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This post has been authored by Gunjan Garg, a B.A.LL.B (Hons.) candidate at the National Law Institute University, Bhopal.
Backdrop
The COVID-19 pandemic has overturned the face of not just global economy and businesses, but also M&A landscape and future deal-making.[i] The pandemic has compelled us to revisit all ongoing contracts including but not limited to employment contracts, tenancy agreements, EPC contracts, supply agreements, etc. Another such set of agreements being relooked at are investment agreements, specifically the MAC/MAE clauses in these agreements. Material Adverse Effect (“MAE”) or Material Adverse Change (“MAC”) clauses, often found in share purchase agreements, financing contracts, underwriting agreements, etc. are specific contractual clauses that allow the buyer to terminate the contract before completion, upon the occurrence of any event, which “materially” affects the economic viability of the investment. MAC/MAE clauses operate in the interim period between signing and closing of the deal, thus providing the buyer with the right to walk away from the transaction. Moving towards the objective of deal certainty, such clauses allocate risks and liabilities assumed by both parties.
Through this article, the author intends to delve into the impact of COVID-19 pandemic on investment agreements and the changes expected in their clauses post the pandemic.
Understanding the Structure of MAC/MAE Clause
A typical MAC clause generally consists of three parts:
1. Basic MAC:
This part usually defines the events, circumstances, changes or effects, which will constitute a material change in business, financial prospects, revenue or operations of the target and allow the buyer to walk out from the transaction, thus placing the risk on the seller. Parties seldom define what amounts to “material change” and leave it on the courts for specific adjudication.
2. Exclusions from MAC:
The second part carves out several exceptions from the basic MAC clause, which will not amount to any material change, thus shifting the risk from the target to the buyer. The exceptions are majorly deal-specific, depending upon the nature of the transaction and the specific industry. For example, any change in law or events having an industry-wide impact, force majeure, etc.
3. Exceptions from the exclusions:
These exceptions from the above-defined exclusion put the risk back on the seller. For example, changes in general market conditions which affect the target and/or its subsidiaries disproportionately as compared to its peers.
Impact of COVID-19 on Investment Agreements and Suggestions for Renegotiating the Clauses
For contracts entered into in pre-COVID-19 times, it is unclear whether MAC clauses will be triggered or not due to the looming market uncertainty over the long-term impact of the pandemic on various businesses. The triggering of MAC clauses will not only depend upon the language of the contract and its governing law, but also upon the specific sector and industry. The impact will be different for essential/non-essential items as well as manufacturing and services industry. However, for transactions still under negotiations, there is a need to relook the contractual terms of transaction documents.
1. Standstill covenants:
These covenants prohibit either party from soliciting any further investment or securities from another until the closing date. Due to this ongoing pandemic, it is now evident that the closing of current deals will be effectively delayed. Therefore, it is suggested that these covenants should be reconsidered and renegotiated if required.
2. Extending Timelines:
Assuming that the signing of transaction documents has taken place or is about to take place, closing will be delayed until the lockdown is lifted. It is suggested that the parties consider extending the long-stop date for execution of contracts.
While a document must be stamped immediately at the time of or before the execution of the agreement,[ii] registration of mandatory documents is to be done within 4 months of the date of signing.[iii] Both registration and stamping may be impeded due to the lockdown. While no relaxations have been announced by the government yet for registration of documents, for agreements not yet executed, parties may reconsider extending the date of execution post lockdown to adhere to statutory compliances.
However, in case timelines are extended, it is suggested the parties settle issues such as who will bear the risk of delay, and for what period, and what degree of change in the target’s financial results and operations will be allowed if the pre-closing period is exceptionally long.[iv]
3. Conditions Precedent (“CP”) and Diligence Requirement:
Due to the limited operation of regulating bodies such as National Company Law Tribunals (“NCLT”), Competition Commission of India, Securities and Exchange Board of India, local municipal authorities, banks, courts, etc., pending regulatory and third party approvals/licenses maybe delayed due to lockdown resulting in filing limitations. It is suggested that either the low importance actions be shifted to the conditions subsequent clause or the long-stop date be extended for the performance of CP’s.
Additionally, while the RBI has extended the moratorium on loans by another three months till 31 August, 2021,[v] lender approvals for acquisitions will be affected. From the lender’s perspective, CP should be amended to ensure long-term return on his investment and sufficient working capital to service loans.
Ongoing due diligence should focus on corporate compliances[vi], review of leave and license agreements, material contracts with customers and suppliers, Foreign Direct Investment restrictions[vii] (if applicable), and labour law compliances (especially in light of extensive lay-offs by various companies due to COVID-19.[viii]
4. MAC Clause:
The buyer should ensure that phrases like “pandemic”, “outbreak”, “act of god”, “lockdown” and other similar events are specifically included in MAC clauses for clear delineation of risks. A more exhaustive MAC clause covering all such events would be buyer-friendly and thus provide walk-away rights.
The target on the other hand should ensure that exceptions to the basic MAC clause are clearly carved out. For example specific exceptions like “poor financial performance”, “change in law” or “change in tax regime”, “fall in revenues” should be negotiated in a MAC clause.
