Private M&A and COVID-19: Key issues for buyers and sellers

Introduction

The COVID-19 pandemic has clearly had a stark and detrimental effect on private M&A activity. In this Insight, we consider some of the key issues for parties either contemplating new deals or seeking to manage current conditional deals.

New deals

There has generally been less appetite for initiating and conducting new private M&A deals as businesses have focused on deploying resources to help manage the impact of COVID-19 and addressing cash flow and liquidity issues. Nevertheless, we are continuing to see some parties press ahead with new deals in some industry sectors, sellers generally preferring to minimise their risk by preferring unconditional deals with cash buyers, and buyers generally preferring to structure deals involving deferred payment options. We are also seeing more appetite amongst certain buyers for distressed businesses or assets.

Current conditional deals

For conditional deals that have signed but not yet closed, we have seen concern expressed by both buyers and sellers. While some conditional deals have proceeded to closing, the COVID-19 pandemic has had a very destabilising effect on other deals that were previously proceeding to closing. In general, buyers have been keener to re-negotiate, defer or pull out of deals until there is more certainty and stability, whereas sellers have generally been keener to proceed to closing and avoid opening up further negotiations. 

Many sellers have been examining their obligations in the relevant acquisition agreement regarding closing conditions, pre-closing obligations, material adverse change clauses and warranties (in particular, any obligation to repeat the warranties before closing and notify the buyer of anything which might lead to a breach of warranty). Buyers have also been examining the same clauses to identify the redress that they might have for breach of these obligations by the seller. Much depends on how the parties have negotiated the allocation of risk during the period between signing and closing (the interim period) and this will have been determined by a number of factors including: the relative bargaining strength of the parties; which party has required a particular condition, thereby causing the gap; the nature of the target business or company (the target); the nature of the conditions; and what the buyer intends to do with the target after closing. Each party's remedies will usually be agreed and set out in the acquisition agreement, and will usually include the right to terminate and/or claim damages.

Conditions to closing

New deals

It is generally preferable for signing and closing to take place simultaneously as this avoids a period of uncertainty for the parties and the target business but where there is a gap, the acquisition agreement usually includes additional clauses dealing with the relevant conditions that must be satisfied and how the target is to be run in the interim period. Buyers contemplating new deals will be keen to negotiate and include a full range of rights and remedies that protect their positions in relation to the closing conditions.

The market uncertainty resulting from the COVID-19 pandemic will lead many buyers to try and preserve their ability to avoid proceeding to closing to the fullest extent by including several general and bespoke closing conditions suitable for the target business. As well as including general closing conditions involving obtaining consents or clearances from regulators or third parties, buyers will be keen to include specific conditions connected with COVID-19 (for example, there being no second wave of the virus, or no material change in the relationship between the target and its key customers or suppliers). On the contrary, sellers will be keen to ensure that the acquisition agreement does not include any vague or unspecific conditions related to COVID-19 that are subject to the buyer's discretion and allow the buyer not to close a deal. This will lead to longer discussions between buyers and sellers. Delays in obtaining consents or clearances because of issues arising from COVID-19 (such as changes in the working practices of governmental and regulatory bodies) can, in certain cases, also be expected to lead to extended deal timetables.

Current conditional deals

Parties that have entered into a conditional deal before or during the COVID-19 pandemic would have become subject to legally binding obligations from the moment they signed the acquisition agreement, although the legal transfer of the target will not take place until any relevant conditions have been satisfied or waived. A significant amount of additional drafting would usually be included in the acquisition agreement to cover matters that might arise in the interim period. However, few people saw the COVID-19 pandemic coming, and so not many acquisition agreements signed before April would have included specific COVID-19 provisions to help parties manage its catastrophic effects in the interim period. Against this backdrop, if a condition is not fulfilled or waived by the date agreed, the acquisition agreement will usually give both parties the right to terminate. Upon termination, all further rights and obligations of the parties usually cease immediately except for specifically agreed provisions such as confidentiality and any obligation to seek to satisfy the conditions.

Before attempting to rely on the non-fulfilment of a condition to avoid proceeding to closing, a party must scrutinise the relevant clause in the acquisition agreement, which will usually specify who is responsible for fulfilling the relevant condition and the process that must be complied with before withdrawing. The level of effort expected of a party in procuring the fulfilment of a condition is also usually specified in the agreement, for example, the extent to which a party is required to use its "reasonable" or "best" endeavours to fulfil a condition. This can involve issues such as the extent to which a party is obliged to incur expenditure or act against its own commercial interests, issues which have been brought into a sharper focus because of COVID-19. If the parties have agreed that a condition must be fulfilled for the deal to complete, and it remains unfulfilled by the specified date, the buyer will usually be able to exercise its right to terminate. However, if the reason that the condition was not satisfied by that date is that the buyer failed to meet its contractual obligations to procure satisfaction of the condition (and if it had done so the condition would have been satisfied by that date) the seller is likely to have a damages claim in respect of that failure, and if the value of the business has fallen substantially between signing and closing, that claim could be equally substantial.

