In this briefing we consider some of the areas of a privately negotiated M&A transaction which may be affected by the continuing effects of the COVID-19 pandemic.
Some of the changes discussed may apply only for the period whilst the worst effects of the pandemic are felt, whilst others may mark a change in practice towards more buyer-friendly provisions designed to protect more cautious buyers in distressed M&A markets.
Whilst this briefing focuses on UK domestic deals and international transactions documented to UK standards, we also highlight some differences in approach in the US market and the attitude of US courts.
Terminating the deal
The need to satisfy conditions to enable completion to take place (such as regulatory approvals or merger control clearances) may necessitate a delay between signing the deal and completing it. In current working conditions, with regulators and merger control authority staff themselves working from home, timetables required to satisfy such conditions may become longer.
In UK domestic deals and international transactions documented to UK standards, it has historically been relatively unusual to see express provisions entitling the buyer to terminate sale and purchase agreements in competitive processes for an event arising or coming to light in the period between signing and completion. This is because sellers in such processes have been successful in maintaining that “business risk” should pass to the buyer at signing rather than completion of the deal, so delivering the seller important execution certainty.
Where a termination right is included in deal documentation, one element of a typical termination event definition is the occurrence of a material adverse change or “MAC”.
In the UK, there has been limited judicial consideration of MAC clauses in the privately negotiated M&A context and no reported case has considered such a clause in circumstances analogous to the COVID-19 crisis, e.g. the outbreaks of SARS, swine flu or MERS over the last two decades. However, the following principles have emerged which are likely to guide the approach to drafting such clauses in response to the COVID-19 crisis:
- The courts are generally unsympathetic to attempts of sophisticated parties to escape a transaction that they have signed up to.
- Drafting will be construed against the party seeking to rely on the termination right imposing a high threshold and a tendency against clauses which are broadly drawn and do not capture specific matters or occurrences.
- A party may not invoke a MAC to terminate a contract where it was aware of the circumstances which it seeks to rely on at the time of the contract, although it may be possible to frame a termination right around a trigger which captures a worsening or significant deterioration of those circumstances.
- The concept of materiality in this context is a high bar in terms of the magnitude and duration of the effect – a transitory circumstance will not usually be sufficient.
The relative lack of case law from the English courts in this area may serve to underline that a well advised buyer will be mindful of the risk of a damages claim for a wrongful termination. However, such clauses may provide a buyer faced with a drastically different landscape with a lever to re-open discussion of the key deal terms, e.g. to secure a price reduction.
Where a MAC termination clause is included, drafting typically excludes events affecting the market generally (with pandemic or disease sometimes, but not invariably, identified as one such event) except to the extent that the effect on the target business is “disproportionate” to the effect on other “similar businesses”. At the current time, a buyer may face two challenges with drafting of this nature. Firstly, the triggering event (i.e. the occurrence of the COVID-19 pandemic) has already happened – there is no new occurrence. Secondly, there would be difficulty in establishing that a target has been disproportionally affected without defining or describing what might be considered to be “disproportionate” as well as adding more definition around the comparator businesses or sectors to be used as reference points. To address these points, it would be necessary to extend triggering language such that it captures steps taken in response to governmental or regulatory compulsion as well as to draft some specific, and ideally measurable, effects or events that will enable termination. Examples might include the closure of named production or operational facilities for more than a defined period or the failure to achieve identified financial metrics, again over an identified timescale.
The sale and purchase agreement (SPA) may also enable termination in the case of a breach of its terms (such as a breach of warranty or pre-completion undertaking). Whilst termination for material breaches would be a typical feature of US deals, in the UK, sellers would often successfully resist this on the basis that if it breaches the SPA, the buyer should have a right to damages in respect of that breach, rather than a termination right. This argument would be strengthened for breaches resulting from the COVID-19 crisis in cases where the seller has conceded that a form of MAC will apply to address the consequences of the COVID-19 crisis as discussed above. In more normal times, if a seller is forced to concede that a termination event includes a breach of the SPA, the seller would additionally require that the breach must have a material adverse effect, as defined, or require that the scope of the clause should be confined to breaches of certain key provisions of the SPA (often specified pre-completion undertakings). However, in the present circumstances, a seller will be particularly concerned that it may be obliged (by virtue of government directives or, more generally, to preserve the target business and its employees) to take actions that could put it in breach of the pre-completion undertakings. This area is discussed further below.
Whilst this is a common feature of US deals, in the UK it remains relatively unusual to repeat or to “bring down” warranties at completion of the deal (other than fundamental warranties relating to title and capacity). Such a concept, which effectively extends the effective date of the warranties, is likely to continue to be resisted by the seller (because it exposes it to consequences beyond its control). This is particularly so where the buyer requires the warranty repetition to confer a termination right as well as a right to damages and especially where the MAC clause has already addressed COVID-19 related issues as above.
