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The global outbreak of the novel coronavirus (“COVID-19”) is currently changing – and will continue to change – the way people and businesses operate, as well as the way private M&A practice is being conducted now and most likely moving forward.
In M&A transactions, we have become very accustomed to certain transaction processes and deal mechanics, including ease of access to a target’s business, assets, facilities, and management team and their advisors when conducting primary and confirmatory due diligence. While COVID-19 has made this typical type of access all but impossible, it is also likely that COVID-19 will have a significant impact on other material aspects of M&A deals and purchase agreements as the pandemic continues to unfold and its impacts become more fulsomely understood.
Many of our clients are asking about the impact of COVID-19 on M&A. By reflecting on current transactions that have gone on “pause” and those which are proceeding full steam ahead, we wish to share with you some of our initial observations on the impacts of COVID-19 on private M&A. More specifically, we will address observations related to “material adverse effect” or “material adverse change” (“MAE”) provisions and the initial impact of COVID-19 on due diligence and associated representations and warranties in purchase agreements.
1. Material adverse effect – today and tomorrow
While COVID-19 has caused some dealmakers to hit the pause button on yet to be signed deals, parties and stakeholders to M&A transactions, which are in the interim period between signing and closing, have a very different set of business concerns to consider.
The foremost question a buyer (and a supporting lender) must consider and assess under these circumstances is whether COVID-19 has had a fundamental impact on the underlying valuation of the target (i.e., its ability to operate, its likely future business earnings, etc.). This would include, among other things, an assessment of the target’s prospects (including its customers, partners, key vendors/suppliers or distributors), and whether the current market conditions in light of the pandemic have encouraged new market entrants that have learned of or devised of new ways to work remotely in competition to the target business. If valuation remains largely unharmed, buyers seemed poised to move quickly to close, or seek to negotiate appropriate purchase price adjustments to address possible adverse valuation impacts. However, if the viability of the business is adversely impacted by COVID-19 and a buyer does not believe purchase price adjustments will suffice, a buyer faces the question of if and how it may be able to walk away from a pending acquisition of a target that has suffered or may suffer potentially grave consequences caused by the crisis. This is, of course, at odds with sellers’ interests who would look to ways to ensure a buyer follows through to close. In either case, for parties in the interim period, the first step is for parties and their advisors to review the purchase agreement’s closing conditions and, most importantly, the agreement’s definition of MAE.
a. What are MAE provisions?
Before considering whether COVID-19 constitutes a MAE and whether it would enable a buyer to walk away from an agreement, it is helpful to consider the nature of MAE provisions generally.
While a MAE provision in a purchase agreement serves a number of purposes, its most critical function in most cases is to set out the circumstances in which a buyer can terminate the transaction during the interim period between signing the purchase agreement and closing. Effectively, MAE provisions serve to protect buyers from unknown events that could severely threaten the earning potential of a target business. Not surprisingly, MAE provisions tend to be heavily negotiated against by the seller parties.
A standard MAE provision in a purchase agreement has three parts:
Part 1: Base form of MAE provision
The base form of a MAE provision typically allows a buyer to terminate a deal upon the occurrence of a MAE, which is usually defined as any fact, circumstance, development, change or effect that is, or is reasonably expected to be, materially adverse to the target, its business, prospects, assets, operations, financial condition or liabilities.
Part 2: Carve-outs in favour of the seller
There are usually a number of circumstances or saving provisions to benefit sellers in a MAE provision, often referred to as “carve-outs”, which specifically exclude certain enumerated events from the MAE definition, thereby preventing a buyer from relying on the MAE provision to exit the transaction in those situations. Carve-outs often include matters such as general changes in economic conditions, acts of terrorism, military action or war, changes in applicable law, natural disasters, acts of God, and “certain other events that are beyond the control of the parties”. It is not customary for epidemics and public health events to be specifically carved-out from the definition of MAE, but there are exceptions to this, in which case a buyer would be prevented from using a crisis such as COVID-19 as a MAE out (subject to the potential application of the impairment clause in certain MAE definitions, as discussed below).
Part 3: Exceptions to the carve-outs – “disproportionate adverse effect”
One manner in which a buyer’s counsel typically attempts to limit the impact of carve-outs on a MAE definition is to add appropriate “disproportionate effect” language to the provision. This language essentially provides that a carved-out matter is effectively removed from the list of carve-outs where and to the extent such matter disproportionately adversely affects the target, as compared to others in the same industry or line of business as the target. In other words, a buyer may rely on a MAE termination right in respect of a general market condition, or another “carved out” event, if such event disproportionately adversely affects the target compared to its peers. Language aside, the burden of proof to rely on such disproportionate effects language rests with the buyer.
b. Does COVID-19 constitute a MAE?