Pre-closing obligations

New deals

Buyers will often endeavour to control the conduct of the seller and the target business by imposing an extensive list of obligations and restrictions on the seller in the interim period. There is usually a general obligation on the seller to carry on the business in its "usual or ordinary course" and, where warranties are given by the seller in the acquisition agreement, not do anything which would breach those warranties (or which would breach the warranties were they to be repeated up to closing). This is often followed by a list of more specific requirements (such as no capital expenditure over an agreed figure) which may or may not be allowed with the consent of the buyer. 

The uncertainty arising from COVID-19 has led to more negotiation between parties about the precise wording of the seller's pre-closing obligations and restrictions in the acquisition agreement. Sellers will wish to ensure that they can comply with any specific pre-closing obligations requested by buyers as the failure to comply with such requirements is likely to open the door for a particular buyer to terminate the acquisition agreement and/or claim damages. In certain cases, COVID-19 might have had such an adverse effect on a target business that it would simply be imprudent for a seller to accept a general obligation to conduct the target business in the interim period in the "usual and ordinary" course.

Sellers in stronger negotiating positions will wish to include wording in the acquisition agreement that gives them the most flexibility to run target businesses during and in the aftermath of the COVID-19 pandemic without breaching their pre-closing obligations. For example, a seller might wish to include wording in which the buyer acknowledges that the seller will not be in breach of its pre-completion obligations and the buyer will not unreasonably withhold or delay its consent to any action which the seller is required to take by law or regulation in the interests of the target business because of COVID-19. Most sellers are, at the least, likely to carve-out or amend some of the widely-drafted standard wording usually requested by buyers, by introducing concepts of reasonableness and proportionality in relation to the efforts required of them in the interim period. 

Buyers will be keen as ever to ensure that sellers are obliged to act in a manner that preserves the value of the target business in the interim period, particularly in the current rapidly-changing and volatile market conditions caused by COVID-19. Some buyers might expect sellers to provide them with even more financial and operational information in the interim period so that they can establish if the target is being run in accordance with their expectations. Buyers in strong negotiating positions will seek to include precise wording entitling them to terminate the acquisition agreement and/or claim damages if the target's pre-completion performance falls below that negotiated. 

Current conditional deals

The essential problem for the buyer in an existing conditional deal is that it is contractually bound to close the deal but will not control the target business, generally, until immediately after closing. The buyer will have effectively put itself on risk to complete the transaction and will have either assumed as much control as it can over the target business or put some of that risk back onto the seller pending closing or, as is generally the case, some combination of the two. It is uncommon for a seller to have relinquished total control over the target business, either fully or partially, prior to closing (and is often not permitted by anti-trust law in any event). In trying to manage and mitigate the effects of COVID-19, some sellers might have legitimate concerns about their actions breaching their pre-closing obligations, potentially entitling the buyer to terminate the acquisition agreement and sue for damages. Once again, it is important for the parties to examine the possible breach against the precise wording of the relevant pre-closing requirement to establish where they stand and what action they should take.

Due diligence

New deals

The main reason why buyers conduct due diligence investigations of target businesses is so that they do not have to rely on what they are told by sellers, but can find things out for themselves before committing themselves. Buyers will need to fully understand the impact that COVID-19 has had on the relevant target business, as well being comfortable with the target's plans for mitigating the impact of COVID-19 on the business. There is likely to be a move away from the quick and limited approach to due diligence adopted by some buyers in recent years. Buyers will wish to conduct more extensive due diligence and, although the extent of that diligence will depend on the nature of the target and the industry sector that it operates in, examples of additional general areas that buyers might need to investigate because of the possible impact of COVID-19 include: 

• finance and financial performance (e.g. emergency government funding schemes, revenues, liquidity, working capital, further finance and solvency);
• key contracts (e.g. customers, suppliers, compliance/non-compliance, termination rights and renegotiations);
• operational (e.g. business continuity, compliance with COVID-19 laws and regulations and insurance cover for COVID-19 slowdown);
• information technology (e.g. infrastructure, resilience, remote working, cybersecurity and data security); and
• employees (e.g. furloughed employees, COVID-19 related absences, redundancies and claims related to work-originated COVID-19).

