COVID-19 (more commonly known as the novel coronavirus) has had a swift and far-reaching impact beyond the spread of the disease. We have already witnessed firsthand the economic impact of this pandemic on corporate transactions, as clients and counterparties have cited this outbreak as the reason to delay or cancel transactions, including venture financings and mergers and acquisitions (M&A). As fear grows and uncertainty mounts, it is seemingly impossible to predict the breadth of economic disruption. One thing is certain, however; this issue will find its way into M&A transactions, both in the context of executed contracts and agreements under negotiation. We have highlighted a number of provisions and issues below that may be relevant in either context. This column does not address “force majeure” provisions in contracts, as our firm recently issued an article regarding such provisions. [Please click here to be redirected to that article.]
Please note that careful consideration should be taken when attempting to account for pandemics and outbreaks such as COVID-19 during the drafting phase of M&A transactions. What is a pandemic? How is it different than an epidemic or an outbreak? Do all of these need to be covered in the acquisition documents? As discussed in our article regarding “force majeure” provisions, it is really difficult to predict and address every seemingly possible event that should be explicitly included as an excuse to performance. This column discusses certain considerations for parties in M&A transactions regarding how to handle outbreaks such as COVID-19. However, parties to M&A transactions should consider their specific circumstances and needs and carefully tailor their acquisition documents accordingly.
Due Diligence
Whether a pre- and/or post-signing matter, due diligence plays a critical role in the M&A process. The coronavirus outbreak has had an impact on the due diligence process in numerous ways. First, travel restrictions have resulted in headaches for deal teams, causing delays and/or outright cancellations of in-person management meetings, integration discussions and on-site inspections. Second, the outbreak has caused buyers to conduct a deeper dive into a target company’s business in order to answer key questions, such as:
- How will the outbreak impact the target’s customers? Will the target’s customers be able to pay their invoices in accordance with past practice? Is pricing going to be an issue? To what extent will the target’s projected sales and financials be affected?
- What, if any, impact will the outbreak have on the target’s vendors or supply chain? Will overall inventory or supply be negatively impacted? Is the target in a position to fulfill open orders or meet projections? Is the target able to timely pay its vendors?
- Do the target’s commercial contracts include applicable force majeure or termination provisions? How is nonperformance handled under such agreements?
- How will the legal and regulatory landscape change as a result of the epidemic? How will potential changes in laws impact operations and compliance matters?
- Is the target able to service its debt and comply with covenants under its debt documents?
- Does the target have any crisis management and disaster recovery procedures or business continuity plans?
Assuming the parties would like to move forward with a transaction, due diligence will affect the drafting of the definitive acquisition agreement, as the parties will attempt to define, limit and shift the risk allocation between the parties.
Closing conditions play an important role in M&A transactions with a bifurcated signing and closing. We discuss closing conditions at length below, but we wanted to mention here that acquisition agreements sometimes include a buyer-favorable closing condition that the consummation of the transaction is subject to the buyer’s satisfaction of legal and financial due diligence. This provides the buyer with additional flexibility to terminate an agreement during the post-signing and pre-closing period if it is not satisfied with the due diligence. From a seller’s perspective, this condition should not be included, since an argument can be made that the bulk of the buyer’s due diligence should be completed prior to executing the acquisition agreement.
Acquisition Agreement Considerations
Representations and Warranties
Representations and warranties (RWs) are statements of fact and assurances made by each party to the other that serve a few different functions in an acquisition agreement, including disclosure and risk-shifting. RWs essentially reflect the parties’ understanding of who will bear the burden of certain losses that arise from certain events. For example, a seller can use an RW to disclose key material information about aspects of its business to the buyer, putting the buyer on notice and preventing it from making a claim that it suffered losses in connection with such disclosure.
RWs have always been a key, if not the most important, aspect of M&A transactions. The outbreak has caused both buyers and sellers to reconsider the RW packages in acquisition agreements. From a seller’s perspective, it is important to pay very close attention when drafting RWs to consider whether the outbreak renders the seller’s RWs untrue. For example, RWs around financial statements, undisclosed liabilities, adequacy and quality of inventory, ability to pay accounts payable, collectability of accounts receivable, and other adverse changes or effects need to be carefully tailored. From a buyer’s perspective, it may want to consider including specific coronavirus RWs in the acquisition agreement, with the goal of understanding the target’s internal controls of monitoring the impacts of the virus and any financial or operational impacts on the business.
As the RW package is being negotiated, both parties should carefully consider the use of knowledge and materiality qualifiers, particularly sellers that are willing to accept specific coronavirus RWs. Additionally, careful attention should be paid to the preparation of the disclosure schedules, which essentially shift risk from the seller to the buyer. It is in the best interest of the seller to review the RWs carefully and make disclosures as it sees fit, shifting the burden to the buyer to remove the disclosure or demand a special indemnity.
Regulatory Approvals
Acquisition agreements typically include conditions on the parties, usually the sellers, to deliver regulatory approvals and consents as a condition to closing. The coronavirus outbreak has caused government offices across the globe to shut down, adding uncertainty and risk to an already stressful transaction process. These shutdowns increase the likelihood of delays and the parties’ inability to obtain such consents in the time frames set forth in the acquisition agreements.
