A Black Swan in M&A COVID 19 Lake: A Material Adverse Effect that Could Strike at Merger and Acquisition Deals


Many mergers and acquisitions, including investments, have a time period between signing the transaction agreement and closing the transaction. Several factors may lead to that time period such as the need to obtain regulatory approvals (e.g., Competition Authority, the Israeli Lands Authority) to complete the transaction or to obtain the approval of the target company’s lenders or shareholders.

That time period usually ranges between several weeks to several months. During this period, the economy, the relevant market and the target company may experience changes that may significantly deteriorate the value of the target company or the buyer’s desire to close the transaction and acquire the target company.

A common closing condition for mergers and acquisitions that is added to the underlying agreement, at the buyer’s request, is that there has been no material adverse change (MAC clause) or material adverse effect (MAE clause) with respect to the target company and its business and operations from the date of signing the agreement to the date of closing the transaction.

Could the effect of the COVID 19 epidemic be a material adverse effect under Israeli law which would allow the buyer to withdraw from the transaction?

No Israeli court decision on material adverse effect in mergers and acquisitions have been published.

Israeli courts ruled in material adverse effect cases in other areas such as in connection with financing agreements or project finance, but those cases have been decided on factual basis with no thorough legal analysis.  For example, District Court ruled in 2009 that there has been no material adverse effect with respect to a financing deal because, although the borrowing company had losses, those losses decreased during the examined period and therefore there has not been a material adverse effect. Those cases have not provided legal doctrine or framework for analyzing material adverse effects cases.

In matters of this kind, the Israeli courts sometimes tend to review the rulings of Court of Chancery of Delaware, which are often a cornerstone of precedents in mergers and acquisitions.

Delaware courts have often held that a material adverse effect clause is intended to protect the buyer from unforeseen events that materially affect the target company’s revenue potential over a reasonable commercial time, and that a buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to withdraw from a transaction.

We can assume for purpose of our discussion that the COVID 19 epidemic is an unforeseen event that can have a significant impact on a target company. For example, the impact of the COVID 19 epidemic can be dramatically seen on airlines, hotels, cruises, restaurants and tourism companies. But is it an event that will affect the target company’s revenue potential over a reasonable commercial time?

In the Tyson Foods matter of 2001, the Court of Chancery of Delaware held that a 64% drop in quarterly earnings did not constitute a material adverse effect. The court held that a change during quarter or so is a short-term change (‘Hiccup’ – in the language of the court) that did not rise to a material adverse effect. The court held that “A short term hiccup in earnings should not suffice; rater Material Adverse Effect should be material when viewed from the longer-period perspective of a reasonable acquiror”.

In the Hexion matter of 2008, the Court of Chancery of Delaware affirmed the Tyson Foods decision and noted that reasonable time was measured in years rather than months. The court held that “The important consideration therefore is whether there has been an adverse change in the target’s business that is consequential to the company’s long term earning power over a commercially reasonable period, which one would expect to be measured in years rather than months”.  In another matter, the Delaware court hinted that a 50% reduction over two consecutive quarters could rise to a material change.

The Akron matter of 2018 was the first time that the Court of Chancery of Delaware concluded that the buyer may not close the transaction due to a material adverse effect. Akron (the target company) had an 86% drop in EBITDA from the prior year and a drop of 51% in adjusted EBITDA from the prior year. That drop continued for at least a year (rather than a quarter or two) with a departure from its historical trend. The reasons for the drop in performance (significant competitor entry and loss of significant contracts) had future implications on Akron’s earnings and were not momentary.

In the Channel Medsystems matter of 2019, which has been decided after the Akron matter, the court reiterated the heavy burden of establishing a material adverse effect in order of a buyer to withdraw from a transaction.  The court repeated the determination that the effect should substantially threaten the overall earnings potential of the target company in a durationally-significant manner for a reasonable period.

If Israeli courts will follow the decisions of the Court of Chancery of Delaware, then it would make it difficult for a buyer to withdraw from a transaction in case that the COVID 19 epidemic has only a temporary effect over several months or quarters, without “destroying” the target company’s future earning potential.

The requirement of “destroying” the target company’s future earning potential over time in order to trigger a material adverse effect clause might mean in certain cases that the fundamental reason for the buyer’s desire to buy the target company has been frustrated. Therefore, such requirement of material adverse effect in certain cases brings that clause closer to the contractual right of exemption by reason of constraint or frustration of contract pursuant to section 18 of the Contracts Law (Remedies for Brach of Contract). Section 18 is a shield protecting against a breach of contract and not a sword. It allows a breaching party not to be subject to specific performance or damages. Section 18 requires unforeseen preventive circumstances which cannot be avoided that result in the inability to perform the agreement or in the performance of the agreement being fundamentally different from the agreement between the parties (“contract frustration”).

One should also consider the duty of good faith which is a fundamental concept of Israeli contract law. A buyer who wishes to withdraw from a transaction due to a material adverse effect will be required to act in good faith. Good faith may prevent the exploitation of situations in order to be released from an agreement when the material adverse effect is temporary or limited in its effect.

The foregoing dealt with general material adverse effect clause. One should remember that sometimes mergers and acquisitions agreements include complex material adverse effect clauses that attempt to exclude from a material adverse effects events that adversely affect the entire economy or the market in which the target company operates. Those complex clauses mainly intended to divide the risk between the parties so that the buyer carries the risk of changes affecting the overall economy or market while the seller carries the risk of changes that affect the target company. In the case of such exclusions, the buyer will find it difficult to justify a material adverse effect claim where the effect of COVID 19 epidemic on the target company is proportional to its effect on other companies operating in the target company’s market or overall in the Israeli economy.

In light of the above, the prospect of a buyer withdrawing from a transaction through a material adverse effect as a result of the COVID 19 epidemic will increase as the impact of the COVID 19 epidemic will erode the target company’s earning potential over time, and in fact will undermine the target company’s earning source beyond the period of the COVID 19 epidemic. This effect will vary from industry to industry. In any case, this threshold, even if it is lower than the threshold required for the cause of contract frustration, is a high threshold that cannot be easily proven.

For future transactions, we recommend explicitly defining a material adverse effect based on objective or other financial condition, with an emphasis on the type of exclusions so that both the buyer and the seller are aware who of them will bear the economy and market risk and who will bear the company risk.

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**The review was written by Dr. Ziv Preis, Partner and Co-Head of the Cross Border – Mergers and Acquisitions, Banking and Financial.