Warranties

New deals

The extent of contractual protection sought by buyers from sellers in the form of warranties is generally determined by the nature, history and industry sector of the target business. The additional warranties that buyers will seek from sellers because of the risks posed by COVID-19 will develop from the enhanced due diligence that buyers will now seek to conduct (see above). The COVID-19 pandemic means that the usual warranty issues negotiated by sellers and buyers are likely to be of heightened importance. Sellers are likely to maintain that some of the general warranties they are prepared to give will address and provide contractual protection for any COVID-19 related concerns that buyers might have. Nevertheless, buyers will seek a range of additional warranties designed to address specific COVID-19 concerns. For example, a buyer might ask a seller to warrant that it has disclosed all COVID-19 matters affecting the target business, has taken all appropriate steps to mitigate the effect of the virus on the business and has complied with all relevant laws, licences and regulations arising from the pandemic. Other examples of important areas where buyers might seek additional warranty protection because of COVID-19 are likely to mirror the additional due diligence questions (see above) and might include: finance and financial performance; the status of relationships and material contracts with key customers, suppliers and third parties; operational and compliance with COVID-19 laws and regulations; insurance for COVID-19 slowdown; IT infrastructure and systems; cybersecurity; and employment (including the impact of COVID-19 on employees).

Buyers and sellers are likely to use the usual warranty negotiation tactics in relation to the additional warranties. Sellers will analyse whether they can give the additional warranties requested by buyers and if so, the extent of any COVID-19 related disclosures they need to make against such warranties to limit their exposure to breach of warranty claims. In other cases, sellers might choose to either amend problematic warranties or delete irrelevant warranties. If they are prepared to give the additional warranties, sellers should seek to include materiality qualifiers and awareness qualifiers, as well as attempting to give the additional COVID-19 warranties on a "boxed" basis, meaning that any COVID-19 claims can only be brought against those specific warranties and not the against all the other general warranties. Although "boxing" the COVID-19 warranties in this way can be a useful mechanism for the seller, a buyer might be reluctant to accept this approach as it carries the risk that gaps may appear in the extent of the warranty cover obtained. Finally, some buyers will need to consider protecting themselves (by, for example, obtaining a guarantee from the seller's parent company) if the seller is in a financially distressed position because of COVID-19 and consequently, unlikely to be able to meet future breach of warranty claims. 

Current conditional deals

Some but by no means all signed acquisition agreements will contain warranties given by the seller to the buyer in respect of the target business. To the extent that these prove inaccurate (and have not been adequately disclosed against in the disclosure letter) the buyer may have a contractual claim for damages. Warranties are given always at signing and sometimes repeated at closing. What could be important in the context of COVID-19 is whether a breach of warranty could give rise to a right to terminate the acquisition agreement prior to closing by virtue of COVID-19 related events occurring between signing and closing. If the warranties are repeated at closing (or deemed repeated for the purposes of the termination rights) then this could be possible but it is a very brave buyer who chooses to terminate for breach of warranty (even where the agreement allows) because if it transpires that it was not entitled to terminate (for instance, because the court subsequently decides that the warranty was not breached) there could be substantial damages payable to the seller.

Price and price adjustment

New deals

The considerable market uncertainty caused by the COVID-19 pandemic has led to difficulties in valuing businesses which is of course a major reason for the lull in deal activity. Nevertheless, one can envisage more deals featuring post-closing performance related contingent price mechanisms such as an earn-out, which enables a part of the purchase price to be adjusted by reference to the target's post-completion performance. Some buyers might also seek to simply defer part of the purchase price (on a non-contingent basis) or retain part of it to offset some of the uncertainty arising from the pandemic. Sellers are likely to resist such attempts but any seller accepting such a mechanism will be keen ensure that it has the benefit of appropriate security in respect of the buyer's payment commitments. Certainty of funds is critical for sellers.

As for the profitability of the business in the months leading up to closing, which party takes the benefit and burden of this generally depends on whether closing accounts or the locked box approach is used. In the former, the price is adjusted post-completion by reference to closing accounts, meaning that the seller generally bears the risk and reward of pre-closing performance. With the locked box approach, the parties usually agree a fixed price for the target before signing based on a set of accounts and, as there is no post-closing adjustment, the buyer usually bears the risk and reward of pre-closing performance. The locked box approach had become popular in recent times but the economic volatility caused by COVID-19 is likely to lead to a shift back to the purchase price being determined by reference to a post-closing adjustment based on closing accounts, and most buyers are now likely to prefer such an approach.

Current conditional deals

The COVID-19 pandemic has adversely affected the financial performance of many target businesses that are the subject of conditional deals. For deals that have signed but not yet closed, which party bears the economic impact of this performance will again generally differ depending on whether the closing accounts or locked box approach has been used. A buyer that has signed a deal before the pandemic on the basis of locked-box accounts might now wish to investigate whether there is any possibility of renegotiating the price mechanism and purchase price in order to take into account the downturn in the target's financial position although most sellers will, of course, be reluctant to do so.

