M&A Activity Infected by COVID-19
By now, it is clear to all across the globe that the novel coronavirus (COVID-19) has altered every facet of life. The human toll, being the most significant, continues to dominate the headlines alongside ongoing market volatility. Much has been and is yet to be written about the myriad effects of the COVID-19 pandemic, but this alert will focus on the effects it has had, and will no doubt continue to have, on global M&A activity. A largescale and developing outbreak like COVID-19 presents challenges, both fundamental and practical, and inevitably injects a level of uncertainty and complexity into deal making.
History has proven that M&A activity will decrease in periods of economic and market turmoil. Not surprisingly, the first quarter of 2020 saw the slowest start for M&A transactions in several years. The market remains highly uncertain while transaction parties appear to be taking a collective breath to navigate the challenges of continued operations under dramatically different and ever-shifting conditions. Amidst shut downs and supply chain disruptions, and concerns about employees, customers and vendors, businesses are shifting work locations, adapting daily processes, marshalling assets and human resources, preserving liquidity, and even simply fighting to remain viable. Nevertheless, pending transactions need to be addressed, and companies, whether out of necessity or strategic opportunity, continue to consider transactions, and the private credit markets continue to function, all with a heightened focus on evaluating, reducing and allocating risk and uncertainty.
Below are some of the key areas of risk and uncertainty and provisions in M&A agreements for parties to consider while negotiating M&A transactions. This is not intended to be an exhaustive discussion as the facts and circumstances specific to each party and deal must be analyzed and considered.
Valuation; Consideration and Purchase Price Adjustments; Financing Concerns and Conditions
Valuing a business during extreme volatility is challenging. Historical financial information may not be a good predictor of value for a target experiencing significant supply chain disruptions, contract terminations, distorted accounts receivable, abnormal inventory levels, a shrunken workforce and a host of other possible adverse or unusual circumstances. The negative impact of the COVID-19 crisis on revenue and earnings forecasts may encourage buyers to aggressively seek favorable pricing while, depending on the ultimate scope and duration of the crisis, sellers may take the position that the effects are atypical and COVID-19 is a well-known market risk. But, for either party, does a fixed price model make sense?
The uncertainty likely will lead transaction parties to continue their existing preference for post-closing purchase price adjustment mechanics (or earn outs or deferred consideration). These aim to ensure that the purchase price paid reflects the state of the target business as of the closing – that the buyer “gets what it paid for.” Deviations from customary approaches to purchase price adjustments also may be necessary. The definition of working capital may need to be adjusted or “normalized” to account for working capital or liquidity fluctuations due to unprecedented and shifting operational demands. Typical provisions require working capital adjustments to be calculated on a basis consistent with past practice. This language may need to be revised to account for changed assumptions and experiences arising from the pandemic and related mitigation measures.
Additionally, in light of the crisis, parties may be increasingly motivated to include restrictions in their purchase price adjustment mechanisms to limit the adjustment amount and to define the parameters for working capital and liquidity. This may include thresholds or ranges for the measured items so that fluctuations within the ranges produce no purchase price adjustment. The parties may also elect to cap their adjustment exposure by establishing a “ceiling” (or a “cap”) and/or a “floor.” The ceiling establishes an upper limit to any purchase price increase paid by a buyer to a seller as a result of a post-closing adjustment, while the floor establishes a lower limit to any purchase price decrease repaid by a seller to a buyer. The use of both a ceiling and a floor is commonly referred to as a “collar.”
The COVID-19 crisis also likely will have an effect on the prevailing form of consideration in transactions, particularly in public deals. Given capital market volatility, we can expect once again to see that “cash is king.” Historically, the fundamental decision to use stock or cash as the form of consideration (e.g., all stock, all cash or a combination thereof) in any M&A transaction has been a business decision inextricably linked to general economic conditions and the broader deal making environment. The use of stock as acquisition consideration is attractive in relatively stable markets because it provides buyers with transaction currency to bridge value gaps with sellers, and allows sellers the opportunity to participate in potential upside. The “exchange ratio,” or the relative number of new shares of a buyer that will be given to existing shareholders or sellers of a target being acquired (or that is being merged with another), is relatively steady. Risk is mitigated because the macroeconomic impacts of market fluctuations are expected to affect the stock price of each party approximately equally between signing and closing. In an environment of extreme market turmoil, wild and disproportionate swings in and across the stock market make securities an unpredictable currency. Using stock as consideration creates the possibility of extreme fluctuations in exchange ratios and uncertainty and risk around value. When used, it can be expected that exchange ratios will be subject to collars.
