonable ways after consultation with the buyer, with the parameters for reasonableness established in advance, would check both parties’ distorted incentives in these scenarios. This approach would promote a more appropriate balance between a buyer’s and a target’s needs and discretion, and, we believe, would lead to the soundest business decisions being made in the aftermath of an extraordinary event.

Gail Weinstein is Senior Counsel at Fried, Frank, Harris, Shriver & Jacobson in New York City, where she previously was a Corporate Partner. David Cooperstein, a 2021 summer law clerk at Fried Frank, is a student at the University of California, Berkeley School of Law, where he is a Scholar at the Berkeley Center for Law and Business. The authors thank Philip Richter, Co-Head of M&A at Fried Frank, for valuable comments on an earlier draft.

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