Mergers and Acquisitions in the time of Corona – Share sale and purchase transactions

Overview

This is the second in an ongoing series looking at the effects of the COVID-19 pandemic on mergers and acquisitions (M&A).  Recently for example the sale by Seven West Media of Pacific Magazines to Bauer was delayed following ACCC clearance, leading to court action being commenced and speculation that the purchaser was reluctant to proceed due to declining advertising revenues.[1]   Also, ASIC has recently promulgated relief for listed entities seeking to raise funds.[2]

This week, we look at how some of the phases of a typical M&A transaction (usually a share sale and purchase) are being affected by the current business and regulatory environment.  Although business confidence is naturally affected, transactions are still being done particularly in sectors less susceptible to short term interruption and in some cases at revised valuations.   In this short paper, we look particularly at the following transaction phases:

• (1) planning and pre-documentation; and
• (2) transaction execution.

1. Planning/Pre-documentation Stage Issues

Due Diligence: Financials

Obviously, many businesses have experienced interruptions and financial loss.  Naturally this means that there needs to be particularly careful financial due diligence on target businesses, particularly in sectors affected by the virus interruptions.   Particular attention should be given to working capital requirements which are being stretched.   There is also additional scrutiny on vendor supports, for example where a business relies on guarantees or other financial support provided by the owner.

Additionally, the following are some other areas requiring careful attention during due diligence in the present environment.

Due Diligence: Insolvency

Recent temporary changes to insolvency laws have increased the period of compliance for Statutory Demands and Bankruptcy Notices to six months.  In addition, directors are for the next six months relieved of their duty to ensure no insolvent trading by the company (although not for blatant breaches).  These changes are well intentioned and are designed to allow directors to attempt to trade out of the present circumstances.  However, these changes may also lead to a ‘cascade’ effect of bad debts through the supply chain, with sleeper insolvent companies effectively trading while insolvent under the old rules, even though legally compliant.

Due Diligence: Supply Chain Logistics

Quarantine measures have markedly disrupted supply chains, especially when reliant on overseas suppliers.  Such supply chain disruptions on businesses have heightened the significance of contractual issues, in particular Force Majeure (FM) clauses and Material Adverse Change (MAC) clauses.

Supply Chain (1): Force Majeure Clause

A Force Majeure (FM) clause applies when an unforeseen event prevents performance of a contract.  FM clauses typically operate to give the parties a specified time-frame in which to work around the event, during which one or both of the parties’ obligations are suspended contractually.  It is usually only after the end of the stated period that one or both parties can terminate the contract.

The question then arises whether supply chain interruptions due to COVID-19 effects are a FM event?  It depends on the text, context and circumstances of each contract, in particular:

1. the definition of a FM in a FM clause;
2. the wording of the impact and effect on contract performance due to COVID-19. The distinction between delay, hindrance or prevention is important.  For example, if a FM clause only gives relief where the supplier is ‘prevented’ from performance, then even a significant delay may not trigger the FM clause.  This could mean that the counterparty is entitled to terminate for breach of contract and thus escape the contract;
3. mechanisms to address or resolve the issues, such as suspension of obligations, termination of obligations, service of notice, reasonable efforts to mitigate the effects of the FM event, automatic extension.

In these cases, the inclusion or omission of one or two seemingly innocuous words in the FM clause can mean the difference between one party being obliged to perform or not, and can result in unexpected termination of key contracts.

A recent example of the operation of a Force Majeure clause (in a different context) is the agreement by ACCC with Telstra that the recent bushfires in Victoria and South Australia constituted a Force Majeure Event under the Migration Plan, and therefore delays in the NBN migration caused by the fires would not contravene the Migration Plan.  This meant that Telstra was contractually entitled to delay performance without being in breach of contract.

Supply Chain (2) Material Adverse Change Clauses

A related issue is the inclusion of Material Adverse Change or Material Adverse Event (MAC) clauses in contracts.  MAC clauses are common in financial transactions, including covenants in loan agreements, and are sometimes included in M&A transaction documents with a delayed settlement period; for example share sale and purchase or subscription agreements.

