As the novel coronavirus (COVID-19) crisis continues to escalate, it has become clear that global M&A activity will likely face disruption. M&A transactions in the planning stage may be paused or abandoned, and there will be questions about whether announced transactions will proceed, and if so, on what terms and when.
The impact of COVID-19 could, however, also spur M&A activity, whether from opportunistic buyers, or from sellers or target companies looking to potential buyers as sources of financial support or in response to shareholder activism. Public company boards should revisit their takeover bid and activist preparedness plans with their advisers to ensure they will be able to effectively respond to a hostile takeover bid or shareholder activism campaign.
While the situation is evolving quickly, here are a few key considerations that parties to pending or potential public and private M&A transactions may wish to consider:
COVID-19 and material adverse effect
M&A transaction agreements in the U.S. and Canada typically include material adverse effect (“MAE”) clauses, which describe circumstances in which a buyer may terminate a transaction. Delaware courts have held that buyers bear a heavy burden in establishing an MAE. To qualify as an MAE, the adverse change must be material when viewed from the longer-term perspective of a reasonable acquirer—as the cases put it, the adverse change must be “durationally significant”. While there isn’t a developed body of Canadian law on MAEs, we expect a Canadian court would take a similar approach to evaluating materiality.
It is too early to tell how durationally significant the impact of the COVID-19 pandemic on target companies in various industries will be and, accordingly, whether the pandemic might meet the threshold materiality test established in the caselaw. Even if the effects of COVID-19 meet the materiality test, the terms of the M&A agreement may exclude the pandemic from the definition of an MAE. Most M&A agreements have carve-outs from the definition of an MAE such that “acts of God”, “changes in the economy”, or “changes in the conditions of a specific industry” do not qualify as an MAE. Such carve-outs could well be viewed as being triggered by the COVID-19 crisis. In addition, some M&A agreements include specific carve-outs for “national or international calamities”, “pandemics”, or “disease outbreak”. So-called “disproportionate effect qualifiers” render carve-outs to MAE clauses inapplicable where a specific adverse change has a disproportionate effect on a target company. From the current vantage point, and depending on the target’s business, those qualifiers may be inapplicable given the broad nature of the impact of COVID-19. For these reasons, buyers should not assume that a standard MAE definition will provide them with the ability to terminate a transaction based solely on the fact of the COVID-19 pandemic.
Even if a buyer is unable to rely on the MAE provision of an M&A agreement to terminate a transaction, parties may nonetheless agree to amend the terms of their agreement in order to permit a transaction to proceed that might otherwise be jeopardized or unlikely to proceed due to the absence of financing, the failure of closing conditions or other reasons that result in the parties’ inability to close absent an amendment.
Buyers that intend to finance acquisitions should also be mindful that, while the MAE in acquisition financing documentation will commonly track the definition in the relevant acquisition agreement, the legal analysis may not always be the same. Instead of looking at the long-term effects of the COVID-19 pandemic on the target company, a court may take a different view of the impact on the more immediate ability of the target to service its debt. Accordingly, there is a risk that, even if buyer and seller proceed on the determination that no MAE has occurred, the lenders may refuse to fund.
While the full effect of the COVID-19 crisis on acquisition finance is far from clear, consistent with earlier downturns, we expect to see equity increase as a percentage of purchase price. We also expect that some customary adjustments in the calculation of financial covenants will draw more attention. Notably, many credit agreements contain financial covenants based on the calculation of earnings before interest, tax, depreciation and amortization (or EBITDA) with a range of adjustments. The definition of EBITDA is often heavily negotiated; however, it is common for EBITDA to include an add-back for non-recurring, unusual or extraordinary expenses. Many businesses will be incurring expenses of this nature in response to the COVID-19 pandemic: for example, the implementation of remote working for employees, or the cost of upgrading IT infrastructure.
Companies may also avail themselves of addbacks for restructuring charges and advisory fees incurred in connection with the current crisis. Buyers should carefully consider any caps applicable to these addbacks. In addition, costs of this nature may cease to be eligible if the effects of COVID-19 last for an extended period and these costs become permanent, regular costs of doing business in a changed environment. This is not a bright line test and developments should be monitored and discussed with counsel. Parties should also keep in mind that EBITDA add-backs generally do not provide for adjustments for lost revenue (as opposed to expenses) resulting from unusual or non-recurring events, so decreases in revenue will generally impact financial covenant calculations.
Need to renegotiate provisions in pending M&A transactions?
The COVID-19 pandemic may affect several provisions in M&A agreements for pending or proposed transactions. For example:
Will uncertainty in financial markets and delayed regulatory approvals (see below) result in parties not being able to meet pre-negotiated outside dates?
Will parties currently in an interim period between signing and closing be able to continue to operate their business in the ordinary course? Will consent be needed for the initiatives or operational changes being taken in response to the pandemic?
Will the impact of the pandemic colour the efforts standards in M&A (and other commercial) agreements?
What types of solvency issues arise on either side of the deal? Is there greater counterparty risk and, if so, what protections or credit support might be available?
Are closing conditions impacted by changed market conditions? For example, will the competition landscape look differently as a result of the pandemic? Are shareholders more or less likely to support the transaction? In deals involving share consideration, what is the impact of the buyer’s declining share price?
Parties to existing M&A agreements that face these questions may wish to consider opening a dialogue with counterparties, possibly with a view to negotiating amendments.
The impact of COVID-19 on regulators could result in delays in the processing of regulatory approvals for pending M&A transactions. Many North American transactions are subject to Competition Act and/or HSR Act approvals in Canada and the U.S., respectively, and some transactions are also subject to foreign investment review and industry-specific approvals. A number of key regulatory agencies in both countries have signaled that review timelines will be slowing down. In connection with competition reviews, it is becoming increasingly difficult for staff to make market contacts or interview witnesses in a timely manner since many businesspeople are working remotely. The agencies themselves are also struggling with staff working remotely and/or with skeleton “head office” staff. Although this should not generally directly affect statutory “no close” waiting period deadlines, it may mean that agencies are unable to narrow issues, resulting in unusually burdensome information requests or subpoenas and delayed file-closings.
In addition to bracing themselves for potentially slower and more burdensome review processes, transaction parties should therefore expect longer overall transaction timelines and outside dates. In Canada, there may also be an increasing trend for buyers to move to close as soon as competition statutory waiting periods expire and waive rights to “no action” letters.
Target board preparedness
Depressed valuations of public companies can drive increased levels of hostile bid activity as buyer and seller expectations regarding price diverge. In addition, activist shareholders may also seek to disrupt publicly announced transactions or agitate for an M&A transaction in this uncertain environment. A public company board should revisit its takeover bid and activist preparedness plan with its advisers to ensure it will be able to effectively respond to a hostile takeover bid or shareholder activism campaign.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
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