SRS Acquiom is closely monitoring the impact of the COVID-19 pandemic on the M&A industry. This is only the opening chapter of what may be a long story of economic change, and as the world and markets evolve we will be sharing our questions and observations--gleaned from our unique position in M&A transactions--on an ongoing basis. We share below our initial thoughts and observations.
Are M&A Deal Parties Rethinking What Constitutes a Material Adverse Effect?
Much has been written about whether commonly used definitions of “Material Adverse Effect” are likely to change alongside the changing M&A landscape. Will buyers successfully push back against the inclusion of pandemic-specific carve-outs from MAE definitions? Will they successfully maintain “disproportionate impact” exceptions to all carve-outs? Or will sellers successfully keep the risks associated with the pandemic with buyers?
As of this writing, we’ve seen little change in these terms. In an analysis of deals closed since March 1, 2020, we’ve seen only a nominal percentage of deals include pandemic-specific carve-outs, and exceptions for disproportionate impact on the selling parties are still in the vast majority of deals we reviewed.
What’s to account for this? It may be the case that deals closing in March and early April 2020 were far enough along at the time of closing to make a revisit of MAE language impracticable. It may also be that standard carve-out items like “acts of god” or “force majeure events” were thought by sellers to be broad enough during this period to capture the impacts of the COVID-19 pandemic. Finally, our data set includes closed deals only, perhaps excluding those transactions for which the pandemic was expected to elevate risks too highly to proceed.
Of course, the data here are young and may change. We’ll continue to monitor developments in this area and provide reports along the way.
Are Covenants Changing?
As deal parties navigate pre-close periods during the pandemic, it’s plain that they will need to address what it means to conduct operations “in the ordinary course of business,” as the provision goes, with threats to workforce stability, vendor and supplier relationships, customer relationships, and the myriad other issues posed by changing economic conditions and the outbreak of disease. We expect that the usual covenants set forth in order to align expectations between buyers and sellers will evolve accordingly in the coming months.
So far, the data show that little has changed. Where we have seen covenants that specifically address COVID-19, it’s been as an exception to the usual terms: provisions prohibiting the delay of the payment of liabilities except as commercially reasonable in the context of COVID-19, for example. We think we will see this on a heightened basis going forward, particularly with respect to covenants that are most likely to impact working capital and purchase price adjustments. How, for example, are parties likely to think about the use of direct government aid like the Payroll Protection Program under the Coronavirus Aid, Relief, and Economic Security Act (or “CARES Act”)? Should the use of any such aid be expressly circumscribed beyond the scope of the law? Should parties be expressly obligated to defer payroll taxes to the extent permitted by the CARES Act?
Each decision along these lines has the potential to impact the post-closing obligations of the parties, and as we see new practices develop, we will report further.
Post-Closing Obligations: Short-Term Adaptation or a Sea Change?
We are already seeing parties adapt what were once run-of-the-mill post-closing obligations. Deadlines for the delivery of closing balance sheets and earnout statements are being extended as parties undergo the transition to reduced or remote workforces. Although releases of escrow funds appear to be largely unaffected, releases of holdback funds are seeing delays in some cases as buyers work to coordinate internal approval processes that, in our experience, have always been somewhatalways somewhat complex and time consuming. And some (in our view, arcane) aspects of notice provisions are increasingly being waived, such as the requirement to deliver all notices by overnight courier in addition to email with confirmation of receipt. Deal parties are being flexible and accommodating in facing these challenges, which may portend a broad rethinking of how definitive agreements deal with timing and delivery requirements.
Substantively, we are seeing M&A deal obligations take into consideration the impact of remote workforces. Requirements for physical inventories, for example, need to be adjusted in order to account for the possibility that a workforce or vendor is simply unable to perform the task. As governments adjust stay-at-home orders and other business restrictions, we suggest that parties are wise to maintain flexibility in their approaches to matters that require the physical participation of a workforce.
Purchase Price Adjustments: New Types of Assets and Liabilities
Large-scale infusions of government aid to the private sector seem likely to impact the way that parties envision purchase price adjustments. Consider, for example, a target that successfully receives Payroll Protection Program funding under the CARES Act, intending to later seek loan forgiveness for funds applied to payroll. The timing of receipt of funds or the review and approval of an application for loan forgiveness may be difficult to square with the traditional sixty- or ninety-day period in which buyers are often entitled to true up estimated balances presented at close.
We often caution that parties should seek to exclude contingent liabilities from the definition of working capital, and instead to treat them as matters for indemnification. Parties should consider how government aid with long-term contingencies ought to be treated in this context.
Earnouts and Milestones
The life sciences industry is justifiably in the international spotlight now, and we hope for our friends and clients that this augurs well for them. For existing deals, however, deal parties in life sciences transactions may be reeling from wide-scale, shifting priorities.
For deals with earnout consideration contingent on clinical trial milestones, companies are grappling with how to continue important investigational work in a public health emergency. It’s understandably difficult to impossible to conduct a trial when patients either cannot or do not want to participate in such trials at this time. The FDA has issued new guidance in this respect, seeking to address the impact of “quarantines, site closures, travel limitations, interruptions to the supply chain for the investigational product, or other considerations if site personnel or trial subjects become infected with COVID-19" on ongoing clinical trials.”1 Further, acquirors in the life sciences space may redirect funding, personnel, and other resources to promising COVID-19 research in a race to mitigate the pandemic, dampening the prospect of achieving clinical- or revenue-based milestones. These are early days, but it seems likely that disputes concerning specific definitions of Commercially Reasonable Efforts are ahead.
In addition to the usual care that parties apply to negotiating the terms of earnouts and milestones, we suggest that parties consider more frequent reports and discussions throughout earnout periods. As tectonic plates underneath life sciences acquirors continue to shift, parties would be wise to seek ongoing discussions and updates rather than annual or bi-annual formal reports and responses, ideally setting expectations for the parties, reducing friction between them, and setting the stage for negotiated milestone extensions or early payments. As for all going concerns at this time, flexibility is key.
1 U.S. Food & Drug Administration, Dkt. No. FDA-2020-D-1106, FDA Guidance on Conduct of Clinical Trials of Medical Products during COVID-19 Public Health Emergency (April 16, 2020).