The outbreak of COVID-19 and the efforts around the globe to contain its spread have resulted in dramatic business disruptions and economic turmoil, raising many new considerations for parties participating in proposed or pending M&A transactions and for public companies assessing their vulnerability to unsolicited proposals. The issues faced by individual companies are seemingly endless, but there are a number of topics that we expect to be of particular interest to M&A participants. Below is a summary of key M&A topics to consider with respect to the COVID-19 pandemic and its potential impact.
Takeover/Activism Defense. The recent turmoil in US equity markets resulting from the COVID-19 pandemic has many US public companies facing depressed stock prices, potentially leaving them vulnerable to unsolicited acquisition proposals or activist activity. This raises a number of items for these companies and their boards of directors to consider:
- Assembling a Team: A company approached by an activist or a hostile acquirer will need rapid assistance from a variety of advisors, such as law firms, investment banks, public relations firms and proxy solicitors. It is prudent to identify these resources in advance so that you know whom to call before the need arises.
- Response Plan: Companies that feel particularly vulnerable may wish to prepare a response plan that defines roles and responsibilities among members of the board of directors, senior management and outside advisors and includes a communications plan for responding to various defensive scenarios.
- Poison Pills and Other Structural Defenses: The board of directors may wish to engage a law firm to assess a company’s structural defenses to determine whether there are vulnerabilities that should be addressed. Such an assessment also provides the company’s counsel with an opportunity to review with directors their fiduciary duties in connection with an unsolicited proposal and the deployment of defensive measures so that they are better prepared to respond. It has historically been difficult to implement defensive measures prior to the emergence of a specific threat without resistance from shareholders and proxy advisory firms. However, ISS and Glass Lewis have recently issued new policy guidance in response to the COVID-19 pandemic, suggesting that a severe stock price decline may be a sufficient justification for adopting a shareholder rights plan (or “poison pill”). In addition, preparation can be a defensive measure in and of itself, and many public companies elect to have a shareholder rights plan prepared in substantially final form (or “on the shelf”) so that it can be deployed quickly if a threat emerges.
- Strategic Plan: A board of directors responding to a hostile bidder or activist will typically need an up-to-date strategic plan, including long-term forecasts, in order to evaluate unsolicited proposals against the prospects of the company under its stand-alone strategy. The strategic plan will be more credible if it existed prior to the hostile approach, so companies should evaluate their existing plans to determine whether the disruptions caused by COVID-19 require a reassessment of the underlying assumptions.
- Shareholder Engagement and Monitoring: Successfully defending against a hostile approach often requires the support of shareholders, and this support will be more readily obtained if management has done the groundwork to familiarize itself with the company’s stockholder base, establish positive relationships with key investors and build conviction in the company’s strategy before a threat emerges. Public companies should monitor trading, Securities and Exchange Commission (SEC) filings and other public announcements that might indicate hostile intent. For example, an investor acquiring 5% or more of a public company’s stock that intends to change or influence control of the company is required to file a Schedule 13D with the SEC within 10 days of such acquisition.
- Strategic Alternatives: If a company believes its stock is undervalued, it may seek to deflect hostile interest by proactively exploring ways to enhance shareholder value, such as stock buybacks, acquisitions or other strategic transactions. However, engaging in stock buybacks in the current environment raises a number of sensitive issues that should be carefully considered in advance. For example, companies that receive funds under the Coronavirus Aid, Relief, and Economic Security Act generally are prohibited from engaging in stock buybacks, and, even if a company is not subject to these restrictions, engaging in stock buybacks in the current social, political and economic environments may be perceived negatively or attract unwanted scrutiny. In addition, companies considering engaging in stock buybacks should consider applicable securities laws in connection with any proposed repurchases, as existing disclosures may have become stale in the rapidly changing environment.
M&A Agreements. As parties negotiate acquisition agreements amidst the turmoil resulting from the COVID-19 pandemic, they should consider the unpredictability of future events, the potential impact of this uncertainty on the assumptions underlying a transaction, including those regarding future performance, and the elevated risks presented by the pandemic that will be allocated (expressly or implicitly) under the agreement. This places a particular emphasis on certain areas of the acquisition agreements.
