Unfortunately, the corona virus has infected thousands of people around the world and this pandemic is costing several human lives. In addition to human casualties, transactions worldwide have been suffering the effects of the corona virus outbreak. Taking into consideration the anatomy of a Stock Purchase Agreement (“SPA”), we will discuss some of the consequences that the current environment may have for an M&A deal.
Deals Between Signing and Closing
The most endangered deals are the ones pending closing. At this stage, any of the parties may trigger the material adverse change (“MAC”) or material adverse effect (“MAE”) clauses that usually say that the absence of any MAC/MAE are closing conditions. The actual scope of a MAC or MAE really depends on the specific wording of the clause, but, at times like the ones that we are living now, at least a postponement of the closing is almost certain. In some cases, buyers or sellers (but mostly buyers) have been saying that a MAC/MAE clause allows them to cancel the deal altogether. Regardless of the actual effect of a MAC/MAE clause, to discuss it in court or in arbitration takes time. To gain time may be very good to some buyers now.
Even if a SPA has no MAC/MAE clauses, it is not guaranteed that it will be closed. Another common condition precedent to closing is the renewal of the representations and warranties. In most of the cases, a seller has to make several representations and warranties about the situation of the business as of the closing date. It is hard to say that nothing has changed in the business since signing when a worldwide crisis is taking place. Even if a seller is desperate to close the deal and makes such representations and warranties, there is room for a buyer to challenge them. The way such situation would be seen by the courts or arbitration chamber is a good question. If the remedy to a breach of a representation and warranty is indemnification, how can a buyer avoid the closing of a deal?
But let us imagine a deal in which the buyer, in a pre-corona world, was desperate to buy. In this scenario, the buyer may have accepted a very light (and now useless) MAC/MAE clause and very limited representations and warranties (really easy ones to renew). This may be a harder situation for the buyer. However, maybe the quality of the collateral that the seller would put as escrow has decreased. Perhaps the shares of the investment fund in which part of the wealth of the selling family was invested (the original collateral) lost some value. It is likely that some negotiation will take place about the escrow in cases like this.
The number of implications that the pandemic may have to SPAs pending closing is large, but the examples above summarize a good portion of them: (i) MAC/MAE clauses; (ii) renewal of representations and warranties; and (iii) quality of the escrow collateral. In all such cases, the delay of the deal appears to be almost certain. Not closing the deal at all in situations (i) and (ii) may be reasonable, but this possibility will really depend on the wording of the SPA and it is almost certain that buyer and seller will litigate. Situation (iii) does not appear to be a reason to prevent the closing of a deal if seller offers a good collateral as escrow to ensure closing.
Closed Deals
Closed deals are not immune to the effects of the pandemic. Let us focus on three particular issues (i) earn-outs; (ii) price adjustments; and (iii) contingencies and escrow.
Earn-out clauses may become real nightmares for sellers. Typically, earn-out clauses have growth targets (growth in sales, EBITDA or profits, for example) that must be met to trigger the earn-out payment to the seller. The economic climate has changed so much that now growth is uncertain and it is likely that many sellers will not have earn-outs to receive.
Price adjustments may be affected by the crisis as well if the closing balance sheet reflects the crisis period. Usually, the price adjustment is the comparison between the working capital and net debt in the balance sheet disclosed to the buyer in the due diligence (“DD Balance Sheet”) and the balance sheet drawn up on the closing day (or very close to it) (“Closing Balance Sheet”). The crisis may cause changes to the levels of working capital and net debt that would not happen under normal circumstances. Also, sometimes the purchase price adjustment takes into consideration seasonality effects, to normalize expected differences in the DD Balance Sheet and the Closing Balance Sheet. Now, under abnormal economic circumstances, clauses that treated seasonal changes in working capital and net debt may distort even further a price adjustment.
Finally, in dire times litigation increases. In a SPA context, it means that contingencies are more likely to materialize. Sellers may see an increase in the materialization of the contingencies of past transactions. In such cases, the release schedule of escrow accounts may be affected. Usually, escrow agreements have clauses stating that if a contingency materializes, a part of the escrow is retained for a longer period to cover additional potential losses.
Final Thoughts
SPAs between signing and closing will most likely suffer the most severe consequences of the corona pandemic. Many of them may have their closing postponed or, in some cases, depending on MAC/MAE clauses, they will not close at all. Also, the renewal of representations and warranties may be an obstacle to the closing of some deals. Closed deals may suffer some of the effects of the corona crisis. Earn-out payments may never happen and purchase price adjustments may face some problems. Finally, we can expect an increase in the materialization of contingencies, increasing escrow periods.
Augusto César Rodrigues
arodrigues@cascione.com.br