This is part five of a series focusing on current M&A
trends, opportunities and challenges.
With positive news with respect to vaccines, there are reasons
for optimism that the worst of the COVID-19 pandemic and the
corresponding governmental health restrictions may ease in
2021. However, it also seems increasingly clear that this
easing is still months away, and that pandemics and other
unforeseen crises are a reality that businesses will need to
address on an on-going basis in the future, including in the
context of M&A transactions.
This article provides a brief overview of a few key
considerations for M&A transactions arising from the COVID-19
pandemic.
Previous articles in this M&A series have looked at specific
considerations for boards of directors of
acquirors, target entities, for companies in financial distress, as well as valuation issues impacting transactions during the
COVID-19 pandemic. This article addresses general transaction
considerations.
Due diligence
In addition to the practical challenges of completing a due
diligence investigation arising from the COVID-19 pandemic as well
as the resulting travel and social distancing restrictions
(e.g. challenges with site visits, physical inventory
review and in person meetings with key personnel), the pandemic has
also highlighted areas of vulnerability for many businesses. As a
result, certain aspects of due diligence have increased in
importance, or in some cases, new issues have arisen. Matters
potentially requiring heightened due diligence include:
- Supply and distribution chain risks – It
is important that any acquiror have a thorough understanding of a
target’s supply and distribution chain as well as where they
could become vulnerable. For example, it is important to understand
if a target is relying on any suppliers where there is not a
practical alternative source of supply and how they may have been
impacted by the pandemic. In the event that a supplier is critical
to the target’s ability to conduct business and is not easily
replaced, it may be appropriate to conduct diligence on that
supplier as well as review diligence conducted by the target when
they entered into the supply contract. - Insurance coverage – Parties should
review all insurance policies to understand the scope of any
pandemic exclusions or limitations on coverage and review all
claims brought against the target and claims the target has made
under its insurance policies as a result of the COVID-19
pandemic. - Employment matters – In addition to
traditional labour and employment due diligence, companies will
need to understand what steps a target has undertaken to mitigate
against the effects of COVID-19 on its workforce, including
ensuring employee safety and knowing how to respond if an employee
tests positive for COVID-19. Where the target implemented layoffs
because of the pandemic or has implemented austerity programs, such
as across the board wage or hour reductions, these should be
reviewed to confirm compliance with employment laws and to
determine their impact on employee benefit plans or insurance.
Finally, it is also important to understand which employees are
required to be physically present at the workplace and which are
permitted to work remotely. As the COVID-19 work-from-home
restrictions abate, it will become increasingly important to
understand return-to-work policies and how the target intends to
re-integrate personnel on site. - Government grants and loans – During the
COVID-19 pandemic, many businesses received government assistance
such as the Canada Emergency Wage Subsidy and Canada Emergency
Business Account non-interest loans. It is critical to understand
what grants or loans were received or applied for and to ensure the
target has complied with and has properly accounted for them.
Finally, there are reputational issues related to accepting
government assistance that should be considered. For example,
stories in the media have recently targeted entities paying out
dividends to shareholders, bonuses to executives or using funds to
buy back shares after receiving government grants. Even if these
actions are technically legal, they may result in unwanted negative
press for an acquired business. - Material contracts – All contracts
should be reviewed in light of business disruptions resulting from
the pandemic. Where parties have been unable to perform their
obligations under material contracts, it is important to understand
whether a target has agreed to modify or waive provisions of its
material contracts, and whether such modifications or waivers may
affect the ability of the target to enforce the contracts. Review
of representations and warranties to see if current circumstances
exist that may allow for the termination of a material contract or
raise the risk of a breach or default of the contract is also
important. - IT systems and data security – Diligence
of a target’s IT systems has become even more important as
businesses have been forced to increasingly rely on their digital
platforms because of remote working. This has stretched the
capacity of IT systems and often made them more vulnerable. A
detailed review of the target’s data security and privacy of
information processes and monitoring should be undertaken. - Debt covenants –It is important to
understand the target’s debt covenants and whether there is a
risk of non-compliance, including as a result of business
interruptions during the pandemic. Many credit agreements contain
financial covenants based on EBITDA calculations that might permit
certain unusual, extraordinary or non-recurring expenses incurred
in connection with the COVID-19 pandemic to be added back. These
provisions should be reviewed in order to understand any caps on
these add backs and whether any costs may cease to be eligible in
the event they become permanent costs of doing business after the
pandemic. Even in situations where the purchaser is paying out the
target’s debt and putting its own debt facilities in place, an
understanding of how COVID-19 has affected the target’s debt
covenants can assist in implementing new banking arrangements.