Material Adverse Change
A material adverse change (MAC) clause (also commonly referred to as a material adverse effect clause) typically allows a buyer in a transaction to back out of a deal in the event of a material change in the financial condition, business or operations of the target during the post-signing and pre-closing period. What constitutes a MAC is negotiated by the parties before the signing of the acquisition agreement. Generally speaking, MAC clauses are intended to protect buyers from adverse changes to a target’s business and not general, broad events. Historically, MAC clauses have been difficult to successfully invoke; U.S. courts have been reluctant to enforce MAC clauses, requiring buyers to prove that the target’s business has sustained a significant decline in business.
The impact of the outbreak will be felt for a significant period of time as parties to M&A transactions will consider and negotiate how such outbreaks should be handled. From a buyer’s perspective, it may be prudent to include a specific closing condition with respect to the spread of an outbreak. From a seller’s perspective, it is important to include a specific exception to the MAC clause for pandemics and outbreaks such as the spread of COVID-19. In a recent merger agreement entered into between Morgan Stanley and E-Trade Financial Corporation, the definition of material adverse effect included a specific exception for effects resulting from an epidemic, pandemic or disease outbreak (including the COVID-19 virus).1
Conditions to Closing
Acquisition agreements include an array of seller and buyer conditions to closing. Closing conditions generally provide that the obligation of each party to consummate the transaction is subject to the satisfaction or waiver of an agreed-upon set of conditions. These conditions are heavily negotiated by the parties. Naturally, there is a battle between buyers and sellers; buyers want flexibility to walk away from a deal (one such buyer-favorable condition was referenced above in the due diligence section), while sellers want to limit a buyer’s ability to terminate an agreement. We may begin to see buyers insist on additional specific closing conditions tailored to expectations of the outbreak. For example, data security and information technology issues may become increasingly important with employees working remotely, and sellers may not be able to confirm that they are in compliance with, or have satisfied, all applicable laws to the buyer’s satisfaction.
One universal condition in an M&A transaction with a bifurcated signing and closing is the condition that RWs remain true and correct at both the signing and closing of a transaction. This poses a massive risk for sellers that entered into an acquisition agreement prior to the COVID-19 outbreak, as the pandemic has likely led to one or many seller RWs becoming untrue during the post-signing and pre-closing period of the transaction.
Operating Covenants
Another common condition in an M&A transaction with a bifurcated signing and closing is the requirement that the seller operate the business in the ordinary course of business consistent with past practice. It is clear that the outbreak has already had, and will continue to have, a lasting impact on many businesses, providing buyers an opportunity to back out of a deal pre-closing. This is a real issue for sellers that have entered into an acquisition agreement prior to the outbreak. For those sellers in the process of negotiating an acquisition agreement, they should consider including the right and flexibility to operate outside the ordinary course of business in order to deal with the impacts of the outbreak.
Outside Dates/Termination Rights
Parties to M&A transactions negotiate provisions regarding the ability to terminate the acquisition agreement, whether by mutual consent or upon the occurrence of certain events. In transactions with a bifurcated signing and closing, the acquisition agreement typically includes a provision allowing either party to terminate the agreement if the closing hasn’t occurred by a particular date (Outside Date). This will undoubtedly become a real issue in transactions impacted by the recent outbreak, as parties will have a difficult time collecting required approvals and consents, along with achieving other closing conditions.
For those parties currently negotiating acquisition agreements, they should consider including an Outside Date further in the future in light of the recent outbreak. This, of course, results in a lengthier pre-closing period, which in turn creates an additional risk of providing buyers with an opportunity to terminate the transaction prior to closing.
Other Deal Considerations
There are a host of other issues to consider when negotiating M&A transactions in the current landscape:
- Target Company Valuation – Price negotiations may be prolonged or even revisited as parties attempt to measure the impact of the outbreak on the target, including both short- and long-term effects on the business, contracts, vendors, customers, and financial condition and projections. Some targets may be willing to accept a lower valuation as their business continues to suffer. This provides an opportunity for ready-and-willing buyers to acquire a target at a reasonably low price.
- Availability of Financing – Financing may become an even more crucial aspect of a transaction. Buyers may have trouble securing adequate financing as a result of market uncertainty and volatility, resulting in delays and/or deals falling apart. Buyers with available cash will have an advantage over their competitors.
- Financing-Out Clauses – In a competitive, seller-friendly environment, buyers that require debt financing to fund their acquisitions are typically forced to not condition the transaction on obtaining such financing. With the growing concerns regarding financing availability, we will likely see more buyers requesting a financing-out clause in acquisition agreements.
- Representations and Warranties Insurance – Over the past few years, representations and warranties insurance (RWI) has become an increasingly popular and indispensable part of M&A transactions. An RWI policy provides a buyer with the ability to recover directly from an insurer for losses suffered by the buyer arising out of a seller’s representations and warranties. Most policies contain certain exclusions, which deprives a buyer of insurance coverage for any losses suffered in connection with such exclusions. Since the outbreak, some insurers have started to specifically add policy exclusions relating to COVID-19-related losses from their policy coverage. Without insurance coverage with respect to such exclusions, buyers will attempt to reduce the purchase price in the transaction or negotiate special indemnities to cover specific liabilities.
Thinking Ahead
The outbreak of COVID-19 has been rapidly evolving and it is extremely difficult to predict the lasting impact it will have on the global economy. A few things are certain, however; parties to M&A transactions should expect delays in deal timelines and additional time and effort in negotiating deal terms, including RWs and closing conditions.
1Agreement and Plan of Merger dated as of February 20, 2020, by and among Morgan Stanley, Moon-Eagle Merger Sub, Inc., and E-Trade Financial Corporation. (https://www.sec.gov/Archives/edgar/data/895421/000095010320003111/dp121716_ex0201.htm)