Special serie COVID-19 - n°7 - How is the COVID-19 crisis likely to impact the negotiation of M&A transactions in the future?

In the context of the COVID-19 outbreak, most companies are currently facing unprecedented legal issues within their organisations. As a result, they have to adapt significantly their way of working to go through this unique time in the best possible and efficient manner. In order to assist you in this task, we have identified several hot topics, which we will present in a separate newsletter, to be published over the coming days, where we will provide you with practical hints to approach the situation efficiently.

The spread of Covid-19 across the globe and the drastic measures successively adopted by all responsible governments to fight the pandemic have severely affected the global economy over the last two months. Even if the final short-, medium- and long-term economic consequences of the Covid-19 pandemic on the M&A market remain uncertain[1], it is already obvious that the Covid-19 pandemic shall trigger some significant changes in the manner (pending and) future M&A transactions shall (continue to) be negotiated in the next months and maybe years.

Indeed, in what was considered as a rather “seller-friendly” European M&A market, the Covid-19 pandemic is likely to lead now to some risk reallocation between sellers and purchasers in M&A transactions, with e.g. a comeback of various contractual provisions which were until now more frequently encountered on the US M&A market[2].

In our seventh newsletter, we will try to identify and summarize below the key contractual clauses and/or mechanisms on which M&A practitioners should most probably focus increasingly on the European M&A Market when negotiating their next asset or share deals in a (post) Covid-19 world.

1.    Force majeure clauses

Force majeure clauses (clauses de force majeure) are contractual provisions pursuant to which a party to a contract shall be - temporarily[3] or definitively[4] - released to perform all or part of its obligations thereunder in case of occurrence of an event which (a) is irresistible (irrésistible), i.e. totally prevents the performance the relevant obligations, (b) is beyond the control of the party having to perform the relevant obligations (extérieur au débiteur) and (c) was not foreseeable (imprévisible) on the signing date. Force majeure clauses are usually deemed valid under the laws of the Grand Duchy of Luxembourg.

They are used mainly to (a) extend or reduce the list of events which are usually deemed to be a force majeure event pursuant to the case law or (b) exclude application of the force majeure theory applying by default under the laws of the Grand Duchy of Luxembourg.

Considering the Covid-19 situation, force majeure clauses (aiming mainly at determining that epidemics, pandemics and/or any lockdown situations resulting thereof must be deemed as force majeure events) could quickly spread as new mandatory standard boilerplate provisions inserted by purchasers in many M&A transaction documents. However, we believe that force majeure clauses - even when properly drafted - may not be the most appropriate instruments to protect purchasers in future M&A transactions in case of continuing and/or new epidemics and/or pandemic situations. Indeed, in many cases, these situations shall not ultimately “totally” prevent the performance of a M&A transaction, but only complicate or render such performance more onerous. In addition, as discussions on the imminence of a pandemic are far from being new, the lack of foreseeability of the force majeure event might also be difficult to uphold. Therefore, tailor-made hardship clauses or MAC clauses could be more appropriate to face the challenges raised by the Covid-19 pandemic and/or any future similar events.

However, on the due diligence side, purchasers will certainly scrutinize, more than ever before, the absence, presence and/or content of force majeure clauses in the various key commercial contracts entered into by their contemplated targets, as well as any exposures triggered by the activation of such force majeure clauses.

2.    Hardship clauses

Hardship clauses (clauses d’imprévision) are contractual provisions enabling a party to a contract to either renegotiate the terms and conditions of, or less frequently exit from, such a contract, when unforeseeable circumstances (beyond the parties’ control and occurring after the signing date) cause an economical imbalance rendering the performance of such contract excessively onerous for such party. Notwithstanding the fact that hardship theory (théorie de l’imprévision) has struggled for years to be recognized by case law under the laws of the Grand Duchy of Luxembourg, hardship clauses are usually deemed to be valid based on the contractual freedom principle.

Hardship clauses mainly differ from force majeure clauses as they may be triggered by their beneficiaries as soon as the occurrence of new and unforeseeable post-signing circumstances renders the performance of a contract simply unreasonably onerous for their beneficiaries, where force majeure clauses would usually require total impossibility to perform the contract in order to be triggered. Considering the (hopefully) temporary consequences only of the Covid-19 pandemic, as well as the past reluctance of the case law to consider former epidemics as force majeure events, the use of tailor-made hardship clauses could also progressively become a new market practice renegotiation and/or exit strategy for purchasers, e.g. by systemic insertion as “boilerplates” in all letters of intent, term sheet, binding offers and/or share purchase or asset purchase agreements.

Back on the due diligence side, purchasers will also certainly scrutinize, with unprecedented attention, the absence, presence and/or content of hardship clauses in the various key commercial contracts entered into by their contemplated targets, especially in the OpCo sector.

3.    Material Adverse Changes clauses

Material Adverse Changes clauses (in abbreviate MAC Clauses) are contractual provisions - usually structured as conditions precedent - which purpose is to protect the purchaser in an asset or share deal against the occurrence of certain material adverse event/change between the signing date and the closing date. Their validity is generally admitted under the laws of the Grand Duchy of Luxembourg based on the contractual freedom principle.