- Material Adverse Effect Clauses: Acquisition agreements typically include a material adverse effect (MAE) clause, which allows a buyer to refuse to close a transaction if, between signing and closing, the target suffers a dramatic, durationally significant and company-specific downturn in its business that threatens the overall earnings potential of the target. While MAE clauses are negotiated and discussed at length, the bar for proving an MAE is so high that in only one case in Delaware has a court found sufficient facts to excuse a buyer from closing an M&A transaction due to an MAE. However, with broad sectors of the global economy brought to a virtual standstill, the COVID-19 pandemic has the potential to trigger business disruption at a scale that could put pressure on the interpretation of these provisions, and drafting choices once considered routine may have significant consequences for the parties. As a result, we have seen, and expect to continue to see, heightened negotiation of these clauses in the wake of the COVID-19 pandemic, as well as an uptick in associated litigation. MAE definitions frequently expressly exclude events broadly impacting industries, markets and economies, as well as natural disasters and other “acts of God,” and sellers have increasingly focused on excluding pandemics (including COVID-19 specifically) and their potential effects on the target business to minimize the potential closing risk posed by COVID-19. Even when events like COVID-19 are squarely excluded, there is often “an exception to the exception” for events of this nature that disproportionately impact the target business. In drafting these provisions, the parties should consider whether there are risks associated with the COVID-19 pandemic that they are not prepared to accept and whether the drafting of these provisions allocates those risks in a manner consistent with their expectations. That said, there is a limit to the degree of risk allocation that can be accomplished by fine-tuning the MAE definition. Because the courts have set the bar so high for an MAE, it is a blunt instrument by nature, and parties that wish to specifically allocate risks associated with COVID-19 (particularly in private transactions) may be better served focusing on other areas of the acquisition agreement, discussed further below.
- Valuation Issues: With valuations and markets reaching all-time highs immediately prior to the COVID-19 pandemic, it may be challenging to align valuation expectations between buyers and sellers due to the volatility triggered by COVID-19. There are a few approaches parties often use to bridge valuation gaps, but each bears new risks in light of the COVID-19 pandemic.
- Earnouts: Buyers often use earnouts as a means of addressing downside risk while theoretically allowing sellers to obtain full value if the target business performs in line with, or exceeds, expectations. Whether or not such an approach is appropriate under the current circumstances may depend on the time frame of the performance period, the potential sensitivity of the performance metrics to the adverse effects of the pandemic, and the ability of a seller to generate a strategic plan that can be executed under so much uncertainty. For obvious reasons, a seller may be hesitant to put a significant portion of deal value at risk based on near-term projections of future financial performance. But earnout structures using non-financial milestones (such as the regulatory milestones common in biotech transactions), or financial milestones that may be achieved over more flexible time periods that could allow the target business to regain its footing after the near-term impacts of COVID-19 pass, may be more palatable. In addition, sellers staking a significant portion of their proceeds on the future performance of the target business may seek reassurance regarding the manner in which the business will be operated to ensure it is well positioned to achieve the agreed performance targets, and these issues can be particularly difficult to negotiate. In a period of unprecedented layoffs and cost cutting, these concerns may be even more acute.
- Buyer Stock: Many companies may seek to limit their use of cash until operations return to some level of predictability. With that in mind, the use of buyer stock in lieu of cash may have the advantage of limiting or avoiding the cash outlay by the buyer, providing some upside potential for the sellers after closing and potentially some tax advantages over an all-cash acquisition if structured correctly. The parties should consider whether a fixed, floating or hybrid share valuation method is appropriate to address fluctuations in buyer stock price between signing and closing, particularly in light of the potential of recent extreme market volatility to lead to unforeseen consequences (such as distorting the deal price or triggering a buyer stockholder vote). Sellers accepting stock consideration from the buyer will also need to consider the buyer’s prospects in the current environment, in addition to their own, in determining whether a proposed structure is attractive.
- Purchase Price Adjustments: Purchase price adjustments are typically structured to compensate the appropriate party if certain financial measures (typically the target’s working capital) deviate from a “normal” level at closing. The target level is often derived by looking at historic balances over a trailing period of several months. However, following this approach today could result in assumptions that are misaligned with the current operating environment. For example, businesses affected by COVID-19 may be seeing dramatic reductions in accounts receivable and may be deferring payments to manage liquidity, all of which could distort working capital compared with historic norms. Sellers will need to consider the impact that this could have on the purchase price and whether to advocate for an approach that accounts for the “new normal.” Parties will often look at seasonal fluctuations, persistent trends and management projections to adjust historic averages, and sellers may wish to advocate for a similar approach that adjusts the working capital target based on the anticipated impact of COVID-19. Alternatively, they may wish to employ limits on the adjustment, such as a collar, to ensure that it does not reduce the price beyond an acceptable range. Buyers, on the other hand, may be even more focused on maintaining robust protections against declines in working capital due to the elevated risk in this area.
