The Covid 19 epidemic continues to spread. On 9 March 2020, the stock markets experienced a “Black Monday” with the biggest losses since 11 September 2001. The German economy is facing a recession. This will inevitably have an impact on the M&A market. Many investors will “keep their powder dry” in the coming months to wait and see, if and when the market stabilizes again.
Regardless of these future developments, the question arises as to the legal impact of Covid-19 on ongoing M&A transactions. Some key issues will be addressed below.
- Effects on the Transaction Process
In ongoing transaction processes, the effects are initially of a practical nature. Are there any governmental entry or exit restrictions to be observed in cross-border transactions? Are the parties involved subject to internal travel bans? Can planned meetings be held? Presumably meetings can only partially be replaced by telephone or video conferences. In an auction process, this may mean that individual bidders will have to withdraw from the process because they are simply unable to meet the time and meeting schedule set by the process letter.
This can become legally problematic where a process is operated by a public seller. For instance, this can be the case in the Energy and Infrastructure Sector. Such a process must be conducted in a transparent, non-discriminatory procedure for budgetary and state aid reasons. In the case of a voluntary Travel Ban of a participating bidder, it may be argued that such a bidder cannot invoke discrimination if he is “thrown out of the process” because of these restrictions. Does this still apply if the bidder is subject to a governmental entry or exit restriction or a governmental quarantine? Or can he request that the process be adapted so that the same conditions apply to all interested parties, which would ultimately result in a right to interrupt the process? In any case, it should not be ruled out that a losing bidder might challenge a sales decision if (only) he is not able to acquire a public target for the reasons mentioned above.
- Due Diligence
A due diligence investigation focuses on identifying risks at the target company. In times of the corona epidemic, the legal due diligence must therefore focus on finding out whether the target company is sufficiently protected against the negative effects of the virus.
For example, specific questions can be:
- Does a contractual partner of the target company have unilateral rights of termination or withdrawal? Hotels and tour operators could be affected by those rights.
- Can supply chains be maintained? Are substitute suppliers available?
- Are there contingency plans, especially for a further spread of the virus?
- Are there alternative sites or can employees work from home?
- Can certain activities be outsourced in case of an emergency?
The identified risks should then be weighed and addressed in the negotiations. As it is not expected that a seller will take over a certain risk by way of an indemnity, the buyer will have to decide whether the identified risks justify a lower purchase price or an abortion of the deal.
- Purchase Price Adjustment Clauses
The corona crisis is having an increasing economic impact on target companies. Supply chains may be disrupted. Trade fairs are cancelled, so that business deals cannot be concluded or can only be concluded at a later point. Inter alia, this can have consequences for the target’s future business, inventories or the recoverability of receivables.
Where these factors have long-term effects, bidders will, if at all possible, take them into account in the valuation of the target. But what if economic changes may occur between Signing and Closing? Or if the opinions of buyer and seller on the long-term effects of the crisis differ? Then purchase price adjustment clauses can help the parties. Some are discussed below.
a) Fixed Purchase Price / Locked Box
At present, the market is dominated by fixed purchase prices with so-called “locked box” purchase price clauses. The purchase price is fixed on a specific date (usually the date of the last annual financial statements) and the economic risk is already transferred to the purchaser at this point in time. Only cash leakages to the seller between the Effective Date and the Closing are deducted from the purchase price. Such clauses offer the seller maximum transaction security. The purchaser cannot claim any influence of economic changes on the target between the Effective Date and the Closing on the basis of these clauses. If he wants to have make an argument based on Corana, he must therefore resort to alternative purchase price clauses or seek protection through other mechanisms.
b) Closing Accounts
Purchase price clauses that provide for the preparation of a Closing Accounts offer the buyer significantly greater security. According to this model, the cash position at Closing is paid, the net financial debt is deducted, and working capital is balanced out if it exceeds or falls short of a previously agreed target.
