As COVID-19 continues to rapidly permeate our society and the financial markets struggle to maintain stability, companies engaged in M&A transactions must overcome increased risk and uncertainties. For now, while there are some publicly-announced deals being pulled or being re-evaluated, we have not yet seen a spike in announced signed-deal terminations due to COVID-19. We expect, however, that parties of those deals that signed pre-COVID-19 are re-evaluating their transaction terms and that after the delirious symptoms subside, we may see a wave of deal renegotiations or terminations, while some deals will still proceed as planned or on a delayed basis. We anticipate the path of pending signed M&A transactions (both public and private ) will vary, as parties determine whether or not to proceed, and if so, on what terms and when, as the pandemic continues to impact different industries and geographic regions.
Some buyers who have entered into M&A transactions at pre-COVID-19 valuations may wish to terminate transactions or renegotiate the purchase price prior to closing and will be looking for ways to do so without incurring liability. Sellers, on the other hand, may wish to proceed to closing and look for ways to force buyers to close. For those deals in negotiation or new deals, the parties will have the opportunity to adjust and/or set deal terms to take into account COVID-19 and the related market and economic impacts and risks. Not so for signed M&A transactions. Where the target company has been materially impacted by the COVID-19 outbreak, the parties to signed deals will need to analyze their purchase agreement to determine their preferred path and potential liability – focusing on conditions to closing, termination rights and fees, indemnification provisions, the impacts of a delayed regulatory or other closing process, and the continued availability of acquisition financing and representation and warranty insurance.
Below are some key legal issues and considerations for parties in analyzing and addressing potential risks and problems in signed M&A transactions arising as a result of COVID-19’s impact.
1. Material adverse change
It is impossible to make blanket statements or judgments as to whether the effects of the COVID-19 pandemic constitutes a material adverse effect or material adverse change (MAC) affecting the target company or business for which a buyer is permitted to terminate the transaction. MAC determinations will depend on the specific MAC clause language in the agreement, what is known at the time the transaction is signed, and the nature and extent to which an event or series of events affect the particular target’s business. MAC clauses are intended to protect the buyer from any unforeseen change specific to the target’s business, not to protect the buyer from the general performance of the global market or economic conditions, during the interim period between execution and closing. MAC clauses are typically drafted so that a material adverse effect on the target’s industry will not trigger a MAC without a showing of a disproportionate adverse impact on the target compared to other participants in the same industry.
If a pre-pandemic agreement MAC definition neither includes or excludes COVID-19 (or even to pandemics or epidemics generally), asserting the effects of COVID-19 in determining whether a MAC has occurred may not be successful because COVID-19 was not referenced. In such case, disputes may focus on whether MAC definitional language that typically excludes general economic, financial or regulatory conditions and other changes that are generally applicable to the industries or markets in which the target operates is sufficient to exclude the impact of COVID-19. In addition, given the widespread impact of COVID-19, it may also not trigger a MAC if the MAC requires a showing of disproportionate effect on the target when compared to its industry. Parties may also debate whether the impact of COVID-19 is sufficiently long-lasting to be considered a MAC under state law. Courts have typically narrowly construed MAC clauses, particularly with respect to MAC outs for the buyer. Generally, courts have held that short-term adverse circumstances are not sufficient to invoke a MAC clause; usually, the effects or change must substantially impact the overall earnings potential of the target in a durationally-significant manner measured in years, not weeks or months. Due to all this uncertainty and potential difficulties in citing COVID-19 as a basis to trigger a MAC as of this date, parties may utilize MAC clauses more as leverage and a basis for renegotiating deal terms, rather than a way out of the deal.
