The pandemic caused by the novel coronavirus, COVID-19, has disrupted social and economic activity globally, altering and, in some cases, preventing the operation of existing businesses and affecting the way buyers and sellers complete and approach M&A transactions. In this article we build upon other articles and webinars in the Gowling WLG M&A in Uncertain Times series, sharing insights on how transactions are being affected and how jurisdictions including the United Kingdom, France, the United Arab Emirates, China and Canada are working to re-open their economies and approaching direct foreign investment.
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The volatility and uncertainty caused by COVID-19 have had a marked impact on the way in which parties are carrying out M&A transactions. From due diligence challenges to structuring the form and manner of satisfying the purchase price, buyers and sellers must be aware of and account for a range of legal and business issues as they consider pursuing a transaction.
In many cases, there are common themes, where deals are being impacted in a similar way across much of the global economy. However, there are many differences, too. The effects of the pandemic have hit many countries and regions in different ways. Various governments have reacted differently to address the needs of their citizens and support their economies. As the initial wave of the pandemic wanes in some regions and economies are re-started, businesses will have to comply with the requirements unique to their jurisdictions.
In this article we explore some of these similarities and differences across each of the United Kingdom, France, the United Arab Emirates, China and Canada. Governments continue to be very active, taking different approaches to foreign investment and providing incentives and support for local businesses. Approaches and responses to various factors continue to evolve depending on the jurisdictions of the buyer and seller and the location of the target business.
Impacts on transaction execution and due diligence
Globally, parties are facing longer timelines in order to complete transactions. Buyers and sellers may wish to extend the period for negotiating and entering into a definitive purchase agreement in order to take into account the effects of the pandemic, the duration of business closures, the impact on working capital, and the prospects for economic and social recovery. Buyers may also find that they require additional time to complete due diligence on a prospective target business if there are delays in collecting and preparing records or if supply chain issues require enhanced scrutiny. Buyers that are unable to complete certain types of diligence that require physical attendance or travel, including site visits, sample testing or environmental assessments, may choose to adjust deal terms to accommodate the corresponding increased risk involved for the transaction.
Some important regional diligence issues include:
- In China, the recent re-opening of courts creates the possibility of new claims being brought against businesses for unpaid wages or overdue rent payable on commercial leases. Updated litigation diligence will be important to understanding the potential liability of a business to its employees and landlord (or from its tenants) as a result of the pandemic.
- In the UAE, buyers who are considering restructuring the work force will need to consider the application of local labour laws. Employees will be entitled to end-of-service payments and repatriation flights on termination, which could have a significant cash flow impact. Under the UAE Labour Law there is no formal redundancy law, so there is a risk that when terminating employment without justifiable cause a buyer in an M&A transaction may be exposed to a claim for arbitrary dismissal which could result in an award of up to three months' pay. Accordingly, potential buyers should consider accrued and future employment-related costs of the target business as part of their due diligence investigations.
- While not unique to the Middle East region in challenging trading times, debtor days in the region can become a significant issue, which again could have an adverse cash flow impact. Receivables should be an area of focus of due diligence and, particularly in the construction industry, the contractual right to payment should be reviewed, as payment when paid clauses are not unusual for sub-contractors.
- In the UK, whilst supply chain considerations and adjustment have very much been a live topic over the last few years as a result of Brexit discussions and planning, a heightened awareness of the limitations of particular supply chain models has become a focus in some quarters.
- In France, buyers will need to focus on how COVID-19 may affect the target's employees' health and safety, in particular by reviewing the health and safety risks unique to the operation of the target business, any remote working arrangements being utilized, the effectiveness and use of business continuity plans and crisis management procedures, and any data privacy implications. When completing due diligence into the target, buyers will need to ensure that the seller has taken all possible precautions to avoid risks to its employees, as discussed in greater detail below.
Some important diligence issues that are common globally include:
- The global pandemic has strained business supply chains in certain industries and adversely impacted the ability to import and export goods. Buyers will need to consider whether "just in time" inventory systems are sustainable in the current context, or whether production and stores of inventory should be increased, moving to a "just in case" model to support ongoing sales requirements. Diligence focused on suppliers, customers, inventory levels and obsolescence of inventory may be necessary.