Given the rapid rate of change and uncertainty the COVID-19
pandemic has created, depending on the length of the interim
period between signing of the definitive agreement and
closing, the purchaser should also consider whether robust bring
down due diligence is also required prior to closing and, if so,
incorporate these terms into the purchase agreement.
Drafting and negotiating the acquisition agreement
While the pandemic has not changed the fundamental structure of
negotiating and drafting an acquisition agreement for an M&A
transaction, a few provisions of these agreements have been
specifically impacted by the pandemic.
Purchase price considerations
Earn-outs
As set out in the previous installment of this series, Valuation
Issues & Nil Premium Transactions, the uncertainty resulting
from the COVID-19 pandemic has exacerbated the valuation tension
that already exists between buyers and sellers. One potential
solution to this is the use of earn-out clauses. Parties to M&A
transactions have generally tried to avoid using earn-outs as they
are complicated and are one of the most common areas of dispute
following the completion of transaction. However, they can be a
useful tool for bridging valuation gaps, especially when
uncertainty (such as that created by the COVID-19 pandemic) makes
it difficult to forecast future profitability.
Purchase price adjustments
Purchase price adjustment clauses should be carefully considered
in the context of the pandemic. For example, sample calculations
agreed to prior to signing can help to ensure each party
understands how particular expenditures or receipts will affect the
purchase price. Sellers will want to be cautious with such
adjustments, and may seek to negotiate a cap as to the amount the
purchase price can be decreased, as government restrictions imposed
because of the pandemic could dramatically affect the adjustment
mechanism.
MAE/MAC clauses
In the early days of the pandemic, questions immediately arose
as to whether COVID-19 and the related government responses could
be characterized as a Material Adverse Effect (MAE) or Material
Adverse Change (MAC) and, if so, whether parties to transactions
that were not yet closed would be able to terminate their
agreements in reliance on an MAE or MAC clause. An Ontario court
has recently provided guidance on the ability to use MAC/MAE
clauses to terminate an agreement, generally and in the context of
the COVID-19 pandemic. BLG’s analysis of the decision in
Fairstone Financial Holdings Inc. v. Duo Bank
of Canada can be found here.
Notwithstanding the Fairstone case, companies will
still need to pay close attention to MAC/MAE clauses as their
interpretation will always turn on the specific facts and language
used in the definition of MAC/MAE and related carve-outs.
Another option to provide certainty is not relying on an MAE/MAC
clause at all, but to consider including specific closing
conditions to address particular COVID-19 or other risks instead.
Where a specific closing condition is not met, the purchaser will
have the option not to close without having the heavy burden of
proving an MAE/MAC has occurred.
Interim period covenants
The uncertainty and rapidly changing landscape the COVID-19
pandemic has created has resulted in additional risk for both
parties arising during the interim period between signing of the
definitive agreement and closing. Accordingly, parties will want to
try to limit the duration of the interim period. A further risk is
that if the parties are utilizing representation and warranty
insurance (R&W insurance), any known breaches will likely be
excluded from coverage.
Parties will want to review the interim period covenants
contained in the definitive agreement carefully to ensure that:
- The interim period is as short as possible;
- The covenants are capable of being complied with in the current
pandemic; and - The covenants give the target business the flexibility to
respond quickly to rapidly evolving developments.
In particular, parties should pay attention to the covenants to
provide access and to operate in the normal course.
Access and inspection
Agreements typically require that sellers provide purchasers
with access to their premises and their personnel. Parties should
ensure it is made clear that this is subject to restrictions and
limitations imposed by governments in response to the pandemic.