Though cash may become increasingly necessary to get deals done, tightening credit markets may make financing more difficult to obtain on acceptable terms (or at all) and without considerably more delay. Buyers therefore may more often press for financing contingencies in transactions. The adverse effect of an enduring COVID-19 crisis on the cash reserves, solvency, and ability of certain buyers to obtain acquisition financing also should not be overlooked. Sellers should evaluate the credit risk of their counterparties and may consider using, among other mitigation measures, escrow arrangements, parent company guarantees and termination fees to reduce the risk of buyers defaulting on closing or payment obligations.
In the midst of COVID-19 realities, due diligence is a challenge for all transaction parties. Projections, customarily subject to an element of uncertainty, are even more difficult to prepare and evaluate as the current and expected future impacts of the coronavirus outbreak continue to unfold. Physical meetings with management and site visits are prohibited, or at least inadvisable, for large swaths of the population globally. Sellers may find it difficult to provide information that cannot be readily accessed given “shelter in place” mandates, office closures and travel restrictions, or that is being tested for the first time such as preparedness for and responses to extensive disasters or business disruptions. Attention will, understandably, be diverted to competing operational exigencies, but sellers should be prepared for buyer sensitivity to these issues and be ready to provide an assessment of the impact of COVID-19 on the target and its relevant mitigation efforts.
Buyers should ensure their diligence on the target business specifically assesses, among other customary matters, the adequacy of certain measures and the impact of the virus on specific aspects of the business including:
- business continuity plans, risk protocols, and crisis management procedures;
- actual and potential liability exposure not yet captured in financial models;
- impacts on customers, suppliers and other third parties and related agreements and the ability of the parties to perform, suspend or terminate their respective obligations, including by exercising force majeure or similar provisions;
- supply chain risk and disruption and the availability of, and costs associated with, alternative sources of supply;
- regulatory compliance;
- capacity of IT systems to support alternative working environments, such as working from home;
- cybersecurity measures and exposure risk given remote working arrangements;
- privacy and human resource management (including workforce disruption and, for companies with international operations, whether key personnel will be able to travel to company locations or will be prevented by travel restrictions);
- business interruption and other insurance coverage including workers’ compensation claims;
- stopgap health and disability coverage;
- inventory location, levels and quality;
- accounts receivable delays; and
- solvency risk and debt service tolerance.
Material Adverse Effect (MAE) or Material Adverse Change (MAC) Provisions
One area of negotiation and risk allocation that merits special consideration in the current environment is the provision relating to Material Adverse Effect or Material Adverse Effect (we’ll call these “MAC” provisions). A common feature of acquisition agreements, one of the main functions of the MAC provision is to allocate between the transaction parties the risk of negative changes in the target business between signing and closing. It is intended to provide buyers with the right to terminate and walk away from a transaction in the event of unforeseen events or circumstances that have a long-term, dramatic adverse impact on the earning potential and value of the target. These are heavily negotiated provisions, with buyers generally favoring an expansive definition of what constitutes a MAC in the target (e.g., its financial condition, ability to close the transaction, its “prospects,” etc.), while sellers generally favor an expansive list of events or circumstances (“MAC exceptions”) that will not be deemed to cause a MAC in the target business. Sellers often propose MAC exceptions for “acts of god” or “force majeure” events including detailed lists of various natural and other disasters (e.g., earthquakes, fires, floods, etc.) as well as “pandemics,” “epidemics” and “disease outbreaks.” If included, buyers often insist that such events do not disproportionately affect the target.