Whatever the outcome of the debate on risk allocation between buyers and sellers as outlined above, cash buyers will continue to have considerable advantage in this debate bearing in mind that prized execution certainty for sellers will be undermined where acquisition finance facilities themselves contain conditions or termination events on the assumption that lenders may prove to be more reluctant to advance funding at all or certainly on a certain funds basis in the short to medium term.
Pre-completion undertakings and exclusions
A key area to consider will be the extent to which the drafting of the pre-completion undertakings remains appropriate for current circumstances. As indicated above, this will particularly be the case where a termination right may arise for breach of such undertakings.
It is interesting to note that whilst there is little UK case law considering the effect of a breach of pre-completion undertakings, in the US buyers have looked to escape from deals including on the grounds that the target business was not operated in the ordinary course of business between signing and closing. Recent weeks have seen a number of claims launched in the US courts focusing on the right to terminate for actions taken by sellers or target businesses in direct response to the COVID-19 crisis and arguably necessary or in the best interests of the target business in that context, but which put the sellers in breach of pre-completion undertakings.
From a seller’s perspective, it is more important than ever to ensure that it has maximum flexibility to take steps which potentially breach pre-completion undertakings in response to a changing landscape without the need to ask for, and associated risk of not obtaining, the buyer’s consent.
A typical UK-style SPA will frame a number of positive pre-completion undertakings along the following lines:
“Pending Completion, the Seller shall use reasonable endeavours to procure that each Group Company shall (except as required under this Agreement or any Share Purchase Document or with the prior written consent of the Buyer [not to be unreasonably withheld or delayed] and to the extent permitted under applicable laws)….”
The most significant positive undertaking for these purposes is often the obligation to “carry on its business as a going concern in the way carried on prior to the date of this Agreement”.
In addition to such positive obligations, there are also typically a number of detailed restrictions affecting the decisions and actions that may be taken with respect to the target business in the pre-completion period. These may include diverting from identified business plans, making significant spend commitments or hiring or firing employees.
Even though these undertakings are often given on a “reasonable endeavours” basis rather than being absolute undertakings, this will obviously be a difficult area for sellers whether they are linked to a risk of termination or solely damages claims. Sellers may seek specific carve outs along the following lines:
“Notwithstanding any other provision of this Agreement the Seller shall not be in breach of this Agreement and the Buyer shall be unreasonable in withholding or delaying its consent to any steps or action which are required to be taken by law or by regulation or in response to [emergency] orders, directions or guidance issued by any government, any Regulatory Authority or any other competent body or authority or any steps or action which are otherwise reasonably [required or recommended to be] taken in the best interests of the business of the Group in the light of the COVID-19 pandemic…”
As will be noted, this carve out is intended to capture not only those steps or measures which the seller/target business is compelled to take, but also potentially a broader range of actions “taken in the best interests of the business of the Group….”
From a buyer’s perspective (and subject to normal gun jumping and competition law concerns) it will wish to have as much oversight and control of the business (and the implementation of emergency or contingency planning) as is possible.
Although a seller would typically avoid giving forward looking warranties, e.g. as to the financial projections for the target business, other typically encountered warranties may be at risk of being breached as a result of the effects of the COVID-19 crisis. Examples might include warranties which cover changes to the business since the date of the last accounts or warranties which mention known or threatened breaches of material contracts either by the target or by key counterparties. Even apparently innocuous warranties, such as those requiring the target business to confirm its compliance with law and regulation, may be challenging in present conditions.
Sellers will have to seek to amend or delete problematic warranties or to carve out from their scope (or disclose against, see below) the expected effects of the COVID-19 crisis on the business. Some sellers may consider giving some limited warranties on the assumed financial and other effects of the crisis on the target business (suitably caveated as to assumptions and the basis of preparation of any such information) and framed on a “so far as the Seller is aware” basis. Alternatively, warranties which cover the target’s compliance with an identified emergency action or contingency plan may be appropriate. In that case, ideally, sellers would wish to state also that such warranties are boxed – in other words these are the only warranties given about the known or anticipated effects of the COVID-19 crisis and none of the other warranties extend to such matters expressly or by implication.
The areas of particular concern for the buyer will obviously be transaction and target business specific, but areas that they may wish to consider for additional warranty protection directed at the COVID-19 crisis may include:
- Ability to comply with law and regulatory/key licence requirements.
- Breaches by or failures (including the insolvency) of suppliers or customers of the business or the parties to other material contracts, including whether any rights to terminate any such contracts have arisen.
- Reliability of historic/recent financial information.
- Availability of cash and changes to debtor/creditor practices, and delays in payments and receipts.
- Employee issues such as redundancies, furloughing or equivalents in other jurisdictions, safe working practices and any particular employee-related difficulties.
- IT resilience for remote-working employees and cyber and data security risks or breach events.
Depending on the financial standing of the seller, it may be more appropriate than would be typical to seek a retention or an escrow as security for warranty or other payments by the seller. Whilst such “hold backs” are fairly common in US deals, they are more unusual in UK deals unless the buyer has a strong bargaining position and the seller’s financial strength is poor.
