On March 24, 2020, the ABA Business Law Section presented a webinar regarding rapidly evolving developments in M&A deals due to the influence of the COVID-19 pandemic.* Among other topics, the panel discussed considerations related to MAE definitions, COVID-19-focused representations, interim operating covenants, and the response of the representation and warranty insurance market to the current crisis.
Material Adverse Effect
Pandemics, epidemics, and similar events were rarely explicitly included as carve-outs to “Material Adverse Effect” definitions prior to the COVID-19 outbreak. Over the last two months, however, there has been a sharp increase in explicit exclusions in MAEs for pandemics, epidemics, or similar health emergencies. A pre-pandemic MAE definition that makes no reference to COVID-19 (or even to pandemics or epidemics generally) may or may not be found to include the effects of COVID-19. In such cases, disputes may focus on whether definitional language that typically excludes general economic or market conditions and other broad-based factors impacting the business climate or the target’s industry generally is sufficient to exclude the impact of COVID-19. Market practice so far has been that carve-outs for pandemics and similar health emergencies do not apply if they have a disproportionate impact on the target relative to (typically) other companies in the target’s industry. As a result, we may see disputes as to the appropriate industry and comparable companies for a given target (if not explicitly defined). Ultimately, MAE determinations will hinge on the specific facts and circumstances and depend on the nature and extent to which an event or series of events affect the particular target’s business.
Representations and Warranties
As buyers (and targets) work to understand the actual and potential impacts of COVID-19, tailored representations can help facilitate the buyer’s due diligence, as well as allocate certain COVID-19-related risks to the target or sellers through the bring-down condition and/or indemnification provisions. Buyers should consider expanding relevant representations to cover concerns related to COVID-19, especially to the extent fundamental to buyer’s valuation. Although the issues will be highly business/industry specific, buyers should consider adding or modifying representations regarding customers and suppliers, labor matters, contractual force majeure (or similar) provisions, insurance, inventory, and accounts receivable to address COVID-19-related concerns. Targets/sellers should expect significant focus on COVID-19 matters—time spent analyzing problems and planning for contingencies will help facilitate transactions. The parties should also carefully negotiate the language of the applicable disclosure schedules to balance permitting disclosure of known issues and providing protection for the myriad unknown problems arising from the rapidly evolving COVID-19 situation.
Interim Operating Covenants
When there is some period between signing and closing, the acquisition agreement usually provides that the target must operate “in the ordinary course of business,” preserve its business, and refrain from various actions.
COVID-19 and the reaction to it have raised questions about what is “ordinary course” when parties are taking actions never before taken, and how a seller should act to preserve the target’s business. Parties are beginning to consider exceptions for COVID-19-related actions. Even in ordinary times, the covenant should be considered in the context of the entire agreement, including, when considered as a condition to the acquiror’s obligation to close, the degree to which the target must comply (often “in all material respects”), and, in private company transactions, the sellers’ indemnity obligations.
Impact on Representations & Warranties Insurance (“RWI”)
RWI insurers are moving quickly to develop underwriting protocols around COVID-19 risk, including (1) proposing exclusions for COVID-19 exposures, some of which are broadly worded, while other insurers are taking a more targeted approach on a case-by-case basis; (2) identifying heightened due diligence requirements for COVID-19 impacts on the target, including with respect to operations, facilities, supply chain, distribution networks, and business continuity plans; (3) reviewing purchase agreements for COVID-19 specific representations and often excluding coverage for them, and (4) asking COVID-19 specific questions during bring-down calls prior to closing to determine known impacts of COVID-19 on the target and any steps the parties have taken to address COVID-19 issues. Proactively negotiating how RWI will address COVID-19 impacts will be an important consideration to effectively utilize RWI in the current deal market. The RWI market remains competitive, and a well-constructed diligence plan around potential COVID-19 impacts will be an important component to narrowing proposed exclusions in RWI policies.
*We wish to recognize, with appreciation, the assistance of Matthew Barnett.