It remains a large task for buyers to prove a MAE has occurred in any M&A transaction. In the absence of specific language, the courts customarily place a heavy burden of proof on buyers invoking a MAE provision. Based on Canadian case law, every case is considered on its unique facts and circumstances, so a buyer who is invoking a MAE provision must undertake a detailed fact-specific inquiry in the courts with no certainty of outcome. While there is currently no standard test to demonstrate that an event qualifies as a MAE in respect of the target, there are certain key questions a buyer must address in making its case:
i. Was the event material?
The analysis as to whether a MAE provision can be invoked requires the buyer to first demonstrate that the event is materially adverse to the target. In general, courts consider the magnitude, duration and long-term impact of the adverse event to be important factors in determining whether it is material. Events or developments that only have a short-term or temporary impact will not warrant application of a MAE provision in most circumstances. Unless specifically set out in the purchase agreement, it is generally insufficient for a target to suffer a temporary downturn in business.
At this point in the COVID-19 crisis, it is unlikely that enough time has passed to determine with any certainty whether the adverse effects of the pandemic rise to the level of a MAE. Of course, this will be a rolling assessment over time and will depend in large part on the staying power of the pandemic and the extent of its negative ramifications.
ii. Does a carve-out apply?
Assuming a buyer is able to show that COVID-19 is materially adverse to the target, the buyer must then establish that the pandemic is not carved out from the definition by demonstrating that the MAE is due to the pandemic alone and not general market conditions or other carve-out categories. This will be a challenge for most buyers given the broad language of customary carve-outs.
iii. Does the pandemic disproportionally adversely affect the target?
If a buyer successfully demonstrates that COVID-19 materially adversely affects the target company but a carve-out applies, the buyer may still terminate the transaction if it is able to prove that the pandemic disproportionally adversely affects the target vis-à-vis other businesses in its industry. There is no standard for comparing how one company is affected by industry headwinds versus another and the courts may look at several metrics in determining whether a target is disproportionally adversely affected (e.g., revenues, net profits, market share, production capabilities, etc.). Nonetheless, it is possible for one company to be more vulnerable to the fallout from COVID-19 than its peers in the industry (e.g., due to its particular cash-flow position, contractual obligations, insurance coverage, geography, supply-chain, distribution of customers, etc.). This is again a fact-driven determination with no clear outcomes.
As we are likely only witnessing the early stages of the fallout of COVID-19, the duration and long-term effect of the pandemic remain uncertain and hard to project. There is no doubt that that COVID-19 is having an adverse impact on businesses worldwide; however, only time will tell whether the impact will be material enough to enable a buyer to rely on a MAE provision to terminate a purchase agreement. Also, there is unlikely to be a one-size-fits-all approach to MAE provisions: interpretations of MAE provisions are fact-driven and outcomes will depend on the particular circumstances of each case, including the specific language in the purchase agreement.
c. Impairment prong of MAE provisions
It is important to note that many definitions of MAE include two prongs and a MAE termination right is available to a buyer by satisfying either prong. The first prong is typically that a material adverse effect on the target, its business, assets or operations has occurred (as described above). The second prong is usually the so-called “impairment clause” whereby any fact, development, change or effect that is, or is reasonably expected to be, materially adverse to the ability of the seller or the target company to close the deal or to otherwise comply with its obligations under the purchase agreement constitutes a MAE. Oftentimes, impairment clauses are not subject to the negotiated carve-outs that apply to the general definition of MAE. When the impairment clause is not expressly modified by the carve-outs (as opposed to the first prong of the MAE definition), it stands to reason that the operation of the definition of MAE shifts the risk of any carved-out event onto the buyer, unless that event prevents the seller from complying with its obligations under the purchase agreement. In other words, if a matter that is carved out of the first prong of a MAE definition causes the seller to breach certain of its obligations under the purchase agreement, resulting in the seller’s inability to satisfy a closing condition, this would relieve the buyer of its obligation to close. It should be noted that unlike the first prong of the MAE provision, a buyer-friendly impairment clause might be satisfied by a short-term adverse impact that interferes with a seller’s ability to satisfy its obligations under the purchase agreement (including its interim operating covenants), even if such impact is not a significant disruption to the business. This could open the door for a buyer more readily make a case for a MAE out.
