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April 23, 2020

Sycamore Partners Terminates Its Agreement to Acquire a Majority Interest in Victoria's Secret Based on the Target's Response to COVID-19

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During the past few weeks, M&A professionals have been considering the impact of the COVID-19 pandemic on transactions that were pending at the outset—deals that had been priced and agreed to, but not completed, before the scope and impact of the pandemic were appreciated. Many of us have had little doubt that some buyers would seek to extricate themselves from obligations to buy businesses on terms that had suddenly become uneconomic or at least seek to renegotiate the price.

Earlier this week, Sycamore Partners gave notice that it was terminating its agreement, dated February 20, 2020 to acquire a majority interest in the Victoria's Secret retail business from L Brands for $525 million. Sycamore also commenced litigation in the Delaware Chancery Court seeking a declaration that conditions precedent to its obligation to close the transaction could not be satisfied and that its termination of the acquisition agreement was valid. Significantly, Sycamore does not argue that it may terminate because the COVID-19 pandemic constitutes a Material Adverse Effect or MAE; it contends that it is L Brands' response to the pandemic that justifies termination.

Business acquisition agreements typically condition the buyer's obligation to consummate the purchase on the absence of an MAE on the target. MAE is generally, and somewhat circularly, defined as anything that has a material adverse effect on the business, financial condition or results of operations of the target, subject to exceptions or carveouts specified in the agreement. These provisions are construed narrowly. The Delaware courts have held that "[a] buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close" and have only once found that burden to have been satisfied. Whether the COVID-19 pandemic would enable a buyer to satisfy that heavy burden is an open question and likely turns on the severity of the effect on the particular target and the precise wording of the MAE definition in the acquisition agreement.

Sycamore does not claim that the COVID-19 pandemic and its consequences constitute an MAE, presumably because MAE is defined in its acquisition agreement subject to a long list of carveouts, including matters "directly or indirectly resulting from . . . the existence, occurrence or continuation of any pandemics." Instead, Sycamore relies on the closing condition requiring that L Brands "have performed in all material respects all of its . . . obligations hereunder required to be performed by it on or prior to the Closing Date" and the related termination right.

Sycamore alleges that L Brands' response to the pandemic breached its covenant in the acquisition agreement to conduct the business in the ordinary course when it:

  • furloughed large numbers of employees, including all store associates below the level of manager, all staff at five closed distribution centers, all processing center associates below the supervisor level and all call associates who cannot work from home;
  • reduced senior management base compensation by 20% and deferred annual merit increases for 2020;
  • effected substantial and ongoing reduction in forward merchandise receipts and failed to dispose of out-of-season, excess and obsolete merchandise inventories; and
  • failed to pay the April 2020 rent on its US retail stores.

Sycamore also alleges an MAE under a less common aspect of the definition included in the agreement—any matter "that would prevent, materially delay or materially impede the performance by [L Brands] of its obligations under this Agreement." This aspect of the MAE definition is not subject to the carveouts. Sycamore also alleges breaches of representations and warranties largely related to the covenant breach.

Sycamore's complaint has just been filed and we cannot know today how the litigation will unfold or whether it will be settled through a renegotiation of the transaction. However, its breach of covenant argument is based on provisions commonly found in acquisition agreements. Companies working toward completion of a sale under a signed acquisition agreement should consider how the actions they propose to take in response to the COVID-19 pandemic may be analyzed under the acquisition agreement covenants, including any covenant to operate in the ordinary course. Parties negotiating acquisition agreements should consider how the covenants in the agreement may apply to actions that may need to be taken in response to the COVID-19 pandemic during the period through the closing.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.