Courts have set an extremely high bar for concluding that a target company has suffered a MAC or breached its representations and warranties to the point of resulting in a MAC. Only once has the Delaware Court of Chancery (affirmed by the Delaware Supreme Court) found, under Delaware law, the ability of a buyer to terminate a transaction based on a determination that a MAC occurred in the target. In that case, Akorn, Inc. v. Fresenius Kabi AG, the court emphasized that “the important consideration . . . is whether there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months” and that a MAC must “substantially threaten the overall earnings potential of the target in a durationally-significant manner.”
Whether the impact of the virus will be considered a MAC will also depend upon both knowledge of the risk at the time a transaction is signed and whether the relevant MAC definition addresses it. A pre-pandemic agreement with a MAC definition that makes no reference to COVID-19 (or acts of god, pandemics or epidemics generally) may or may not be found to include the effects of COVID-19 in determining whether a MAC has occurred. In such cases, disputes may focus on whether definitional language that typically excludes general economic or market conditions and other broad-based factors affecting the business climate or the target’s industry generally is sufficient to exclude the impact of COVID-19. Parties also may debate whether the potential impact of the virus was reasonably foreseeable at the time the agreement was signed or whether the impact is sufficiently long-lasting to be considered a MAC under applicable state law.
While the ramifications of COVID-19 continue to unfold, it remains too soon to determine whether the crisis will be short-lived or cause catastrophic long-term effects. At this point, transaction parties would be well-advised to negotiate explicit language to address COVID-19 risk-allocation in the context of a MAC provision. Such exclusions have begun to appear in recent acquisition agreements, most often building on an exclusion for “acts of god” or “pandemics,” often limited by disproportionality, to guard against unexpected results. Some exclude it completely while others define the quantitative or qualitative parameters for defining a MAC caused by the financial or operational impacts from COVID-19. In addition, it is wise for parties to reassess other regularly negotiated MAC exceptions, including for changes in general economic conditions, financial markets, or laws that are in turn potentially caused by or made in response to large-scale events like the COVID-19 pandemic. Transaction parties should also consider appropriate alternative solutions to address allocation of risk (such as price adjustments, earn-outs, closing conditions, termination rights and fees, or other mechanics) as opposed to relying solely on the MAC for resolution.
Representations and Warranties; Representation and Warranty Insurance
Buyers may seek the ability to make COVID-19-related claims across all representations and warranties, which sellers will surely resist. To the extent they can be adequately drafted in a fast-changing and unprecedented environment, COVID-19-specific representations and warranties may serve as a backstop for buyer due diligence providing some level of comfort and certainty. In exchange for expanded representations, sellers may seek appropriate knowledge, materiality and other qualifiers, and resist projections and forward-looking representations and warranties. To maximize defenses against buyer claims, sellers should also disclose in the disclosure schedules as much as possible about the adverse effects of COVID-19 on its business, operations, and assets. In addition, sellers may push for the ability to amend disclosure schedules between signing and closing to, in particular, address ramifications of the pandemic situation. Without any ability to amend or supplement disclosure schedules, it is foreseeable that sellers will be at particular risk of breaching certain representations and warranties between signing and closing. Exposure exists across the entire suite of representations and warranties, but sellers are particularly vulnerable, for example, with respect to representations and warranties relating to: undisclosed liabilities arising from the impacts of the crisis; the status of material contracts and other business relationships with customers and suppliers (which are at heightened risk of termination or material amendment under force majeure provisions due to supply chain disruptions and other COVID-19-related challenges); collectability of accounts receivable; sufficiency of inventory; the accuracy of financial statements, including the adequacy of reserves; the adequacy of internal controls monitoring the effects of COVID-19; and any so called “10b-5 rep,” in which a seller represents and warrants that the information provided by it in an acquisition agreement is complete and correct in all material respects and does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statement not misleading.
Transaction parties will also need to agree upon the remedies for any material breaches or inaccuracies of representations and warranties, or the effect of disclosure schedule amendments or supplements that reflect material adverse changes, on the parties’ respective obligations to close or renegotiate the purchase price or other aspects of the deal. Will there be termination rights (generally or only if a MAC has occurred)? Will the parties include pre-closing renegotiation mechanics? Or will post-closing indemnification be the sole remedy? These provisions will garner special attention and be heavily negotiated.
