Diagnosing and Treating Coronavirus Risks in M&A Transactions

Ryan Scofield and Parthiv Rishi are partners at Sidley Austin LLP. This post is based on a Sidley memorandum by Mr. Scofield, Mr. Rishi, Dan Clivner, Brian Fahrney, Paul Choi, and Charlie Wilson. Related research from the Program on Corporate Governance includes Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here).

Novel coronavirus (COVID-19) continues to dominate headlines as confirmed cases of the virus escalate. As of March 2, 2020, the World Health Organization reported over 80,100 confirmed cases of the disease in China, and roughly another 8,800 elsewhere. These developments have led global markets to decline precipitously, local economies to suffer and governments to take dramatic steps to protect against the spread of the virus turning into a pandemic. Factory, school and office closures, quarantine and stay-at-home orders, travel and transport restrictions and other measures have been introduced around the world and will inevitably expand as more nations report COVID-19 cases. These steps have significant consequences on businesses across industries by reducing consumer spending, creating disruption to supply chains and workforces and decreasing energy demand. The full effect of COVID-19 on global M&A activity will not be known for some time, but as buyers and sellers continue to diligence businesses and negotiate transactions, they can take certain steps to protect against risks introduced by this outbreak.

This post seeks to help parties navigate such issues in the context of M&A transactions. While these issues are most acute when the target business is based or has significant operations in Asia, as COVID-19 continues to spread globally, so too will the relevance of the issues discussed below.

Due Diligence

Many offices and factories in the communities most affected by the coronavirus epidemic largely remain closed or limited in operation. Combined with significant travel restrictions and quarantine measures, in-person management presentations and site visits have become challenging or impossible, especially in the hardest hit areas. Transaction parties will need to adjust expectations and timetables accordingly. Due diligence and electronic meetings, however, can continue to proceed thanks to the proliferation of virtual data rooms and video conferencing.

Buyers should ensure their diligence on the target business extends to:

  • existing insurance policies and their coverage, including business interruption policies and the nature and extent of stopgap health and disability coverage related to the target’s welfare plans for employees;
  • 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;
  • exposure of the business (including its key counterparties, suppliers and customers) to jurisdictions highly impacted by the coronavirus epidemic;
  • regulatory, licensing and data privacy implications as a result of remote working arrangements, particularly in certain industries (e.g., financial services);
  • the effectiveness of any risk protocols in place for dealing with unwell or higher risk employees, the communication and implementation of health and safety procedures within the workplace, adequate compliance with relevant government health guidelines and the possible impact of travel bans for highly mobile or immigration dependent workforces;
  • the legal basis under privacy laws, particularly the GDPR in the EU/UK, to process health data on employees, visitors and customers and whether privacy notices cover processing for COVID-19 purposes;
  • solvency or going concern risk and the ability to service debt (especially where high-yield debt may be in place); and
  • the ability of the target business or its counterparties to perform, suspend or walk away from obligations under material contracts, including exercising force majeure or similar provisions—in particular, investigating scenarios where the non-performance by the target’s counterparty has the consequence of causing the target to breach its obligations under other contracts.

Sellers should be prepared for buyer sensitivity to these issues and pre-emptively prepare information on the current and expected future impact of the coronavirus outbreak on the target business and relevant mitigation efforts. Sellers should also be prepared to manage due diligence expectations and be prepared and organized, including making use of third-party advisor resources to help manage the due diligence process. The effects of the coronavirus outbreak are likely to have an impact on various aspects of the target (or seller) businesses resulting in management time and attention being diverted away from the relevant transaction.

Price and Consideration

The uncertainty around the short- and long-term impact of the virus on businesses can make valuations challenging. Because the outbreak is likely to have a negative effect on revenue and earnings forecasts, and deals are commonly priced on the basis of revenue or earnings expectations, certain buyers may be tempted to take advantage of the outbreak to secure more favorable pricing. On the other hand, because the outbreak’s effects are still unknown and may be short-term, sellers are likely to resist such attempts and take the position that the effects and duration of the outbreak are atypical and business fundamentals are unaffected. How negotiations will unfold on this issue is yet to be seen, but largely will be a function of several factors, including the negotiating leverage a party has relative to its counterparty in any particular transaction and the ultimate scope, reach and duration of the outbreak.

Buyers should consider whether locked-box and fixed pricing carries too much risk in this environment. In this regard, a trend may develop toward post-closing purchase price adjustment mechanics to ensure that the purchase price paid reflects the state of the target business as of the closing (i.e., that it reflects any deterioration of the target business between signing and closing). Buyers may also consider structuring the purchase price through deferred or staggered consideration payments that are contingent on the performance of the business post-closing in line with agreed targets. If a deal involves post-closing deferred payments, sellers should insist on adequate audit and information rights and post-closing covenants from the buyer to ensure that the new owners conduct the target business optimally post-closing. Given the highly public nature of the coronavirus outbreak, however, sellers may instead prefer to resist these types of purchase price adjustment and payment mechanics altogether on the premise that COVID-19 is a well-known market risk at this time that should be borne by buyers.

