With negotiation power tilting towards buyers, the catalogue of deal protection provisions that a buyer is able to assert may expand again. Buyers will need to capitalise on this by first maximising the areas on which they conduct due diligence (where certain matters will need particular focus) and then translating any concerns into useful representations and warranties, and indemnities.
Similarly, other deal protection provisions will become increasingly important in a volatile deal environment in the context of targets that have weathered, and may still be in the process of weathering, the effects of significant economic and operational impacts on their business. Buyers will want to focus on the management of the target during a potentially volatile pre-closing period. These gap controls need to be tailored to ensure they remain sufficiently flexible to permit management to confront any follow-on shocks (and avoid violating gun-jumping restrictions under merger control and antitrust laws), yet robust enough to offer the buyer the necessary comfort that the value of the target business is not being eroded.
In this last of four blog posts, Global Transactions partner Jochen Ellrott looks at how due diligence processes may look in a post-COVID-19 world, at related deal protection provisions and how these may be expected to evolve in SPAs.
Representations and warranties, indemnities
The importance of due diligence
As much now as ever before the importance of due diligence on a target business cannot be overstated. In an environment where many businesses have been subject to significant and wide-ranging adverse shocks – from their earnings to their supply-chains, from their employee base to their distribution logistics , gaining an insight into the state of a target business will be vital for buyers looking to execute confidently on deals.
In terms of legal due diligence processes, in addition to the customary reviews, areas of particular interest may include:
- compliance with state aid terms where the target has obtained government support (buyers should also seek to cover state aid received by the sellers for the benefit of the target business as state aid repayment liability may travel with the business);
- “crisis compliance”, both in terms of how the target has dealt with existing crises such as COVID-19-induced financial distress (or even an outbreak of coronavirus itself within the business) but also the robustness of business continuity / crisis planning in the event of a crisis event post-signing;
- occupational safety and data protection in employment matters as well as generally (given the increased use of new communication technology used for working remotely as well as contact tracing applications); and
- disputes around force majeure in supply chains.
The biggest challenge to the due diligence will be difficult to capture with reps and warranties: how reliable and instructive are the financials and business plan of the target in an unprecedented crisis where business planning may by as conducive as crystal ball reading?
In most major transactions, sufficient warranty coverage will require that warranty & indemnity (W&I) insurance remains available on acceptable terms. This appears to be holding true, but will be tested when the number of distressed transactions increases and parties become more litigious, as they typically do in times of crisis. It is also possible that we will see a return to “sell-side” W&I policies (which had become far less common immediately prior to COVID-19) given the more buyer-friendly environment.
While sellers may no longer be in a position to reject broad sets of representations and warranties, W&I insurance will continue to be a valuable tool to bridge the gap between (distressed) sellers’ desire for a clean exit and buyers’ need for contractual protection.
Buyers will need to keep in mind that W&I insurance will only cover areas that have been diligenced properly and that insurers are requiring more up-to-date diligence with increased focus on areas of the business affected by COVID-19 (if insurers do not exclude COVID-19 issues entirely).
In any event, where it is unclear whether a seller will be “good for the money” in case of actual warranty claims, W&I insurance will be (if available) a more efficient tool than costly bank guarantees, escrow or similar arrangements. Advisors should dust off their templates for such arrangements anyway.
While W&I insurance may continue to be available on sensible terms to cover unknown risks, they will typically not cover known risks, which we may come across more frequently in an unsteady deal environment. Significantly, any loss relating to breaches resulting from COVID-19 have been specifically excluded in most W&I policies we have seen so far, though we are aware of policies increasing in sophistication with more targeted exclusions.
Buyers will therefore need to either factor the risk in when calculating the purchase price or, where that is not possible with reasonable accuracy, insist on being indemnified by the seller. This in turn will only be valuable if there is certainty that the seller will be able to honour its obligations or if appropriate collateral is provided.
Qualifications and disclosures
Both buyers and sellers are likely to focus on the extent that COVID-19 related market conditions will be taken to qualify the warranties. A move to a more buyer-friendly deal environment will likely see more reduced specific disclosures, though sellers are likely to seek wider general disclosures or otherwise ensure that information about market conditions is deemed to be within the knowledge of the buyer (conversely buyers will likely seek to restrict the scope of this definition to the actual knowledge of named individuals).
Undertakings, or covenants, limiting the seller’s ability to carry on the target business between signing and closing may also need to be refined or recalibrated in a post-pandemic world – subject always to regulatory gun-jumping restrictions – particularly where pre-closing periods may become lengthier to accommodate extended regulatory reviews.
Many businesses are roaming in unchartered territory, and therefore a target may have to take unprecedented action that may not immediately appear to fall within the usual “ordinary course” exclusion, or otherwise be “consistent with past practice”. Parties should therefore consider defining a broader leeway within which a target business can manoeuvre without the buyer’s consent, e.g. an increase in debt up to a limit that may be higher than in normal times, permitting capital increases, defining certain human resource-related measures required to respond to a (further) deterioration of the business, discontinuation of (shortlisted) business lines or variations to the (capex) budget within a corridor – and the ability to cure breaches within an appropriate time frame.
In any event, given the volatility and unpredictability of the markets, swift decisions may have to be made and so the time allowed for the buyer to consent to a proposed action should be reasonably short, with the buyer’s consent should deemed given if it does not object explicitly within such period.
(The consolidated version of all four blog posts is available in the attached/linked PDF.)