Such clauses typically state that one or both parties can terminate if the borrower/target undergoes a MAC in its business operation.  Such clauses are, however, uncertain in their operation.  Courts have repeatedly found in the past that a MAC is only triggered when the change is both material and permanent.

While the effects on many business operations due to COVID-19 issues are clearly material, the question of permanence is not so clear-cut.  The applicability of a MAC clause in each contract would therefore require careful analysis of the wording, context and circumstances (much like a FM clause).  Additionally, it’s considered best practice to specify particular events that are deemed to be a MAC, particularly where, as now, the market is volatile.  For example, it would be common to specify that a drop in EBITDA (or some other metric) of more than X% during the relevant period constitutes a MAC.

Due Diligence: Employment issues

Wide-ranging and quite major changes to awards (including, as well as others, Hospitality Award 2010, the Restaurant Award 2010, Clerks-Private Sector Award 2010) were introduced in March 2020.

Many employers have rapidly restructured their workforce, and it is therefore important to check a target’s compliance with workplace laws, including the general requirement for employers to consult with employees before making changes in their working arrangements, as well as compliance with the new awards.

Other pre-documentation issues

Financing Availability

• Many businesses are scrambling to re-finance depleted balance sheets.
• Capital raising is occurring on discounted terms for both listed and unlisted companies.
• New fundraising rules apply. These are designed to make it easier for listed companies to raise funds.

Debt finance market 

While the debt capital market is still open to business, lenders are taking an unsurprisingly cautious approach (for example, requiring MAC clauses and other financial covenants), and are also looking to robustly secure their positions. Relevantly, to support the flow of credit, the government has recently announced the Coronavirus SME Guarantee Scheme.  Under this scheme, the government will guarantee eligible lenders 50% of an unsecured new loan to small and medium enterprises (SME) under certain conditions.

FIRB (Foreign Investment Review Board)

There have been temporary changes to the requirement and conditions for FIRB approval.  These may affect Australian companies seeking funding from foreign investors, including from existing foreign shareholders, or seeking to sell assets to foreign buyers.  The changes include a zero threshold for requiring FIRB approval, and a six-month time-frame for approval by FIRB, which may cause significant delays to proposed sales to foreign buyers.

2. Transaction/Documentation Stage Issues

Share Sale and Purchase Agreements

In the context of the issues identified during due diligence, particular clauses in transaction documents require careful drafting and agreement between the parties.

1. Should the documents include any additional representations, warranties and indemnities from the seller to the buyer, to cover any of the relevant due diligence issues identified above?
2. Due to some of the regulatory changes outlined above, as well as changes in business conditions, there is increasing conditionality being introduced into transaction documents. In some cases, this is leading to longer completion periods while the conditions are satisfied.
3. There is increasing scrutiny on the wording of a MAC clause. As above, if a MAC clause is included, the buyer should seek to articulate specific events that constitute a MAC; the type of damage that will trigger the MAC clause; mechanisms for defining the trigger point; and practical application of the clause.  The greater the specificity of the drafting, the better the buyer’s position to terminate the contract in event of a MAC.  Conversely the seller would seek to resist such increased conditionality.
4. Parties should discuss and assess their respective positions on whether to include a deferred consideration clause (where the buyer agrees to pay part of the price after completion, sometimes two years later). The current uncertain business environment is not conducive to deferred consideration arrangements.

Conclusions

The current business environment means that careful due diligence and pre-transaction planning is now even more important than ever.  Particularly, due diligence must extend to the full supply chain and include careful consideration of the issues outlined above.   Similarly, transaction documentation needs to be carefully reviewed and constructed.  The Keypoint M&A team is highly experienced in these issues and currently advising clients facing them.

[1] It has recently been reported that this sale has now completed.

[2] ASX changes include increasing the placement capacity for listed companies, waiving certain share plan requirements, and permitting back to back trading halts.