Victoria’s Secret Deal Called Off
Recently, the private equity firm Sycamore Partners filed a lawsuit in the Delaware Court of Chancery seeking a judicial declaration that it could terminate its $525 million agreement to acquire Victoria’s Secret (owned by L Brands). This lawsuit would have been the first high profile case to explore the right of a party to a merger or purchase agreement to rescind a transaction due to complications resulting from the ongoing Covid-19 pandemic. However, the parties settled the case within days after the filing of the declaratory judgment action, without either party being obligated to pay a termination fee to the other. Although the case did not offer any further insights into how the Delaware Court of Chancery — the nation’s leading court on M&A disputes — will address attempts to rescind transactions due to the effects of the pandemic in the future, it does highlight a couple of important lessons for parties that are struggling to close acquisition transactions entered into prior to the pandemic or that currently desire to enter into an agreement for such a transaction.
The first lesson is that a buyer may not be able to back out of a deal on the basis of a claim that the pandemic has had a material adverse effect on the business or prospects of the business to be acquired. Most acquisition agreements require, as a condition to the buyer’s obligation to close, that no such material adverse change have occurred after the signing of the agreement (a provision commonly known as a MAC). However, MAC provisions are very carefully negotiated to describe those circumstances under which a buyer may back out of a deal. They typically include a number of exceptions that provide that most material adverse changes do not count as a MAC unless they disproportionately affect the seller as compared to its peers in its industry. In Sycamore’s case, it had agreed to a MAC clause that provided that it could not back out of the deal as a result of a pandemic unless it affected Victoria’s Secret more severely than other similarly situated retailers of “women’s intimate and other apparel, accessories, beauty care products and fragrances”, which was almost certainly not the case. However, Sycamore was able to find a way to back out of the deal based on another provision of its agreement with L Brands.
The second lesson is that there is another way for buyers to back out of these kinds of agreements due to complications caused by a pandemic. Many acquisition agreements are signed on one date but not closed until a later date in order to allow for the completion of acquisition financing, the obtaining of regulatory approvals and third party consents, and the satisfaction of a wide variety of conditions to closing. A practically universal condition to closing is that the seller continue to operate its business in the ordinary course, consistent with past practice, and to therefore not make any material changes in the way it operates its business without first obtaining the consent of the buyer. Failing to comply with this condition can constitute a breach of the agreement that gives a buyer the right to walk away unless the seller is able to cure the default within a certain amount of time, usually 30 days.
In the face of the Covid-19 pandemic, most business made major changes in the way they operate their businesses, ranging from making changes required to comply with state “stay home” orders to furloughing employees or even shutting down completely. In the case of L Brands, it shut down all of its Victoria’s Secret locations. This gave Sycamore the ability to claim that L Brands had breached its covenant to operate in the ordinary course and that, further, the nature of the breach was such that it could not be cured. Of note, Boeing made a similar argument in backing out of its $4.2 billion agreement to acquire Embraer, claiming the seller failed to satisfy conditions specified in its agreement with Boeing.
L Brands had contractually agreed to provisions allowing for this outcome, so there was not much it could do to prevent it other than attempt to reach a new deal on price with Sycamore, which efforts obviously failed. In the Delaware lawsuit, L Brands was likely planning to argue that it was excused from performing its covenant to operate its business in the ordinary course on the basis of the doctrine of impossibility (i.e., that its performance of that covenant was rendered impossible by a government shut-down order), but it ultimately decided not to fight that battle.
Going forward, buyers and sellers will need to carefully consider and negotiate the conditions to closing specified in their agreements in the light of the effects of this or any other pandemic. Sellers will want more certainty to closing transactions, while buyers will want to ensure they get the benefit of what they bargained for or have the ability to walk away or negotiate the purchase price if the value or prospects of the business to be acquired change materially after the acquisition agreement is signed. This will likely result in an increase in the use of earn-outs as a means of hedging the risk for sellers while providing buyers with the potential to achieve a desired purchase price.