Material adverse change

New deals

The purpose of a "material adverse change" (MAC) clause is to allow a buyer to terminate an acquisition agreement if, between signing and closing, the target business is adversely affected by certain defined events. More specifically, a MAC clause is generally intended to cover unforeseen events or consequences that either materially affect the long-term operation of the target or could reasonably be expected to result in a long-term diminution of the revenues, earnings or net asset value of the target. Using a MAC clause as a basis for terminating an acquisition agreement has traditionally been difficult. However, given the continuing uncertainty caused by COVID-19, buyers in strong negotiating positions are likely to seek the inclusion of MAC clauses in appropriate circumstances in order to improve their positions should economic conditions deteriorate further because of the pandemic. In some cases, a well drafted MAC clause may simply provide a buyer with the leverage to renegotiate terms with the seller. In order to improve the effectiveness of a MAC clause, buyers should avoid widely-drafted clauses and should consider using specific and objective financial or target industry metrics in the MAC definition. Buyers must also be wary of attempts by sellers to carve out from the MAC definition events or circumstances that affect the economy or target industry as a whole.

Current conditional deals

Whether or not a buyer can rely on a MAC clause in a current signed deal will depend on what was known at signing and the precise drafting of the clause. Sellers are generally reluctant to accept the inclusion of a MAC clause in the acquisition agreement. However, even if a seller has conceded to the inclusion of a such a clause, it is likely to have excluded circumstances that affect the economy or target industry generally, which means that the impact of COVID-19 is likely to be excluded. Consequently, a buyer seeking to pull out of a current signed deal by attempting to rely on COVID-19 as being a MAC event is very unlikely to succeed unless it can show that the target business has been affected disproportionately.

Indemnities

The impact of COVID-19 on target businesses means that the use of indemnities to address specific and known risks is likely to increase. Although much will depend on the particular deal and the relative negotiating strengths of the buyer and the seller, an indemnity might help to manage the risk from a known COVID-19 issue by giving the buyer a contractual right to compensation for a specific loss suffered as a result of a particular event occurring. By negotiating the inclusion of an indemnity, the buyer avoids the difficulties which may arise in respect of a warranty claim regarding quantum of loss. A seller prepared to give an indemnity should limit it to a specific known COVID-19 related risk, whereas a buyer might seek an indemnity which covers a broader range of areas arising from the COVID-19 pandemic.

Insurance

Where buyers and sellers cannot reach a consensus between themselves, warranty and indemnity (W&I) insurance is increasingly used by the parties to insure against the risk of any claims arising under the warranties. Although the use of such insurance is likely to increase even more, it is important to appreciate that such insurance will not cover matters known by the parties. As a known risk, W&I insurers will exclude any losses related to COVID-19. In such cases, the parties may wish to work with insurers or brokers to see if there is any scope to limit such exclusions for specific limited and defined scenarios. There may also be difficulties with recovering for COVID-19 related losses arising in conditional deals. If the warranties given at signing are to be repeated at closing, W&I insurers are again likely to completely exclude the impact of COVID-19 in determining losses.

Logistics and execution

Lockdown restrictions and physical distancing rules arising from COVID-19 have, in some cases, limited the ability of buyers to conduct thorough due diligence and engage in face-to-face meetings with senior managers. However, the pandemic has not generally disrupted the ability of parties to execute deal documents. On-line meeting platforms have permitted parties to hold board meetings remotely in order to approve deals and any shareholder resolutions that have been required have, in many cases, been passed by circulating written resolutions by e-mail and then using virtual or digital signing processes. Government assistance has also been forthcoming with many departments temporarily permitting the use of e-signatures and accepting soft copy documents.

Virtual signings (where signatories are not all present in the same place) have been used to execute documents for some time and involves the e-mailing of documents to signatories followed by the printing, wet ink signing and re-scanning back of signature pages along with a copy of the final form document. The use of digital signatures and digital signing platforms to execute documents has become much more common during the pandemic as they neither require a printer nor a scanner. By giving access to the relevant digital signing platform (together with authentication codes and passwords), parties have been able to sign documents by inserting their e-signature from a computer or mobile phone before the document is made available to other parties to sign in the same way. Despite the common use of virtual signings or the popularity of digital platforms to execute documents, some documents that need to be lodged with particular registries might still require a wet ink signature. The law and practice around virtual and e-signings also varies in different jurisdictions so local advice is always recommended for international signings. 

For further information please speak to your usual contact at Ashurst or any of the contacts listed below.