MAC clauses differ from hardship clauses mainly as (a) they intervene at the level of the entry into force (or not) of a contract, where hardship clauses intervene at the level of the performance of a contract already entered into force, (b) they normally only enable their beneficiaries to fully “exit” from a deal, where hardship clauses usually generally enable their beneficiaries to renegotiate the terms and conditions of a deal and (c) MAC events must not necessarily render the performance of a deal excessively or unreasonably onerous for the purchaser, but simply not in line with certain more or less defined purchaser’s expectations (commonly related to the incidence of a material adverse change - generally defined -  having a long-term negative impact over the contemplated target). On the other side, MAC clauses differ essentially from force majeure clauses because MAC events must not necessarily be unforeseeable and/or irresistible either.

Considering the Covid-19 situation, it is likely that specific and tailor-made MAC clauses, less used in the “seller friendly” European M&A market over the last years, will most probably reappear in most of the asset and share purchase agreements structured with a signing and a closing phase. It being understood notably that purchasers will certainly no longer be so keen to accept listing epidemics and pandemics amongst MAC clauses Seller’s carveouts.

4.   Purchase price adjustment clauses and earn-out clauses

Purchase price adjustment clauses and locked box clauses are the two most frequent clauses used on the global M&A market to determine the purchase price in an M&A transaction.

Pursuant to purchase price adjustment clauses, the final purchase price of a target is only determined after completion of the transaction based on financial statements closed at the completion date, which mechanically protects in principle the purchaser against any decrease in the value of such target between the signing date and the closing date. Pursuant to locked box clauses, the final purchase price of a target is determined based on financial statements established on a date prior to signing (the “locked box date”), which mechanically protects the seller(s) against any decrease in the value of the target between the signing date and the closing date.

In those cases where locked box clauses have become increasingly popular in a “seller-friendly” European M&A market, it is predictable that purchase price adjustment clauses shall certainly make a strong come back on the European M&A market in the next year(s), as Covid-19 crisis evidenced clearly that a target financial situation on the signing date may obviously no longer reflect its financial situation on the completion date.

In the same manner, the number of M&A transactions including earn-out clauses (i.e. contractual clauses providing that a seller will be entitled to an additional price in the future, provided that the target achieves certain financial goals) are also likely to become more popular in a (post) Covid-19 world, as the value of a target based on its past financial performance seriously risks (to the extent it was ever true) to no longer necessarily reflects its future value.

5.    Conditions precedent and long stop date clauses

Long stop date clauses are contractual provisions pursuant to which an asset or share purchase agreement automatically terminate before completion when all the conditions precedent to which such an agreement is subject to are not satisfied or waived (as applicable) within a certain period of time.

Considering the Covid-19 situation, it is likely that purchasers will try to negotiate shorter a long stop date in the future (especially, but not only, in case of locked box purchase price mechanism, absence of MAC clauses…). However, in deals where the delivery of a consent from a regulatory authority is required prior to completion, parties may potentially have to expect some potential delay in the treatment of their consent application. Purchaser could solve such a dilemma e.g. by negotiating shorter long stop date, with a discretionary purchaser’s (only) option to extend the initial long stop date once.

It is further likely that, in addition to MAC clauses referred to above, conditions precedent relating to financing[5], certain business performances (EBITDA/EBIT/revenues not being met), non-performance or delayed performance by key suppliers/customers… will return in force.

6.    Interim covenants

Interim covenants are contractual provisions which purpose is usually to ensure that a seller shall continue managing the target in an “ordinary course of business” between the signing date and the closing date. However, interim covenants do not usually impose an obligation on the seller a seller to maintain any kind of “financial condition” of the target.

Considering the Covid-19 situation, some purchasers may consider negotiating extended interim covenants e.g. to be able to monitor more closely the evolution of the target’s business and, as applicable, occurrence of a MAC. Purchasers may also be willing to shift the sanction applicable in case of breach of such interim covenants from damages to the possibility to walk away from the deal, in order to further keep open their options to close or not a deal.

Conclusion

On the long run, the Covid-19 pandemic will serve probably as a good example for the parties to M&A deals to seek enhanced contractual protection against the occurrence of unexpected risks between the signing and closing dates. It will most probably influence the standard market practice risk allocation model between sellers and purchasers, which was previously encountered on the European M&A market. Indeed, leverage of purchasers should increase in a slowing down M&A market, so that we should expect to witness an increased use of e.g. MAC clauses, hardship clauses, force majeure clauses, purchase price adjustment clauses, earn-out clauses… It is also fair to believe in this context that the drafting and negotiation of such clauses will be prioritized differently on the parties’ “bargaining lists” in a post Covid-19 world.

PwC Legal can assist you with each of those measures and help your organisation.

Please contact the members of our M&A team, should you need any assistance in relation to the above.

^Notes:

^{[1] with some experts believing that the Covid-19 crisis shall soften temporarily the M&A market before generating unexpected opportunities for “healthy” companies to conclude deals that create long-term value and other experts believing that the Covid-19 crisis shall dry up the M&A market due to e.g. a flight to safety, reduced access to traditional capital sources, increased reliance on seller financing and earn-outs as well as increased scrutiny of deal terms.}

^{[2] which remained always globally a more “purchaser-friendly” market over the last years.}

^{[3] when the force majeure event prevents temporarily the performance of the contract.}

^{[4] when the force majeure event prevents definitively the performance of the contract.}

^{[5] Even if on the date hereof there seems not to be any liquidity crisis resulting from the COVID-19 situation}