Sellers may wish to clarify that employees will not always be
available in person and that web conferencing or phone access is
acceptable.
Operations in the normal course
Agreements typically restrict the ability of the target to take
any actions during the interim period that are outside the normal
course without the prior consent of the purchaser. However, this
requirement may result in the target entity not being able to act
in a timely manner to protect its business, its personnel or its
customers in response to the pandemic or another unforeseen crisis.
In addition to ensuring there is good communication between the
parties, the seller might seek to include exceptions allowing the
target to respond unilaterally to pandemic developments. The
purchaser would want the pandemic exceptions to be as narrow as
possible and to include a requirement for the seller to notify the
purchaser of the actions taken immediately.
Another alternative may be to amend the definition of
“ordinary course” to include any actions taken or omitted
to be taken because of COVID-19, provided the actions are
reasonable and necessary to protect the health and safety of the
business’ employees, customers or other third parties, or to
protect the business and financial condition of target entity.
The Fairstone decision mentioned above also addressed
alleged breaches of the target’s covenants to operate its
business in the normal course during the interim period. The Court
rejected these allegations and held that where businesses take
prudent steps in response to an economic contraction, consistent
with prior behaviour and that do not impose long-term obligations
on the purchaser, this should not seen as outside the normal
course.
Closing and related matters
Other matters for parties to consider while completing an
M&A transaction include:
- Financing – Purchasers that must rely
upon acquisition financing may face additional challenges because
of the volatility in the equity and debt markets, and may face
challenges in obtaining more traditional bank acquisition
financing. As we entered the second half of 2020, however,
financing challenges appeared to ease and current low interest
rates may make leveraged acquisitions more appealing to purchasers.
While purchasers may want to try negotiating a financing out, if
financing is not certain, sellers will want to push back on any
such ask. A compromise may be a finance out with a reverse break
fee payable to the seller if the transactions does not close as a
result of a failure to finance, to ensure the seller’s expenses
and lost opportunity costs are covered. Both parties will want to
ensure that the conditions in any commitment letter in respect of
financing are as limited as possible and parallel the conditions in
the definitive purchase agreement. - Third party approvals and outside date –
Although most businesses and governments have found ways to operate
remotely in an effective manner, the pandemic may result in slower
turn around times in obtaining third party approvals. Accordingly,
parties will want to ensure that the outside date for completion of
the transaction is either far enough out to ensure that approvals
can be received, or is appropriately flexible in the event any
third party approvals are not received. - Physical closing mechanics – Physical
distancing means that physical closing may not be possible and that
a virtual closing may be the only option. Virtual closings are done
via electronic exchange of signature pages and there are tools
available, which BLG utilizes, to fully implement virtual
closings,. - Indemnities – The parties will want to review
the indemnity section in light of the current COVID-19 landscape
and determine if the standard indemnities for breach of covenants
or if warranties are sufficient. If there are specific risks
created by the pandemic, it may make sense to include a specific
indemnity to address potential losses arising from that
risk. For example, if due diligence determined a key customer
may be able to terminate their agreement with the target as a
result of breaches resulting from the pandemic, the purchaser may
request a specific indemnification from the sellers for losses
resulting in the event that agreement is terminated. Purchasers
should also consider if a portion of the purchase price should be
escrowed to ensure that funds are available in the event of an
indemnification claim and if a higher cap may be appropriate if a
specific risk with a potential large loss is
identified. Sellers will want to push back on indemnification
provisions by adding exclusions to any sandbagging provisions to
ensure that they exclude claims or losses resulting from known
COVID-19 losses.
Conclusion
While the COVID-19 pandemic has caused disruptions to all
aspects of life, including M&A transactions, BLG is still
seeing robust M&A activity occurring, with deal volume
increasing in the last half of 2020 and into 2021. While there are
new considerations that need to be addressed in completing
transactions in a post-COVID-19 environment, BLG is well positioned
to assist its clients in ensuring M&A transactions are
completed successfully.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