Approach to disclosure
From a seller’s perspective, a general disclosure as to the known and unknown effects of the crisis may be the optimum way to proceed. However, English case law suggests that generic rather than specific disclosure may not be effective. Contractually, such general disclosure may fail to meet “fair disclosure” standards specified in the SPA which often require that disclosures are only “fair” where they provide information which is sufficiently detailed to identify the nature and scope of the matter in question. Further, from a buyer’s perspective, such a general disclosure may be unattractive as it leaves uncertainty as to the residual warranty cover and the buyer may press the seller for specific warranty disclosures. Accordingly it may be necessary to make as much detailed disclosure of COVID-19 consequences as possible against warranties.
New and enhanced diligence requirements
As in the case for warranty cover (and clearly there is overlap between the two areas), the areas for focus for any legal or commercial due diligence will be transaction and target business specific but some common areas of concern for buyers (and W&I insurers where relevant) may be:
- General: Understanding the changes in business operations necessitated by the COVID-19 crisis, including the operation of contingency and emergency planning, cash flow management and cost tracking/containment-how good is the planning and how effectively is it being carried into action?
- Employees: Has national and international guidance on the safe working of employees been followed and for those working in business locations, are there any safe working concerns including documentation as to any complaints? Have statutory sick pay requirements been followed and if redundancies or dismissals have taken place has proper process been followed- is the target managing workforce issues effectively?
- IT infrastructure: IT resilience or performance issues associated with a remote work force-is the IT platform performing satisfactorily or are there are areas of concern where business operations are compromised or capital expenditure may be required to ensure that the IT is sufficiently robust?
- Cyber/data security: Increased or significant cyber or data security issues or breaches as well as compliance with government directions as to the protection of personal data of those infected with COVID-19 and (related to the preceding bullet point) are the systems, controls and processes effective for the current circumstances?
- Suppliers: Issues or concerns with suppliers to the business and their continued capacity to perform, including any existing or anticipated contractual breaches or insolvency risk - does the target business risk operational disruptions as a result of supply chain difficulties?
- Customers: Issues or concerns with the customers of the business – reductions in volumes, payment delays, contractual breaches or insolvency – is the cash flow and bad debt position of the target business under strain?
- Insurance: Business interruption or other insurance in place under which claims may be made- is there cover that may respond to the effects of the pandemic?
- Government financial support: Government aid, funding or relief applied for/received, including in respect of staff- has funding or support been secured and, if so, are there are problematic conditions attached to it? Is it repayable if those conditions are not met?
- Taxation: To the extent that any tax liabilities have been deferred or a tax holiday obtained, what resources are in place for their discharge at the later date? Does the way in which the group has been run during the COVID-19 crisis expose the group to any additional tax risks (such as unintended permanent establishments and/or employee tax liabilities)?
W&I insurance considerations
As a general matter, it is not the role of W&I insurance to cover the sort of systemic risk which the fallout from the COVID-19 crisis represents and insurers will not, in any event, insure matters of which the buyer is aware. However, how these principles will be translated into policy exclusions and how broadly drawn these will be remains an evolving picture.
Many of the areas highlighted in this briefing will be of concern to insurers – in particular an emphasis on due diligence to understand the substantive effects of the COVID-19 crisis on the business and the manner in which due diligence has been conducted considering restrictions on travel (including site visits and other physical inspections of assets), and the due diligence timetable as well as any “gaps” or outdated due diligence as a result of an interrupted period of due diligence.
We can also expect to see an increased focus from insurers on the range of protections for buyers discussed in this briefing so that insurers can understand the allocation of risk between buyer and seller. In particular, whether reliance on warranties is the sole protection for a buyer or whether other measures such as the extent of any financial recourse to the seller or termination rights are also available to it.
Other sources of protection/measures to bridge the uncertainty gap
It is worth noting that in some circumstances it may be possible to cover the risk of an unexpected event or occurrence arising in the period between signing and closing by an indemnity designed to cover the buyer for losses arising in consequence. This was the approach taken in a recent UK case in the energy sector where an indemnity was given for damage caused to subsea cables in the period before closing. On the facts of that case, the court found that the indemnity was not engaged because it was limited to patent damage arising in the short period between signing and completion which was not established in this case (the only changes to the cables during that period being unobservable ongoing corrosion). In any event, it is difficult to see how such an indemnity might be framed around a specific set of consequences arising as a result of the COVID-19 crisis, at least in terms that would be acceptable to a seller.
Finally, in terms of pricing structures for deals that have yet to sign, whilst locked box pricing structures may prove to be less attractive to buyers in future, the use of completion accounts to verify the financial position of the target at completion and/or earn outs to peg deferred consideration to the future resilience and performance of the target business, may help to get a buyer comfortable that adverse economic effects of the COVID-19 crisis will feed through to the completion accounts or be reflected in a future earn out payment. Of course, for earn outs that are already running, the crisis may place considerable strain on the already difficult balancing of the interests of the seller wishing to receive fair value for the target business and the buyer’s need to integrate, and possibly restructure, an affected business.