If, for example, the target company’s inventory level falls between Signing and Closing due to corona-related interruptions in the supply chain, the working capital is also reduced and consequently the seller is obliged to compensate if it falls below the agreed target level. Such clauses are naturally disadvantageous for the seller. He will try to avoid these clauses altogether or will argue to disregard corona-related special effects in the calculation.
c) Earn Out Clauses
If buyer and seller cannot agree on a purchase price, the parties often agree on earn-out clauses, i.e. a purchase price increase if certain target figures (e.g. turnover, EBIT or similar) are achieved within a certain period of time.
This instrument may be helpful if the parties have different opinions as to whether certain virus-related influences on the target company will quickly or slowly disappear. However, earn-out clauses are difficult to formulate because the party who has to pay the earn-out (the purchaser) has the opportunity to control the target company after closing and thus also to influence the key figures that trigger the payment obligation. For an earn-out, therefore, key figures that are difficult to manipulate, such as turnover, are often chosen. It remains a question of the individual case whether figures such as turnover adequately reflect Corona-related changes in the target company.
- MAC Clauses
Corona-related changes in the target between Signing and Closing could possibly also be addressed by way of material adverse change (MAC) clauses.
What are such clauses aiming at? They give the parties an opportunity to withdraw from the contract or to refrain from Closing if there has been a substantial economic change in the target company. With a clause of this type, the transaction risk is shifted to the seller. It gives the buyer the de facto opportunity to force a reduction in the purchase price before Closing by threatening to withdraw from the contract. Accordingly, clauses of this kind are rarely agreed.
If MAC clauses are agreed at all, the focus of the negotiations is to define the term Material Adverse Change very specifically in order to defuse part of the ri-scope of these clauses and to clarify in a binding manner for the parties at the time of the conclusion of the contract and not only in the event of a dispute which event should entitle them to withdraw from the contract.
It seems doubtful whether an acquirer will succeed in shifting the risk of an imbalance of the target company due to corona to the seller by means of a MAC clause after signing and before closing.
- Disruption of the Basis of the Transaction?
Pursuant to German law, a termination of concluded contracts or at least their adjustment can be demanded under certain conditions also with reference to the principles of the disruption of the basis of the transaction (Störung der Geschäftsgrundlage).
Whether an adjustment or even cancellation of a contract can be demanded on the basis of the principles of disruption of the basis of the transaction depends on various factors. First, a certain circumstance would have to have become the basis of the contract and would have changed seriously after the conclusion of the contract. The next step would be to examine which allocation of risk applies between the parties – be it by contract or otherwise according to general principles according to which the typical risk of a contract is to be determined. In other words: Is the concrete risk that is realized here assigned to one of the two parties alone? Only when the party affected by the disruption can no longer be expected to continue with the unchanged performance of the contract on the basis of a comprehensive weighing of interests, can a contract adjustment or even termination of the contract be considered.
Thus, an adjustment of a contract can only be considered as an exception if circumstances outside the sphere of influence and risk of a party result in such a blatant disproportion between performance and consideration that it is no longer possible to adhere to the unchanged contract. However, the hurdles set by case law are quite high.
With regard to M&A transactions, the following should be pointed out in this context: It already seems doubtful whether the absence of corona-related influences on the target company has become the basis of the contract. Furthermore, it seems doubtful whether this risk can be unilaterally assigned to one of the parties. Finally, negotiated M&A contracts regularly form a self-contained system of clauses for the balanced allocation of certain company-related risks to buyer and seller. This deliberate allocation would be broken by the concept of “disruption of the basis of the transaction”. This view is largely shared by the M&A community: in the vast majority of cases the possibility to refer to the “disruption of the basis of the transaction” is expressly excluded in M&A agreements.
There are a number of issues that need to be considered in current M&A transactions against the background of the Covid-19 epidemic. Referring to vaguely formulated clauses or general legal principles such as “disruption of the basis of the transaction” does not seem very promising. If one of the parties wants to mitigate a corona-related risk, it should explicitly address such desire in the negotiations and demand corresponding contractual clauses. In particular, purchase price adjustment clauses and/or providing for specific closing conditions and corresponding withdrawal rights in the M&A contract could be considered.