This article has been authored by Himanshu Chandel, a third-year law student at Campus Law Centre, New Delhi.
The continuing effects of Covid-19 crisis has struck at the heart of businesses across the world as they continue to navigate in the uncharted waters presented by the crisis. It would be needless to say that M&A (Mergers & Acquisitions) transactions have taken a hit and any new covenants in the same will inherit a predisposition to acclimatization and modifications. M&A in economic downturns is an important mechanism for recovery and growth. As the crisis which has uniquely disabled and defied forecasting continues to unfold, those who leverage M&A well as part of a holistic response to the crisis over the next 12-24 month will be more likely to outmaneuver uncertainty and outperform those who do not in the next three to seven years. The crisis has compelled the acquirers to place additional emphasis on some key areas like due diligence, Implementation of MAC (Material adverse change) clauses, Warranties including Insurance, Pre closing covenants, business valuation and legal documentation. Limitations posed by the crisis will have to be factored in and recalibrated accordingly to address the prevailing risks in covenants that are undertaken during this interval related to M&A across the world.
Material Adverse Change (MAC)
A MAC clause in the Sale and Purchase Agreement (SPA) suspends or alters performance obligations due under a contract in the event of a material change which adversely affects the operations of a business which is liable to perform such obligations. In essence, it helps in allocating and mitigating risk in agreements concerning mergers and acquisitions. The MAC clause is read in the context of the entire agreement and in conjunction with other provisions of the agreement with other evidence of the contracting parties’ intent. Identification and interpretation of an event that constitutes a MAC and course of action to be taken in the occurrence of a MAC has been a matter of dispute between contracting parties in an M&A deal.
Invocation of MAC clause in the SPA is likely to be seen during this time and that could allow a buyer to discard the transaction completely. Whether or not the Covid-19 crisis has actually resulted in an MAC will have to be evaluated on a case to case basis. To determine the attributes constituting a MAC, the scope of the MAC clause will have to be corroborated with the industry/sector and geography in which the target operates and it will be seen whether the circumstances render the performance on part of the acquirer to be impossible. In Nirma Industries Ltd. v. Securities and Exchange Board of India the Supreme Court held that an open offer can be withdrawn only if the circumstances render the performance of the open offer impossible on the part of the acquirer. The most important consideration is whether there has been an adverse change in the target’s business that is consequential to the target’s long term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months. Courts in other jurisdictions have also allowed the acquirer to discard the transaction for failure of a MAC clause only if the event is material in the sense that it strikes at the heart of the transactions, almost akin to a frustration of a contract.
The closest precedent concerning the current situation can rightly be said to be the 2008 financial crisis where the operations crumbled and it became problematic for businesses to honor their contracts. In the midst of the 2008 financial crisis, the Court of Chancery of the State of Delaware in Hexion Specialty Chemicals, Inc. v. Huntsman Corp held that, in the absence of the contrary, an acquirer may be assumed to be purchasing the target as a part of a long-term strategy. The target’s failure to meet its financial forecasts by itself will not constitute a MAC, as the merger agreement “explicitly disclaims any representation or warranty” with respect to any projections, forecasts or other estimates. Marching by such an argument would mean that an acquirer will require circumstance of an entirely exceptional nature and amounting to something of the kind which would frustrate a legal contract akin to Section 56 of the Indian Contract Act. The standard to constitute a MAC although has been diluted but remains fairly high.
Even where a pandemic or health emergency or related clauses are not specifically excluded, other exclusions (e.g. events having industry-wide impact, general economic conditions, change in law or force majeure) could potentially exclude the application of the MAC clause to the present crisis. The fundamental detail to take a note of is that withdrawal will be permissible only if the circumstances giving rise to the incompetence of the acquirer/buyer to complete the offer is beyond its control. Moreover, to take suggestions from other jurisdictions, such circumstances would require to pass the test of objective determination and mere subjectivity by the acquirer would not suffice. A revamp in economic, industrial or political circumstances will not ordinarily justify the abolition of a takeover offer already made public. To justify unilateral withdrawal, the effect of the circumstances in point must be sufficiently adverse to meet the high test of materiality, not in terms of short term profitability but on their effect on the longer term prospects of the offeree company.
The Acquirers/Buying party will likely muster arguments to enlist the current pandemic, lockdowns and disruptions in the supply chain as a result of closure of borders as MAC events whereas the Seller/Target will want to narrow down the scope of a MAC clause to the best possible limit. Depending on case to case basis, the contracting parties should come together on the negotiating table and specifically agree on how a transaction is affected due to the impact arising on account of the Covid-19.
A switch in due diligence is rightly anticipated as parties to an M&A will reposition themselves from a traditional due diligence process to a more specific one where decisions will have to be primarily constructed around the aspects of Covid. The nucleus to a legal or commercial due diligence will certainly be related to the target and the nature of the transaction but the “new normal” will give birth and preference to areas of concern.
