Although the impact of COVID-19 on M&A and capital raising activity within Australia continues to evolve, it is clear that deals and transactions (both current and future) will need to be looked at through a different lens. Below are some initial issues that we are currently experiencing, or can reasonably foresee, in M&A transactions as businesses and investors navigate the crisis and seek opportunities.
While legal due diligence is a fundamental part of most transactions, an in-depth assessment of the target’s business vulnerabilities is attracting far greater scrutiny in a COVID-19 world. The key areas being focused on include:
What is the legal status of material contracts in connection with the target’s business (eg customer contracts, supplier agreements, joint venture arrangements etc)? What are the parties’ rights and obligations in respect of performance, suspension and/or termination? Could the target be exposed to breach, damages or litigation? Are there opportunities for the target to suspend or terminate contracts? Can ongoing business with key customers (and payment) be assured? Is there a risk of key suppliers failing?
Have governance standards slipped? Has the target maintained compliance with financial reporting requirements and other regulatory obligations? Has the target met its continuous disclosure obligations (if listed)? If not, can this be mitigated? What government imposed restrictions/relief measures impact the target’s business?
Has the target complied with its obligations under applicable industrial awards, agreements, legislation, regulations, contracts of employment and/or written policies and procedures (including leave entitlements, workplace health and safety and superannuation commitments)? Has the target applied for, or is the target eligible to apply for, the JobKeeper payment or the Supporting Apprentices and Trainees wage subsidy?
- Tax and government stimulus
Has the target availed itself of, or is the target entitled to avail itself of, any tax relief or other government measures proposed under the government’s stimulus package? If the target has already availed itself of funding and/or relief, was it compliant with the terms and conditions thereof? What R&D tax incentives have been claimed/are available to the target?
What compliance measures does the target have in place to deal with the collection, storage and disclosure of personal information, in particular given the transition to online processes and working remotely?
What insurance is currently in place and how might the policies respond to the COVID-19 pandemic? Has the target made any claims on the policy?
Has the target adequately protected its security interests on the PPSR? What registrations exist over the target or its assets? Have those registrations been perfected? What exposure does the target have to the financial distress/insolvency of its contracting parties?
- Material adverse change or effect
A ‘material adverse change’ clause or condition (commonly referred to as a ‘MAC’) can become an essential provision within a sale agreement. A MAC clause or condition gives the buyer or investor the right to terminate and walk away from the sale agreement if the target is materially and adversely affected by the occurrence of specified events prior to the intended completion date.
MAC clauses can often include quantitative thresholds (eg a specific dollar amount or percentage that net asset value or annual EBITDA must have been reduced by). It remains questionable as to whether a short-term impact on these figures triggers the MAC clause. Parties will need to consider the precise definition of the MAC condition; ie, its scale and scope, whether it covers the worsening of conditions due to the crisis (limited to areas in which the target operates or beyond) and/or whether it will take into account that the target is not disproportionately impacted relative to other industry participants. A number of matters must be considered in drafting and negotiating an effective MAC clause in the current circumstances.
- Ordinary course of business
An ‘ordinary course of business’ clause typically requires the buyer to be satisfied that the target’s business has been run in the ordinary course in accordance with its usual practice. This can be for a specified period prior to signing the sale agreement (eg between an accounts balance date and signing), or for the period between signing and the earlier of completion or the termination of the sale agreement. The sale agreement may also provide that this does not prevent any action required or expressly permitted by law or any act or omission consented to in writing by the buyer.
Target companies may also require carve-outs to make time-sensitive judgement calls and preserve the business to be sold, such as taking steps to protect their workers and complying with recommendations issued by public authorities. It may be beneficial to allow target companies to assess these issues as and when they arise and/or obtain pre-approval for activities outlined in their business continuity or contingency plans. These provisions are being closely considered in the context of the ever-changing issues presented by COVID-19.
- Warranties and indemnities
Most sale agreements require the seller and/or target to provide extensive representations and warranties in relation to the business: ie, that they are true and correct at all times up to and including signing and completion. Even if the impact of COVID-19 does not lead to a MAC, or to a business being carried on outside its ordinary course, a seller or target will need to ensure that each of their warranties is still accurate at signing and at completion.
Buyers may seek warranties and/or specific indemnities relating to specific due diligence matters such as those set out above. COVID-19 is likely to have implications on warranty and indemnity insurance policies should the parties wish to explore this type of insurance (ie, insurers may exclude COVID-19 from the policy coverage). And regardless, a key consideration will be security, escrowed funds or guarantors available to the buyer for warranty and indemnity claims, especially if there’s a possibility of financial distress or insolvency of the seller or target. Registration on the PPSR should be considered.
- Purchase price adjustment mechanisms
The most common type of purchase price adjustment we see in Australian private M&A deals is a working capital adjustment, which adjusts the purchase price based on the working capital (current assets minus current liabilities) of the target at completion when compared to a normal or target level of working capital. The likelihood of a decrease in working capital for buyers suggests that parties may continue to prefer this mechanism to a locked box mechanism. A locked box mechanism fixes the purchase price payable on completion by reference to an agreed historical balance sheet of the target, removing price uncertainty for all parties. There is likely to be debate around the appropriate mechanism and, in particular, whether adjustments need to be made to historical average working capital levels or balance sheets to reflect the short-term impacts of COVID-19.
- Deferred payments, earn-outs, deposits, guarantees and other security
The parties will need to give careful consideration to the payment and timing obligations under the sale agreement. Deferred payments and earn–outs may become more attractive because these can minimise exposure to the financial impacts of COVID-19 by linking the deferred payment or earn-out to achieving certain future earnings.
Of course, these deferred payment structures come with the potential risk of delayed payment, non-payment or dispute, especially in times of financial distress or insolvency. For this reason, deposits, guarantees and other forms of security are essential – and again, registration on the PPSR should be considered to ensure that any security interests are properly protected. Appropriate dispute resolution clauses are essential to properly drafted earn–out clauses.
- Investments or acquisitions of Australian businesses by foreign entities
The Treasurer has announced temporary changes to the foreign investment framework effective from 10:30pm AEDT 29 March 2020, which have increased restrictions on foreign investment or acquisitions in Australia in response to COVID-19 (see our recent article here). These new rules apply to acquisitions of land, companies and businesses, so it is essential that these new rules are considered when looking at acquisitions of this nature in Australia. Prior to these changes, there were relatively high monetary screening thresholds for foreign investments or acquisitions in Australian companies or businesses (excluding those owning land), and applications to the Foreign Investment Review Board for clearance would often not be required. The increased restrictions are achieved by reducing the monetary screening thresholds to $0 for all foreign investments or acquisitions and it is predicted that there could be extensive delays in obtaining approval. Accordingly, the parties should ensure that these requirements are considered early in the transaction process.
The logistics of completing a transaction in the context of social distancing must be considered. While a number of completion deliverables can be effectively exchanged online, there will be varying levels of comfort with this approach among M&A practitioners. Parties need to ensure that documents are executed and exchanged effectively in the circumstances to avoid any potential issues down the track.
This article highlights that a number of issues must be considered in the context of the COVID-19 crisis when undertaking M&A deals and transactions. It is a non-exhaustive list and of course, the situation is ever-changing. We are able to help clients navigate these uncharted waters.
If you have any questions about this article, please get in touch with an author or a member of our Corporate & Commercial team.
This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.