2. Interim operating covenants
Parties should look at if and how they can comply with ordinary course operating covenants covering the pre-closing period after signing as they navigate the operational exigencies resulting from the pandemic. “Ordinary course of business” may look different now given that sellers need to make decisions to comply with new and changing government laws and orders and circumstances. Despite a seller’s best intentions to comply with the ordinary course of business covenants, which are intended to preserve the value of the business a buyer has agreed to purchase, sellers may find it necessary to take “rescue” measures without the buyer’s consent, such as to incur additional debt, stretch payables, modify budgets, lay off employees, defer capital expenditures or shut down facilities – actions that could breach the covenant and give the buyer a walk away right. While there is often an exception for actions taken in compliance with applicable laws and some specified limitation on the degree of effort a target is required to exert to comply with these covenants, the language may not appear or be sufficiently definite or clear to cover government mandates, health and safety measures or the extraordinary measures the target believes is prudent to take. Whether or not there is any applicable language in the agreement, sellers may need to argue that the target is only required to exert “commercially reasonable efforts” to comply with the covenants; or that the target is excused from complying with the covenants for actions required by applicable law, government mandates or health and safety measures, or is excused under the legal doctrine of impossibility; or that the buyer’s consent cannot be withheld unreasonably.
3. Bring-down of representations and warranties
Sellers may find it difficult to bring down at closing the accuracy of representations and warranties made at signing, even if the “bring down” condition is qualified by materiality. Because the ramifications of COVID-19 are broad and far-reaching, numerous representations and warranties in a typical purchase agreement potentially could be impacted. Some representations that could likely be impacted by COVID-19 include representations regarding business operations and continuity, counterparty risks, the status of material contracts and commercial relationships, top customer orders or that receivables will be collectible, indebtedness and full disclosure. Determining which breaches of representations and warranties, if any, would give rise to a termination right may be difficult. Additionally, addressing the appropriateness and adequacy of remedies for breaches may be challenging. Sellers will need to balance trying to limit their potential indemnification exposure by including broad disclosures regarding the impact on COVID-19 on the target’s business when the representations and warranties made as of the signing date are “brought down” to closing and providing the buyer with a potential walk away right as a result of such disclosure updates.
4. Regulatory delays, other closing logistics and drop-dead date
Parties should expect delays in obtaining governmental approvals and third party consents, and delays in other closing logistics. Regulatory approvals such as antitrust, FERC, FCC, CFIUS or other state agencies are typical gating items for a transaction’s timeline, and under current circumstances, extra time pre-closing may be required. For instance, although the FTC just issued guidance indicating that HSR early termination requests were now back on the table, parties should expect fewer early terminations being granted than under normal circumstances. Deals that require stockholder approvals and filings/clearances with the Securities and Exchange Commission may face delays, as these will be affected by slower governmental action and potential challenges of obtaining stockholder approvals. Parties should also plan for longer pre-closing lead time considering the disruptions in the third parties involved in the closing logistics (e.g. closure of recording offices, closure of state comptroller offices, limited staffs of banks and perhaps the need to coordinate notarization virtually). If a closing is now unlikely to occur by the agreement outside date, a party should consider whether it or the counterparty has an option to terminate the agreement under such provision, as well as any conditions that may need to be met in order for this option to be exercised, or if the outside date to close should be extended through mutual agreement. In extending any outside date termination provision, the parties will need to consider who bears the risk of delay, and for what period, and what degree of change in the target’s financial results and operations will be allowed if the pre-closing period is exceptionally long.
5. Purchase price adjustments
Most private acquisition agreements contain purchase price adjustments to address fluctuations in a target’s debt, cash and working capital between signing and closing, typically measured against a peg (representing a normalized level of working capital), set at the time of signing, and based on historical information. However, that historical information may no longer be the best measure if the target’s financial situation has been, or is expected to be, materially impacted by COVID-19. Sellers may need to take extreme measures to maintain acceptable liquidity at the target company and thus will need to prepare for greater than expected post-closing adjustments if the pandemic has negatively impacted the target’s working capital relative to historical or normalized levels, unless the purchase agreement contains agreed floors or collars in the purchase price adjustment mechanism. Buyers may seek to renegotiate any agreed upon purchase price adjustment floors or collars if the target’s working capital and liquidity levels are significantly below the agreed criteria.