The crisis will necessitate relevant operational changes in business related to Contingency and emergency planning. This would vary from business to business as the ones who operate in more specific industries which are the most vulnerable to a halt in operations will have to manage their cash flows and track their cost accordingly. Parties to a M&A (typically a buyer) will transfigure their due diligence exercise to verify whether the target has incorporated the post-Covid necessary changes or not. These changes would largely be but not limited to the Emergency Planning, Supply chain management, Customer agreements, Insurance, Employee welfare, Infrastructure, Taxation and Cyber Security etc.
A buyer will investigate the operational disruptions caused in the target and will have to assess the significant reasons for such disruptions. The Supply chain which is the impetus for running businesses across the world and is primarily impacted will have to be evaluated on the basis of its capacity to perform the contractual obligations. This would be a grueling task as an extensive exercise into the supplier’s operational capacity will be have to judged on the basis of empirical and anecdotal evidence. At the same time, issues with respect to customers will be examined, contractual breaches and delays in payment will have to be addressed and substantiated by the seller, disclosing the risk of reduction in volumes of customers and a possible strain on the cash flow position. An essential element that a buyer will have to diligently look into is whether an insurance cover is under place to respond to the effects of the pandemic and whether an interpretation can be placed to activate such a cover. In case where the Insurance cover does not meet the standards that a buyer urges, then Govt. aid, and the regulations and complications that arise with it will have to be extensively studied. Priority under the “new normal” will now be designated to safe working requirements of employees along with assuring a satisfactory infrastructural setup. Due diligence exercise will now focus on assuring whether the issues of the workforce are managed effectively and whether statutory sick pay requirements are followed. A buyer will see whether an IT platform is in place for business capable of functioning remotely when required and whether such a platform is robust and capable of providing satisfactory results without compromising business operations or increasing capital expenditure. Most governments across all jurisdictions have provided relaxations concerning tax Liabilities and therefore businesses have rightly availed tax holidays, therefore a buyer who wishes to invest in and possess a target in the current scenario will have to emphasize on having the knowledge and understanding of resources in place for discharge of such tax liabilities at a later stage. Whether the way in which the group has been run during the COVID-19 crisis expose the group to any additional tax risks (such as unintended permanent establishments and/or employee tax liabilities) will have to be taken into consideration.
The complication in a due diligence exercise always lies in connection to efficiency and effectiveness of carrying a plan into action. There would be no difference between a traditional due diligence exercise and the one post Covid with regard to the same. Given the limitations on due diligence on account of the crisis, buyers are likely to ask for inclusion of a satisfactory bring-down due diligence (including an on-site inspection and title due diligence for real property), as a condition precedent to closing.
There now exists a risk of breach of warranties as a result of the effects of Covid-19. From a Seller’s outlook, deleting and amending such warranties which may constitute an issue or diminishing the scope of such warranties by adding disclosures against the same will be desired. Forward looking warranties will be explicitly avoided. A seller will usually push for a general disclosure as to the known and unknown effects of the pandemic. However such general disclosures might not succeed to meet “fair disclosure” standards in the SPA as most SPAs would require an adequately comprehensive or exhaustive particulars to relate to the nature of the matter in question. They would also appropriately consider disclosing any specific facts, which are germane to the crisis in the disclosure schedule. Accordingly, it may be necessary to make as much detailed disclosure of COVID-19 consequences as possible against warranties. Greater reliance would also be placed on warranties and indemnity insurance. Knowledge and materiality qualifiers will be appropriately used for qualification of such warranties.
From an Acquirer/Buyer’s perspective, an inclination towards specific warranty cover is always expected but for the current scenario there might be areas where additional warranties will be desired. Such warranties may be related to the target’s ability to comply with regulatory requirements, having a safe working environment for employees with the resilience of the IT mechanism in the company to handle the business remotely and most importantly for breaches of supplier or customer contracts. General disclosures may prove to be repugnant as they can be unreliable and equivocal and therefore propelling towards more specific warranty is fittingly anticipated on part of the Buyer. Seeking a retention or an escrow as security for warranty would be contemplated by the contracting parties.
The COVID-19 pandemic exposed critical weaknesses in almost every business. The accurate impact of the crisis cannot correctly be ascertained until things settles. However, it can be said to constitute a MAC if it has considerable impact on the earning potential of the target, and is likely to have a lasting impact on the operations of the target. Short-term or cyclical difficulty will not be considered as a MAC. At present, it is difficult to comment on how courts will the pandemic from an impact and duration perspective, as it is almost impossible to predict the path ahead as multiple dimensions of the ‘crisis’ are unprecedented and unknown.
Incorporation of situation specific representations and warranties, Securing indemnity and risk mitigation will be a priority. Parties to contracts with and without clauses such as MAC or force majeure should carefully consider their course of action if those agreements are impacted directly or indirectly by the pandemic. The contracting parties’ ability to fulfil the pre-closing covenants will be significantly impeded on account of the lockdown if they intend for the transaction to proceed. Several clauses in the transaction documents (viz. warranties, conditions precedent, MAE and consideration adjustment) are likely to be heavily negotiated and the allocation of risks on account of a ‘change in law’ are likely to be keenly contested.
Forward-thinking leaders will take a holistic approach, keeping in mind to balance stability and resilience while enforcing necessary short term moves and keeping opportunistic growth plays on the radar. Every crisis creates opportunities to be better prepared for the future.