- Interim Operating Covenants: Acquisition agreements typically include covenants that restrict the operations of the target company between signing and closing to those activities that are consistent with the ordinary course of business. In the middle of a pandemic, however, targets may need additional flexibility to do what is prudent over what is consistent with past practice. The target may need to respond to sudden and severe challenges raised by COVID-19, such as local government restrictions, liquidity issues and supply chain disruptions, all in a manner that might breach a typical operating covenant. Buyers, on the other hand, may worry about a target making imprudent financial decisions, failing to invest in the business, or making irreversible staffing or strategic decisions during the interim period. The parties will need to consider whether to adjust these provisions to provide the target with additional flexibility, such as qualifying the restrictions with an efforts or materiality standard, or employing broader categorical exceptions to address the challenges of the current operating environment. Sellers may also seek covenants by the buyer to consult in good faith with them during the interim period regarding operational issues resulting from the effects of the COVID-19 pandemic, or at least a commitment not to act unreasonably in withholding their consent to changes in operations. Finally, both parties should consider the ability of the target to participate in and accept funding from government relief programs, such as the SBA’s Paycheck Protection Program, during the pre-closing period. Buyers and sellers may have differing perspectives on whether such relief is desirable or appropriate, and on what role, if any, the buyer should have in any application process.
- Representations and Warranties: Representations and warranties are likely to take on increased scrutiny where COVID-19 has had, or is expected to have, an impact on the target company’s business. Buyers may want to place an increased emphasis on representations regarding customer, supplier and vendor relationships. Work-from-home policies may result in increased risk to the IT systems of unauthorized intrusions, and valuation of inventory and the quality of accounts receivable are areas worthy of increased scrutiny, both in negotiation and in diligence. Target companies should consider whether certain representations should be limited to dates as of or prior to signing to limit exposure to breaches outside their control during the pre-closing period, as well as whether recent changes in guidance and regulations could result in their failure to comply with employment or other laws. Sellers may also wish to include language that limits the buyer’s ability to rely on information provided outside the representations and warranties to ensure that they are not liable merely because the target business has not achieved projections made available to the buyer.
- Closing Conditions: In an environment with ever-changing news and shifting expectations, the closing conditions take on particular importance. The bring-down standard for representations and warranties and covenant compliance could have a significant impact on closing certainty in this volatile environment, and both parties should consider whether the current crisis could impact the perspective of governmental entities and other third parties that must provide consents or approvals. For example, the pandemic may lead to a reassessment of foreign investment restrictions, and contractual counterparties may have more incentive to withhold consents in an effort to renegotiate key contracts. Buyers that have leverage may attempt to use the closing conditions to add protection against downside risk, such as by seeking conditions that require the satisfaction of particular operational goals, restrict customer losses, require retention of key customers or delineate other adverse changes to the target business that would result in the failure of a condition, such as the sustained shutdown of a key facility or a large-scale reduction in force.
- Outside Date and Termination: As discussed further below, considering the potential logistical considerations that may impede closing preparations and third-party approvals, parties should consider tempering expectations regarding timing and be careful to choose an “outside date” that provides sufficient time for unexpected delays, which may take the form of automatic extensions for areas particularly likely to affect overall timing, such as regulatory approvals. In addition, to the extent parties are unable to agree on an allocation of closing risks potentially impacted by COVID-19, such as risks associated with timely regulatory approvals or the availability of financing, they may consider termination fees as a means to bridge this gap.
Due Diligence. The due diligence process always requires close coordination among teams and careful allocation of responsibilities to ensure that all areas of inquiry are covered without creating inefficiencies, as well as consideration of the effects of current events, regulatory developments and industry trends on the target business. Below are key insights from recent transactions regarding the impact of the COVID-19 pandemic on due diligence activities:
- Process Matters: Diligence teams should consider early on the logistical limitations that may be involved in running an acquisition process in the current environment. In-person meetings are likely to be impossible or inadvisable for the foreseeable future, so teams will want to familiarize themselves with conference and screen-sharing applications to build trust and collaboration, both internally and through virtual diligence meetings with target management and other key stakeholders. Certain paper or backup electronic records may be impossible to obtain within short time frames, and site visits, inspections, physical inventories and other hands-on diligence activities may not be practical, so teams should plan accordingly.
- Contractual Issues: Buyers should apply heightened scrutiny to certain areas of contracts that take on added importance given the uncertainty around the COVID-19 pandemic. For example, could the effects of COVID-19 provide a basis for non-performance or termination, result in material liabilities allocated to the target or make it more difficult to obtain consents from key counterparties? Pricing terms and take-or-pay features may no longer make sense in the current operating environment, and key contracts may contain commitments that the target business or its counterparties are likely unable to perform, raising the risk of breach or default. Identifying these risks should be an increased focus of any due diligence process, to permit the parties to allocate them precisely in the definitive agreement and to avoid post-closing surprises.