- As mentioned above, the ability to undertake surveys that require a physical presence or attendance (for example environmental reports) has been significantly impacted by the travel restrictions currently in place globally.
- As discussed in further detail below, consistent financial records will be more difficult to produce in all jurisdictions, for the current period, with almost all businesses being impacted (whether that be positively or negatively) by the effects of COVID-19 restrictions and/or changes in behaviour vis a vis their products or services.
- Finally, governments around the world have imposed unique sets of restrictions on business operations, travel, and the production of and import and export of goods in their jurisdictions to control and prevent the spread of the novel coronavirus, each of which may positively or negatively affect the subject business.
Each of these diligence issues requires careful study and will impact the target and the transaction valuation.
For parties to an M&A transaction that had already established a given valuation, global uncertainty resulting from COVID-19 may affect the structure of the transaction. Market volatility, risks associated with supply chain and demand disruptions, travel restrictions and mandated business closures all present macroeconomic factors which may cause parties to re-negotiate previously agreed valuations or adjust the transaction's payment terms. Buyers will be motivated to shift risk on to selling parties, requiring that the purchase price include an element of deferred compensation, earn-outs, claw backs or escrows in order to compensate for difficulties in creating reliable financial models to reflect the future performance of the target business. Longer than normal earn-out periods may be negotiated in order to provide sufficient time for the operating business to recover from the effects of the pandemic.
Where parties are in the process of negotiating the value of a business, buyers and sellers may negotiate in favour of or resist establishing the purchase price on the basis of recent financial reports, depending on whether they perceive the current state as representative of the future prospects and operating capacity of the target. Financial information for periods since the impacts of COVID-19 were initially felt may not represent normal operating data as businesses may have experienced a decline or surge in activity. See here for additional insights regarding definitive agreement deal terms that have been impacted as a result of COVID-19, including changes in the valuation of the transaction.
In France and the UK, prior to the onset of the COVID-19 pandemic, the M&A market favoured selling parties and a significant number of transactions included a "locked-box" purchase price mechanism. Given the impact of this crisis on the financial situation of many companies, buyers will likely shift away from this approach, negotiating the purchase price based on debt and working capital positions as at the closing date, in order to capture the impact of COVID-19 on the target business. Parties may try to bridge their disagreements on the purchase price mechanism by combining both a "locked-box" mechanism and an adjustment on the closing accounts, or by including earn-out clauses or other forms of post-closing adjustments meant to capture the future financial performance of the target.
Some of our observations include the following:
- In the UAE, businesses with cash flow issues may require capital injections in order to continue operating in the ordinary course. In circumstances where the consideration is being paid on an earn-out basis and the target business requires funding, the buyer should be aware that the capital paid into the target by the buyer may be financing the target's ability to meet earn-out targets.
- In certain jurisdictions, including China, forecasting challenges have been resolved with securities pledges or performance guarantees by the selling parties. From the perspective of a seller, reduced availability of financing may lead to deal strategies including payment in equity of the buyer or through the use of vendor-take-back arrangements.
- In Canada, with a material drop in the Canada-US dollar exchange rate, some target domestic businesses now appear more attractive to US buyers. See here for additional insights.
Employment and labour issues
As jurisdictions around the world begin to "flatten the curve" of the pandemic, some businesses and economies have gradually begun to re-open. The process of re-starting normal operations will require businesses to proactively introduce measures to protect employees, take preventative measures to avoid potential future outbreaks of the virus and plan to respond in the event of further business closures as a consequence of a "second wave" of the pandemic. Each jurisdiction has unique challenges. For example:
- In France, employers are required to meet an "enhanced best-effort standard" for protecting employee health and safety at work. Businesses must assess the health and safety measures in place, implement action plans and take all necessary measures to guarantee the safety of and protect workers. Employers are required to cooperate with and regularly meet with employees' representatives. Businesses should formalize any safety measures implemented and document any health and safety related steps taken in order to defend against future claims, including those by the labour inspector. Recently, multinational organizations have faced criminal and regulatory claims in France as a result of implementing insufficient worker safety measures.