COVID-19 will continue to impact the revenue and solvency of businesses in certain industries and, of course, in affected jurisdictions. This, in turn, may adversely affect the cash reserves and ability of certain trade buyers to obtain acquisition financing. Sellers should be cognizant of the credit risk of their counterparties and should undertake due diligence on the financial viability of buyers and also consider the use of structures such as escrow arrangements, parent company guarantees and termination fees to reduce the risk of buyers defaulting on their payment obligations under acquisition agreements. Sellers should also carefully review all acquisition financing documents, including all side letters, in order to make sure that the coronavirus risk is not treated differently than in the acquisition documents themselves.

Material Adverse Change

Buyers would be well-served to insist on material adverse change (MAC) clauses that capture COVID-19 and other pandemic or epidemic risks to give them the ability to terminate and walk away from an agreed transaction if the situation continues to materially worsen. These clauses are heavily negotiated, however, and buyers should expect strong pushback from sellers on the basis that the coronavirus risk has been broadly publicized and is well known to market participants. Parties may, however, be able to compromise so that situations where the impact of the coronavirus on the target business is disproportionate to other businesses in the same industry or jurisdiction, or where there is a disproportionate impact of the coronavirus on specific important contracts, would trigger the MAC clause. MAC clauses with these compromise formulations (i.e., specifically picking up the effects of the COVID-19 outbreak to the extent disproportionately impactful on the target business relative to other industry participants) have begun to appear in acquisition agreements.

Outside Dates

Most acquisition agreements include a “drop-dead date,” “outside date” or “long stop date” provision that enables termination of the agreement if the transaction has not closed by a specified date. Even though some governments and regulators are publicizing that their operations are business as usual, the reality is that office closures, working from home arrangements and dislocation of employees means that parties should expect governmental and regulatory approvals and other change of control approvals or third party consents to take longer than normal in the countries affected by the outbreak of the coronavirus. Given that due diligence and in-person meetings are increasingly being delayed or have become impossible, and credit markets have begun to tighten quickly, it is likely that financing may become more difficult and take longer than would otherwise be customary. In light of all of the foregoing, parties should adjust outside dates accordingly. Given the fast-changing environment, longer periods between signing and closing of a transaction will mean greater risk on the operations of target businesses and buyers should be alert to this when negotiating clauses such as purchase price mechanisms and MAC clauses (each described above), as well as the scope and granularity of interim operating covenants (described below). Parties should consider including automatic extensions of outside dates where the only unsatisfied conditions precedent are in highly affected jurisdictions (e.g., Chinese regulatory approval), but only if the relevant party has used, and continues to use, appropriate efforts to satisfy the relevant conditions.

Interim Operating (and Other Operating) Covenants

Between the signing and closing of a transaction, buyers generally want sellers to operate the target business in the ordinary course to protect the value of the business they committed to purchase and want to be consulted (and their consent obtained) on a variety of material or non-ordinary course matters. On the other hand, sellers continue to own the target business until closing and, particularly if the transaction has been priced under a post-closing adjustment mechanism, sellers will continue to take pricing risk on the business during the applicable measuring period. Sellers will therefore want to retain the authority to take the steps they feel necessary to operate the business during the sign-to-close period with minimum oversight and interference by the buyer, as well as rights over the operation of the business during any post-closing adjustment period. The uncertainty associated with the coronavirus outbreak means that sellers should insist on being able to (and buyers should be amenable to allowing them to) respond quickly to the coronavirus threat in order to protect their workforce, comply with legal or public health requirements and orders and undertake other activities that may be deemed necessary or prudent in this environment. In this regard, it may be beneficial for sellers to review their coronavirus contingency plan with a buyer prior to signing the acquisition agreement to obtain pre-approval for activities outlined in the plan.

Representations and Warranties

Buyers should consider seeking additional representations and warranties relating to the target business’s emergency protocols, contingency planning, business continuity processes and other similar matters that are critical in this environment. If sellers are willing to agree to such expanded representation and warranty coverage, it is fair for them to seek appropriate knowledge, materiality and “subject to law” qualifiers, to resist forward-looking representations and warranties, and to insist on appropriate “bring-down” standards at closing. Sellers should also consider ringfencing their representations and warranties to protect against buyers having the ability to make coronavirus-related claims across the entire suite of representations and warranties. In addition, sellers should disclose as much as possible in the disclosure schedules about the impact or potential impact of the coronavirus on the target business and its effects or potential effects to ensure adequate defenses in the event of a claim. If parties are considering utilizing representations and warranties insurance, they should pay close attention to the policy exclusions—since coronavirus is a known risk, some insurers have started to specifically exclude coronavirus-related losses from their policy coverage.

Choice of Governing Law

Finally, buyers and sellers should be thoughtful and deliberate in selecting the governing law applicable to their contracts. While a full accounting of the differences among various jurisdictions is beyond the scope of this article, it is worth noting that the laws of many U.S. jurisdictions will deal with the interpretation and enforcement of contractual clauses (e.g., MAC clauses) differently than the laws of other jurisdictions (including those of China, Hong Kong, England and Singapore, for example). Ultimately, it is likely that no jurisdiction is entirely seller-favorable or buyer-favorable in the context of contractual issues arising from the coronavirus outbreak, so parties will need to take the good with the bad.

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