d. MAE definitions post COVID-19
We expect that sellers will seek a pandemic, disease outbreak or similar carve-out in a purchase agreement’s MAE definition, arguing that COVID-19 is a known problem that buyers can assess. Sellers will likely rationalize that buyers should be undertaking COVID-19-related diligence before signing a purchase agreement, and that any identified issues should be accounted for by way of negotiating the purchase price and payment mechanics. Buyers, on the other hand, are likely to contend that the long-term impact of COVID-19 and the possibility of other similar outbreaks remains unclear, and that if there is going to be a lengthy interim period between signing and closing that they need the ability to analyze the ongoing and evolving effects. At a minimum, a prudent buyer will want to request a disproportionate effects qualifier in the MAE provision (assuming they accept a pandemic, disease outbreak or similar carve-out), and will seek appropriate closing conditions in the circumstances (i.e., where the assessment of the impact if COVID-19 can continue related to key business metrics).
2. Diligence and representations & warranties
Conducting effective and comprehensive operational, tax, financial and legal due diligence is certainly more challenging given that many industries and geographies have been impacted by COVID-19. Buyers will need to consider the effects of COVID-19 on a target in terms of the industry and jurisdiction in which it operates, as the pandemic has not impacted all businesses to the same degree at this point in the crisis. When conducting diligence, it is also imperative to keep in mind that certain business lines have quickly evolved and transitioned to a “new normal” (e.g., parcel transportation companies that have effectively transitioned business from commercial to residential to capitalize on the remote working environment, and certain technology companies that facilitate remote working functions), whereas other business models have not changed fundamentally (e.g., insurance brokerages focused on property insurance).
More time and expense will likely be required for financial and tax diligence, including the possible cash-flow impact of an extended slowdown of the economy, in order to understand a target’s economic viability in light of the pandemic. A target’s economic activity prior to the outbreak is not a reliable indicator of future performance of the business, and hence, additional focus and attention will be needed to assess a target’s economic health (and the appropriateness of the purchase price to be paid). As well, once “normal” economic activity returns, which is a relative term, it will take time for a target business to return to proper function, provided they are able.
Buyers should spend additional time reviewing all material contracts of the business (such as key customer or supplier contracts, credit agreements, key real estate leases, etc.) with specific focus on force majeure or similar provisions. For more information on the effects of COVID-19 and force majeure, please keep an eye out for an additional article we will be publishing this week.
In considering the appropriate suite of representations and warranties, the impact of COVID-19 or other negative impacts that could be caused by a similar outbreak should be top of mind for buyers and counsel across all representations to ensure that a buyer receives sufficient information to make informed decisions in valuing the transaction and providing for proper downside protection in the purchase agreement. Stand-alone COVID-19 representations, if any, should be narrowly drafted and bespoke to the concerns in a target business.
In addition to considering the impact of COVID-19 in terms of representations and warranties regarding key focus areas of almost all M&A transactions, namely, financial matters and material contracts, buyers should spend time considering representations regarding the target’s business interruption insurance coverage, and whether a target’s insurers will remain capable of paying claims related to COVID-19 under this insurance. The impact of COVID-19 on insurers providing business interruption insurance is something to pay close attention to as the monthly economic impact of the crisis will likely dwarf the annual premiums paid for this line of insurance, absent government intervention to protect insurers.
Also, given the move to “remote working” or “work from home” environments, enhanced representations and warranties should be sought relating to the target’s compliance with the applicable employment and workplace safety legislation, the target’s policies and practices related thereto, and any potential related liabilities. Enhanced representations and warranties regarding a target’s contingency plans and business continuity practices and policies, and protections in place with respect to privacy and cybersecurity, should also be considered carefully. Related to work from home circumstances, representations (and diligence) regarding intellectual property should include detailed consideration of third-party software license compliance as many companies struggled to get workforces set up remotely in part, because of a lack of necessary licenses.
3. Representation & warranty insurance coverage
While the impact of COVID-19 on the scope of representation and warranty insurance coverage is not completely clear at this time, insurers will not cover known events under these policies, and they will most certainly seek broad exclusions for losses related to COVID-19. As such, buyers should be prepared to negotiate for specific indemnities to cover potential losses, such as identifiable supply chain interruptions and contractual breaches. Please check out our previously published article for further thoughts on the impact of COVID-19 on representations and warranties insurance.
Should you require any assistance with reviewing your agreements or any other matters, please do not hesitate to contact one of our lawyers.
Miller Thomson is closely monitoring the COVID-19 situation to ensure that we provide our clients with appropriate support in this rapidly changing environment. For articles, information updates and firm developments, please visit our COVID-19 Resources page.