- From a UK perspective, good corporate governance practices, including documenting decision-making processes, receiving expert reports, and consulting with stakeholders and local experts, will be important to ensuring a successful re-opening of the business and mitigating the potential for future claims or employee withdrawals from work. Such practices are advisable for any entity or transacting parties operating across multiple regions and jurisdictions, regardless of where they may be located.
As the global pandemic presents a dynamic, constantly evolving challenge, operators of multi-jurisdictional businesses cannot assume that a "one size fits all" approach to re-starting operations in all locations, based on a central decision-making model, will succeed. A proactive, location-specific approach is needed to ensure that the business meets the requisite local employment and health and safety standards.
Foreign investment opportunities and obstacles
Governments around the world have taken different approaches to foreign investment in the wake of the global pandemic.
- China has responded to the economic fallout of COVID-19 (and in some cases pre-empted it) by easing restrictions on foreign investment, introducing new government programs, providing opportunities for investment and encouraging transaction activity:
- The Chinese government is soliciting comments on new rules relating to initial public offerings of stocks. The new registration rules will dramatically reduce the time required to complete a public offering and give stock exchanges more oversight over IPO applications. The stringent existing requirements relating to profit, common management and control for candidate issuers will be relaxed and exchanges will permit listings of securities with special voting rights. Foreign registered companies can also issue Chinese Depositary Receipts in the Chinese market. The new securities regulations are expected to be enacted later this year.
- Effective January 1, 2020, China implemented a new foreign investment law which focuses on promoting and protecting foreign investment. The new legislative regime provides national treatment to foreign investors, other than in specified industries set out on the "Negative List". The Chinese government announced that starting April 1, 2020, foreign ownership restrictions applicable to most financial institutions will be cancelled, and restrictions on the business scope of foreign invested institutions will be substantially reduced.
- Similar to China, the UAE has recently taken steps to attract new foreign investment in onshore or mainland businesses. A "Positive List" was published by the UAE Cabinet in March under the country's foreign direct investment legislation. The Positive List sets out 122 sectors (including manufacturing, hospitality, healthcare and construction) in which foreign buyers can acquire a 100% interest in an onshore business, subject to the satisfaction of certain conditions. Under the previous framework, investors were limited to acquiring a minority interest, with a local partner required to hold 51% of the business. Similar to China, the UAE maintains a Negative List of certain protected sectors (including oil and gas, telecommunications and defence), which restricts foreign investment to 49% of the business. Such legislative changes are targeted towards attracting large-scale investment to the region, technology transfers and the creation of new jobs.
- In contrast to the Chinese and UAE contexts, the French government recently enacted temporary measures designed to prevent opportunistic foreign buyers from taking advantage of depressed business valuations caused by the global pandemic. Under the revised rules, a buyer located outside the European Economic Area will require approval from the French Minister of Economy and Finance for any acquisition of 10% or more (previously 25% before COVID-19) of the shares or voting rights of a listed company in a "sensitive" sector, including biotechnology, defence, energy, transportation, media and public health, among others. Parties should note that the screening process must be completed prior to closing. Any transaction closed in contravention of the review process may be deemed void or unwound, and significant criminal or administrative sanctions may apply.
- Similar to France, the Canadian government is taking a more restrictive approach to foreign investment, applying enhanced scrutiny on certain foreign investments into Canada. See here and here for further details.
M&A transactions continue to evolve rapidly as parties adjust to the effects of COVID-19 on businesses and markets. Given the uncertainty present in the current global climate, buyers and sellers will need to be aware of the risks inherent in the business that is the subject of the investment or acquisition transaction, as well as the social and economic characteristics and legal regime of the local jurisdictions. While some practices are common across many jurisdictions, an understanding of local difference is important. Each transaction will present unique issues and all parties should engage with local advisors at the earliest opportunity in order to assess their options and develop strategies to maximize potential returns while mitigating risks. As an international law firm, Gowling WLG is well-positioned to provide strategic advice globally and to assist you in navigating the challenges presented by COVID-19.