COVID-19, MAEs, and Preliminary Evidence of Disproportionate Impacts Within Industries

09 June 2020
Dr. David Tabak and Edward Flores

The ongoing COVID-19 crisis is not only affecting the physical health of people but also the financial health of firms. Moreover, the effects on firms are not uniform, either across industries or within industries. This may be particularly relevant to deals that have been placed in jeopardy by the crisis.

A recent article points out that many deals have material adverse effect (MAE) clauses that allow a purchaser to withdraw from the deal.1 MAEs often contain exceptions (i.e., the MAE does not apply to the effects of certain events, often events that affect the economy broadly), which, if they apply, would deprive the purchaser from the right to cancel the deal by invoking the MAE. However, the article points out that the “exceptions to MAE clauses are normally subject to a disproportionate-effect exclusion, which returns the risk to the seller (i.e., giving the buyer the right to terminate) to the extent that an event falling into one of the exceptions disproportionately affects the target company as compared to other participants in the industry.”

Thus, an important question is whether the ongoing COVID-19 crisis is tending to create disproportionate effects within industries. Our previous and ongoing analysis has shown that the COVID-19 crisis has created a growing disparity across members of the S&P 500 Index, as shown in the graph below.

As this chart shows, the differences in the daily returns (or price movements) across various firms have spread dramatically since the COVID-19 crisis first hit. The lines on the graph, each representing the return of a company at a particular percentile of daily returns each day, seem reasonably constant through early March of this year. However, at that point, the lines not only move farther from 0% (i.e., larger net movements), but also spread apart from each other.

Another way to see the dispersion in daily returns across firms is by examining the range between selected percentiles. In the graph below, we examine the range between (a) the 25th and 75th percentiles and (b) the 5th and 95th percentiles of daily returns for 2019 and 2020, plotted over a trading day calendar in order to see any year-over-year differences. As can be seen in the graph, the 25th–75th and 5th–95th percentile ranges in 2020 are roughly constant through mid-February, at which point the 2020 percentile ranges increase dramatically, remaining at elevated levels through May 2020. Moreover, from mid-February onward, the 2020 percentile ranges are substantially higher than the 2019 percentile ranges when comparing similar points in the year.

While these figures highlight that firms across many industries have been differentially affected, it does not speak to the degree of differential impacts within industries.

To examine this further, we look at the cumulative returns since 31 December 2018 and 31 December 2019 for all members of the S&P 500 within each of the 11 Global Industry Classification Standard (GICS) sectors.2 While GICS is a well-known, standard industry classification scheme, it may or may not be the appropriate measure of industry participants for any individual test of disproportionate effects across an industry for MAE purposes. In addition, stock-price movements are not the only possible measure of the impact of an event.3 As an example of a specific industry, the graph below shows the results for the GICS Consumer Discretionary sector.4

When comparing cumulative returns across firms in the Consumer Discretionary sector in 2019 and 2020, the range between the 25th and 75th percentiles and the 5th and 95th percentiles of cumulative returns has increased substantially during the COVID-19 crisis. The 2019 and 2020 percentile range lines are reasonably similar through early March, when they start to diverge. From that point on, the 2020 lines have substantially increased relative to the 2019 lines at the same points in the trading calendar year. This shows that the spread between firms experiencing above-average returns and firms experiencing below-average returns in the Consumer Discretionary sector has increased during the COVID-19 crisis.

In conclusion, it is clear that the COVID-19 crisis has been causing disproportionate effects both across industries and within industries. Whether the effects have been disproportionate for any one company will likely be an interesting area of analysis in some business disputes. Fortunately, there are tools that may help address that question, though questions of defining the relevant industry and the proper tool(s) to employ will depend on the facts and circumstances of each individual dispute.

1. Kathleen M. Porter and Anna Jinhua Wang, “The Coronavirus (COVID-19) and Material Adverse Effect Clause,” The National Law Review, 23 March 2020. See also Gail Weinstein, Warren de Wied, and Steward Kagan, “COVID-19 as a Material Adverse Effect (MAC) Under M&A and Financing Agreements,” Harvard Law School Forum on Corporate Governance, 4 April 2020.
2. The Global Industry Classification Standard (GICS) is a four-tiered hierarchical industry classification system comprised of 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries.
3. Stock prices have the benefit of taking into account the market’s estimate of current and future effects and summarizing those effects into a single number. However, the observed stock prices will account for all new information over the period being examined, which may include material news unrelated to the event that is the subject of the potential MAE clause. Other measures of impact (e.g., changes in actual financial results and changes in analyst forecasts) may provide additional information relevant to understanding the depth and duration of the effect of a possible MAE.
4. Graphs for other sectors are available by request from the authors.
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