COVID-19 is disrupting M&A transactions in Canada, at all stages. In this article we take a look at some of the impacts we have seen on transactions at different points in the deal lifecycle.
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Whether your deal is in its infancy, you have signed an acquisition agreement and are working towards closing, or you closed your deal a few weeks or months ago, the COVID-19 pandemic has altered the deal dynamics. Buyers and sellers alike must be wary of the impacts of COVID-19. We anticipate the pandemic will continue to affect the M&A landscape in the short, medium and long term.
Letter of intent stage
A number of M&A transactions at this early stage are now on indefinite hold. Where the parties have signed a non-binding letter of intent and still intend to complete the deal, some of the immediate challenges they may face include:
- Exclusivity: The parties may find that their initial exclusivity period for diligence and negotiation of a definitive acquisition agreement is too short. Buyers are likely requesting very long exclusivity periods given the uncertainty as to when social distancing measures will end and non-essential businesses will be allowed to reopen. Many sellers will be resistant to being tied up for a period of many months rather than a few weeks, as would be common in normal circumstances.
- Due diligence: The restrictions on non-essential business activities, travel and group gatherings will have a significant impact on transactions that require physical inspections of facilities or assets. Inventory counts or environmental assessments may be impossible to carry out for the time being and delays will have a significant impact on timing and execution.
- Financing: Where a transaction may hinge upon the buyer obtaining debt or equity financing, funding uncertainties may put the deal at risk. At this stage in the crisis, many lenders and equity investors are focused on existing portfolio investments as the priority. Until they have a better understanding of the impact of the pandemic on current investments, new investments will most likely be delayed. The funding capacity of significant debt and equity investors will also need to be considered in light of the pandemic.
- Allocation of risk: As the effects of the pandemic evolve we have seen parties increasingly engaged in allocating risks related to COVID-19, such as supply chain disruptions and decreases in work-flow due to remote work policies. This can take many forms, such as additional representations and warranties or covenants in the acquisition agreement, a further escrow or holdback of proceeds in private M&A transactions, or simply a reduction in the purchase price.
Interim period stage
In our experience, where a binding acquisition agreement has been signed but closing has not occurred, careful consideration must be paid by the parties to several issues. These include:
- Material Adverse Change or Effect: An acquisition agreement will typically include a material adverse change or material adverse effect (MAC) definition, and representations and warranties and a closing condition to the effect that no MAC has occurred. Whether or not the impact of COVID-19 can constitute a MAC will depend largely on the definition agreed upon by the parties in the acquisition agreement. The threshold is very high. Indeed, most MAC definitions will include carve-outs for widespread events, such as a general economic downturn or a pandemic, such that a MAC would only arise if the target business was disproportionately impacted by the widespread event. A party, most likely the buyer, will need to assess whether the seriousness of the impact on the target company's business rises to the level of a MAC and, if so, whether the buyer is prepared to exercise its termination rights or pursue some other course of action such as seeking to amend the deal.
- Bring down of representations and warranties: Sellers are typically required to "bring down" to closing the representations and warranties within the acquisition agreement – i.e. confirm they are true at closing on the same (or a similar) basis as they were true at the date of signing of the acquisition agreement. The COVID-19 pandemic provides a textbook example of why parties negotiate a "bring down" obligation. The pandemic has, in the case of many deals, had an adverse impact on the target company's business and is leading to situations where sellers are unable to "bring down" or confirm the accuracy of representations and warranties at closing. Parties will need to assess their ability to meet the "bring down" requirement, and consider the implications of a failure to meet this closing condition.
- Interim period covenants: Target companies will need to review their obligations during the interim period, and assess the impact of COVID-19 on their ability to comply. Potentially problematic interim period covenants may include a requirement to operate in the ordinary course of business, or a requirement to not make any changes to personnel without the buyer's consent.
- Regulatory, court and third party approvals: Volatility in financial markets, public lockdowns and the significant downturn in the economy are affecting the ability of the parties to obtain timely approvals from third parties. This may include obtaining consents and waivers in connection with a change of control or transfer of assets, holding a meeting of shareholders to approve the transaction or, in the case of a plan of arrangement, obtaining an interim or final order from the court. With regards to regulatory approvals, timelines may be significantly extended. This could include Competition Act clearance, notification and review under the Investment Canada Act, stock exchange approvals, and licensing applications with Health Canada, IIROC, FINTRAC or any other regulatory body. The pandemic has impacted the ability of staff at many of these bodies to review and act on submissions within regular service timeframes. Parties need to consider whether to extend timelines for obtaining regulatory, court or third party approvals as a means to maintain deal certainty.
- Termination clauses: As the impact of the pandemic on businesses continues to manifest, parties are paying special attention to language in the acquisition agreement relating to termination rights and other remedies. As discussed above, a MAC clause, a failure to effectively bring down the representations and warranties within the acquisition agreement, or a refusal or delay in receiving regulatory approval may result in the conditions to closing not being met. How these and other provisions are worded will be relevant in determining whether a party can walk away from a deal and the potential cost of termination.
While certain buyers and sellers may be patting themselves on the back for closing before the pandemic, they should be mindful of post-closing obligations that may be affected by COVID-19:
- Earn-out clauses: Earn-outs or post-closing incentive payments are typically tied to meeting particular post-closing milestones. A prolonged delay or disruption to the target company's operations may significantly hinder the ability of the target company's business to meet those milestones, and put in jeopardy the seller's entitlement to the earn-out. If, as a result of COVID-19, the milestones are no longer achievable, the buyer may wish to consider renegotiating the earn-out obligation period or the milestone thresholds as a means of ensuring the seller has reasonable incentive to remain committed to the target company's business.
- Vendor take-back mortgages or promissory notes: Where the parties have agreed to a vendor take-back mortgage or promissory note to satisfy a portion of the purchase price, the seller will want to carefully consider whether the COVID-19 pandemic has impacted its level of risk as a creditor of the target company. Typical vendor take-back arrangements are subordinated to senior lenders. If the target company's business is no longer able to support its debt obligations, then the holder of the vendor take-back mortgage is at greater risk. The parties may want to proactively engage in discussions with senior lenders and other creditors if this is the case.
- Transition services agreements: Where the parties have negotiated a transition services agreement (TSA), careful attention will need to be paid to the wording of that agreement, particularly if there is an inability to perform the services in light of COVID-19. The TSA may contain a force majeure clause, in which case the parties will want to consider whether the pandemic constitutes a "triggering event" that could postpone or limit obligations under the TSA. Additionally, parties to the TSA will want to discuss expectations of performance arising as a result of the pandemic.
- Indemnification claims: Sellers should be aware that buyers will likely be looking very carefully at the representations and warranties given in an acquisition agreement to see if they have any claims for indemnification in respect of a business that may now be performing poorly due to current economic conditions. While these breaches may not have been material in the normal course, combined with the stresses brought on by the disruptions to the economy as a whole, they may now become material and worth pursuing. Parties will also want to focus on representation and warranty insurance policies, to the extent in place, as a further recourse for compensation.
Each M&A deal is different and the issues encountered by transacting parties as a result of the COVID-19 pandemic will depend on the stage of the deal and the specific circumstances of the deal and the parties involved. Consequently, there is no magic pill to fix the issues that arise. All parties to the transaction will need to evaluate the situation carefully and engage with their advisors at the earliest opportunity to assess the options available to them.