6. Third-party financing
With continued volatility in the financing markets, transactions that depend on third-party debt financing can present particular challenges. Buyers should consider the risks involved in a situation where the third-party financiers pull the funding whereas the buyer cannot walk away from the deal. Typically, MAC conditions in the financing documents should match those conditions in the acquisition agreements. However, there may be other conditions provided in the financing documents, such as certain financial measures of the target and the buyer (e.g. EBITDA-to-debt ratios), which lenders may use as a reason to walk away if such conditions are not met. Therefore, buyers will want to ensure the third-party financing documents will not allow the lenders a way out while buyers are forced to close the deal. This issue also poses high risks for the seller as it is impossible to enforce specific performance in a situation where the buyer has insufficient funds. Even in instances where the seller and the buyer have agreed on payment by the buyer of a reverse break-up fee for a “financing failure,” the seller may not view such remedy as adequate under such circumstances.
7. Interim period due diligence
Since interim period due diligence will now take longer as offices and factories remain closed or limited in operation, in-person management presentations and site visits are challenging and scrutiny of targets may be heightened, transaction parties should adjust expectations and timetables accordingly. If interim period due diligence uncovers material or potential risks from COVID-19 that impact target valuations, parties may wish to review their termination rights and consequences in such case or seek to renegotiate the purchase price. Buyers should ensure their interim period due diligence on the target business extends to, among other things: revenue risk of significant travel restrictions and quarantine measures on the business; existing insurance policies and their coverage; the effectiveness and use of business continuity plans and crisis management procedures; supply chain risk and the availability of, and costs associated with, utilizing alternative sources of supply; triggering of force majeure provisions and the target’s ability to perform under existing contracts; and regulatory, licensing and data privacy implications as a result of remote working arrangements, particularly in certain industries involving sensitive or personal data.
8. Representation and warranty insurance
For signed pending deals, the parties should expect enhanced bring-down due diligence by underwriters, and buyers should expect longer, more detailed bring-down calls, especially for deals with longer interim periods. Insurers are now frequently excluding from coverage adverse impacts that constitute a breach of representations and warranties arising out of COVID-19, including supply chain interruptions, adverse impacts upon the target company’s workforce, inability to perform under existing contracts, loss of business, etc. This means that insurance coverage likely won’t be available to address key issues that can impact the health of the target company’s business or transaction valuation. Parties should carefully consider their options because: (1) insurance policies typically exclude coverage for any known breach and insurers will look to classify COVID-19 related breaches under this category when the representations made as of the signing date are “brought down” at closing), (2) if representations and warranties insurance (“RWI”) is the sole recourse against sellers (or the sole recourse absent “fraud”) for breaches of representations and warranties, buyers must plan for damages from the breach, and (3) if RWI is the primary (but not sole) recourse against sellers, and RWI will not be available, sellers should prepare for indemnification liability for buyer’s damages, which may be significant if the sellers’ indemnification obligation for breaches of representations and warranties in the purchase agreement is uncapped.
9. Difficulty of seeking remedies in courts
Going to court is now more burdensome with court facilities closures, postponed or sustained docket timelines, difficulties due to the courts’ revised operations (such as telephonic hearings and trials or virtual depositions) or uncertainties over the extension of the length of time of courts’ revised policies. This may impact a party’s view of the relative utility and value of adjudication and enforcement of remedies such as specific performance and may incentivize the parties to compromise and negotiate a more balanced solution, rather than terminating the deal or being forced to close the deal.
10. Deals with stock as consideration
For deals where the consideration consists in whole or in part of buyer stock, the risk of obtaining target, and if necessary buyer, stockholder approval is now higher, particularly for deals where there is a fixed exchange ratio (i.e. there is no mechanism to adjust the stock exchange ratio where there is a disproportionate change in the value of the buyer and target stock as a result of COVID-19), as stockholders of the target may view themselves as being underpaid and stockholders of buyer may view buyer as overpaying. Boards of Directors of the seller and buyer, as applicable, will need to consider their fiduciary duties in determining whether or not they can continue to recommend the deal to stockholders based on the agreed deal pricing structure and future prospects of buyer and target, as applicable.
The Norton Rose Fulbright team is monitoring these developments carefully, and is able to assist parties to signed transactions in thinking strategically about how to manage the current circumstances for their signed pending transactions. The analysis of each deal situation will be fact-specific.