- Operational Risks: Buyers should consider in detail the impact of the COVID-19 pandemic on a target’s operations. It has been well publicized that certain industries, such as travel and hospitality, are particularly vulnerable to COVID-19. But other businesses may have more specific operational features that expose them to heightened risk, such as supply chains, customer bases, and key facilities in disproportionately affected regions or industries. Companies continuing or resuming operations may encounter scrutiny under the lens of hindsight as to whether they violated applicable stay-at-home orders then in effect and whether they established appropriate health and safety protocols for their employees, including whether they allowed employees to return to work at an appropriate time or in an appropriate manner. As mentioned above, IT systems and employee health and safety procedures have come under additional pressure and may have recently changed for many companies as a result of the pandemic, and buyers will need to consider what preventive measures are adequate and appropriate.
Financing. Many of the risks to be allocated in the definitive agreement will also need to be considered in the drafting of financing documentation if the buyer is relying on outside financing to fund the transaction. For example, commitment papers and other financing agreements will often have their own MAE condition, and the borrower will want to ensure that this term is defined in a consistent manner so that COVID-19-related risks are not allocated differently in the financing documentation. In addition, financing commitments may require pro forma compliance with financial covenants as a condition to funding or borrowing base calculations as a limit on available funds, and parties should consider carefully whether associated assumptions regarding financial condition and performance are sufficiently conservative in light of potential business disruptions due to the COVID-19 pandemic. Buyers concerned about the possibility of committed funds being unavailable may wish to mitigate their risk by negotiating for a reverse termination fee structure. Even when financing is ultimately available, buyers should consider the increased possibility that they could receive less attractive terms than expected due to the potential impact of COVID-19 on debt markets. For example, if debt is difficult to syndicate, the arranger may have the right to use market flex provisions to make the terms more attractive to lenders, and an unsuccessful bond financing could trigger alternative funding arrangements on unfavorable terms.
Representation and Warranty Insurance. In the past several years, there has been a significant increase in M&A transactions that rely on representation and warranty insurance as a source of post-closing recourse. However, these policies contain limitations and exclusions, and known risks are generally excluded from coverage. Parties considering representation and warranty insurance should expect the insurer to seek exclusions for losses related to the COVID-19 pandemic and should seek to define these exclusions as narrowly as possible. In addition, many policies do not cover breaches that first arise and become known between signing and closing. The risk created by this coverage gap may be exacerbated by the uncertainty of the current business environment, particularly for transactions where a longer period between signing and closing is expected. Buyers may prefer a more traditional escrow and indemnity arrangement that allows them to allocate known risks through negotiation rather than committing to using insurance at the outset of the deal. Buyers using insurance might consider whether coverage gaps created by COVID-19-related exclusions can be addressed through other insurance products, such as business interruption insurance, although it is possible insurers may seek COVID-19-related limitations on other products as well.
Process/Timing. The logistical challenges caused by the COVID-19 pandemic may have a significant impact on the nature and duration of the M&A process. Physical meetings can no longer be used as a tool to expedite negotiations; regulatory clearances and other government processes may take longer than is customary; and routine administrative matters, such as certifications and other documents from secretaries of state, may not be fulfilled within customary time frames. Vendors may also struggle to meet demand due to staffing issues and office closures, and routine in-person services, such as notarization, may not be possible depending on the location of the signatory. It is important for parties and their advisors to confirm timing expectations with other transaction participants to ensure that schedules need not be adjusted. Agencies such as the SEC have announced various relief measures to account for the challenges of meeting deadlines and complying with formalities that may be impractical under the circumstances, but some deadlines may not be flexible and might require more lead time. In addition, parties should consider how such delays might impact negotiated deadlines, such as the outside date for termination and deadlines for providing, and responding to, notices.
Looking Ahead. As the financial markets stabilize and companies gain a greater understanding of the consequences resulting from the COVID-19 pandemic, opportunities will arise for the right buyers and sellers to return to deals that were in the pipeline or in the initial stages of diligence. Uncertainty about future prospects and unquantifiable risks are front of mind for dealmakers. While these uncertainties and risks create challenges, our team has helped buyers and sellers find creative solutions to these problems and can be a valuable resource for those considering forging ahead in the current M&A market. Finding the best path to navigate the many challenges faced by participants in the current dealmaking environment will require careful analysis of the facts and circumstances surrounding a proposed transaction. The authors of this alert or the attorneys at WilmerHale with whom you have regular contact are available to advise you if you wish to discuss any of the matters discussed here.