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By: Ryan M. Scofield and Parthiv Rishi, Sidley Austin LLP
Novel Coronavirus (COVID-19) is now a global pandemic and continues to dominate headlines as confirmed cases of the virus escalate. As of March 27, 2020, The World Health Organization reports more than 509,164 confirmed cases and 23,335 deaths worldwide.
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 article 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.
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:
Sellers should be prepared for buyer sensitivity to these issues and preemptively 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.
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 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.
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.
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.
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.
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 ring-fencing 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.
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.
This is a rapidly evolving situation, and Sidley’s global team of M&A and Private Equity lawyers based in Asia, the United States, and Europe are ideally positioned to help you address and mitigate the risks posed by the coronavirus and ensure you are appropriately protected and informed.
Editor’s Note: The global situation around COVID-19 outbreak continues to evolve daily, with increasing numbers of confirmed cases and expanding response by private industry and public institutions.
Ryan M. Scofield is a partner in Sidley’s Dallas office who regularly advises public and private companies, private equity firms, and financial institutions on complex corporate and transactional matters, with a primary focus on public and private mergers and acquisitions across various industries. Parthiv Rishi is a partner in Sidley’s Singapore office who advises private equity firms, financial sponsors, and large corporate and financial institutions on acquisitions, investments, divestments, venture capital financings, restructurings, joint ventures, and shareholder arrangements across Asia Pacific and India.
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