If the parties intend to rely upon representation and warranty insurance as a source of post-closing indemnity, they will need to understand exclusions and limitations for COVID-19-related claims as well as interim breaches particularly in deals with longer interim periods. As COVID-19 is a known risk, insurers are increasingly excluding COVID-19-related losses from policy coverage. For pre-crisis pending deals, insurers may insist on blanket COVID-19 exclusions across the entire suite of representations when “brought down.” Parties should carefully assess the impacts of COVID-19 and related diligence disclosures and their effect on knowledge of the insured party as known matters are typically excluded from policy coverage. Transaction parties may need to negotiate seller financing of any exclusions and monitor the cost-benefit analysis of purchasing insurance.
Acquisition agreements with a delayed closing routinely include a “drop-dead date” or “outside date” provision permitting parties to terminate the agreement if the transaction has not closed by that date. This customary provision also warrants special attention in the current environment. Third-party consent and government approval or filing requirements, along with other closing conditions, are taking longer than normal to obtain or achieve due to office closures, staffing shortages, remote working conditions, and allocation of resources to exigencies. As an example, the U.S. government has suspended the early termination option for Hart-Scott-Rodino Act antitrust review, meaning clearance will take at least 30 days. Uncertainty in credit markets also increases the likelihood that financing will be more challenging and take longer to secure.
Accordingly, transaction parties should adjust outside dates to a reasonable period, consider automatic extensions in certain circumstances where the parties are working in good faith and with appropriate levels of effort toward closing, and allocate the risk of delay. Easier said than done. Outside dates will be heavily negotiated as longer periods between signing and closing mean greater risk on the operations of a target implicating issues discussed above (e.g., purchase price adjustments and MAC clauses) and below (e.g., the scope and specificity of interim operating covenants).
Interim Operating Covenants.
Between signing and closing of a deal, buyers typically require sellers to operate the target business in the “ordinary course” in order to protect the value of the business they have committed to purchase, and to consult with and obtain the consent of buyer for any deviations or material or non-ordinary course matters. This provision does not obligate sellers to maintain the financial condition of the target. However, particularly if the transaction has been structured with a post-closing adjustment mechanism, sellers will bear the pricing risk during the interim and any applicable post-closing measuring period. Sellers will want the authority to take the steps it feels are necessary to operate the business with minimum oversight and interference by buyers. Liquidity maintenance, debt refinancing, and working capital management all require heightened attention in the interim operating covenants during a time of crisis.
Sellers need extra flexibility to respond to and take actions they deem necessary or prudent in response to the COVID-19 crisis to protect the target business, its employees and assets, and to comply with legal or public health mandates without arguably breaching an interim operating covenant and risking exposure to a breach claim. Buyers also should consider specific provisions to address the effects of the pandemic on the business and to protect its investment. Transaction parties should consider whether and how to address these considerations. In addition to specific operating provisions, it may prove beneficial for the transaction parties to develop a mutually acceptable COVID-19 contingency plan with pre-approval of activities outlined in that plan. Business interruption insurance also may be worth considering if it can be obtained at a reasonable cost and provided that there is not an exclusion for COVID-19-related claims.
In addition to the impact that a still developing and disrupting COVID-19 crisis may have on the risk appetite of transaction parties and certain mainstays of M&A deal making, there are a variety of other agreement provisions and the nuts and bolts of the deal-making process itself to consider in light of the pandemic. Of course, the facts and circumstances of a specific transaction (parties, industry, etc.) outside of the context of COVID-19 also must be addressed. We encourage you to contact your Butzel Long attorney to discuss specific questions or issues you may have whether you are considering or in the middle of a transaction.
Arthur Dudley, II
 Even in deals that are signed and closed simultaneously, a representation that there has been no MAC may protect a buyer against unknown changes since the date of the most recent seller financial statements.
 Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018).
 So called because it is modeled on the antifraud provisions of Rule 10b-5 under the Securities Exchange Act of 1934,
 Buyers, too, will want to avoid asserting premature control over a seller’s business, to avoid regulatory problems such as antitrust or CFIUS noncompliance, as well as liability claims should the transaction fail to close.