The author believes that the Delaware court’s interpretation of materiality to be assessed “over a commercially long period” in “years rather than months”, as laid down in the Huntsman case might not be appropriate in most M&A deals due to a short period of few weeks/months between signing and closing. Therefore, it is suggested that the parties carefully assess a suitable period for determining the existence of MAC by way of a contractual stipulation. For example, the parties may define this period as ranging from 1-2 years immediately preceding or immediately following the closing, depending upon the buyer’s preference.[ix]
Secondly, to ensure deal certainty and avoid potential disputes, buyers may consider introducing objective criteria or a materiality threshold for determining triggering of a MAC clause. Thresholds for determining financial downgrade may be introduced, for example, reduction of EBITDA[x] by a certain percentage calculated over a longer period of 6 months or more.[xi] Moreover, since extraordinary or unusual and non-recurring expenses are adjusted from calculation of EBITDA, and it is still unclear whether COVID-19 will be considered as an extraordinary event, the parties may themselves negotiate adjustments to EBITDA for calculation of earnings.[xii]
5. Break Fee and Reverse Break Fee:
Break fee is the amount to be paid by the target in case it walks away from the proposed transaction, while reverse break fee is the amount paid by the buyer for the same. Currently, break fee ranges from 1-3% of the transaction, but might increase to 10% or more to safeguard interests of the buyer. Sellers should insist on the inclusion of reverse break fee in case the buyer invokes the MAC clause to walk out of the transaction.
6. Representations and Warranties:
Specific representations and warranties maybe negotiated by the buyer to ensure protection against any adverse impact of the pandemic. Considering the current state of market uncertainty, the seller should focus on specific knowledge and materiality qualifiers to avoid breaches due to immaterial violations. On the litigation aspect, the seller should focus on disclosure of all pending and potential litigations in wake of COVID-19.
Further, the different buckets of warranties will be affected in wake of COVID-19. Firstly, parties must reconsider fundamental warranties, i.e. warranties going to the root of the transaction to ensure the target has title and capacity to enter into transaction, and is not on the verge of insolvency. Secondly, business warranties, which deal with the day-to-day affairs of the target, generally extend up to a period of 18-24 months from closing (as per the general market trend). This period may potentially increase up to 36 months or longer to cushion the interests of the buyer from the long-term impact of the pandemic. Lastly, there might be an increased demand for tax warranty by buyers from the seller as taxes may more actively be collected in the post COVID-19 era.
7. Indemnity:
One of the most highly negotiated clauses in M&A contracts, indemnity is a promise by the seller to protect the buyer from any losses arising from acts of third party his own arising under the contract.[xiii] Due to multiple extensions of lockdown, buyers may want broader protection and negotiate for lower thresholds of both tipping basket and de minimis. The most commonly used indemnity which is a combination of de minis and tipping basket is most commonly defined as 0.1% de minis and 1% tipping basket of the amount of transaction may substantially decrease to tilt in favour of the buyer.
Furthermore, there exists a market cap of 15-25% on indemnity for breach of business warranties. In case the pandemic takes a turn for the worse, especially for industries dealing with non-essential goods/services, this cap may increase to 30% or more to ensure protection of buyer’s interest from the implications of the pandemic.
8. Warrant and Indemnity Insurance (“W&I Insurance”):
W&I Insurance is an increasingly helpful tool for the target to provide for future claims arising out of breach of warranty or indemnity. In the aftermath of the pandemic, insurers will see an increased demand for buy-side W&I Insurance for broader buyer protection. Additionally, the premiums on the same, with the current market rate of 1.5-2.5%, might increase to 5% or more, post COVID-19.
9. Financing Condition
Financing condition is a pre-condition to the buyer closing the deal that they have received the third party debt financing required to fund the transaction. If the buyer does not receive the debt financing, then the buyer would not be required to close the deal, thus allowing a walk out, thus posing a high risk to the target.
Due to the current bearish market state, a liquidity crunch may pose a hindrance in providing debt financing, thus hampering closing of the deals. Moreover, if the financing condition from the lender is tied to the credit rating of the target, then the bearish market may adversely affect the target’s rating and in turn block debt financing, thus taking a hybrid form of financing condition and MAC clause by allowing walk away right to the buyer.
It is suggested the target enforces a stringent ‘reverse break fee’ to deter buyer walk out in case of failure of financing, since specific performance will not be a remedy available to it.
10. Reserved Matters
Due to supply-chain disruptions and significant impact on working capital cash, etc. of the target, it may be compelled to take immediate measures such as lay-offs, restructuring, incur additional debt, increase share capital by way of share/asset sale, which may negatively impact the buyer’s investment. These measures might even conflict with the contractually agreed/negotiated reserved matters clause and amount to a breach.
It is suggested that the buyers insist for increased rights to participate more on board meetings and various committees, while at the same time, providing the seller with greater business/operational autonomy, thus ensuring returns on the buyer’s investment.
Conclusion
To overturn the negative market sentiment caused by rapidly falling deal volumes,[xiv] the upper hand is expected to shift towards the buyer. Given the uncertainty of the current situation and falling revenues, buyers should negotiate for clawback rights, set out purchase price adjustment mechanisms and other financial parameters to safeguard investment. Sellers on the other hand should focus on post-closing covenants and operational autonomy to realize the aim of achieving targets without unnecessary disruptions. Thus, by having watertight agreements, the parties would be in a better position to safeguard interests and avoid potential disputes.
End-Notes
[i] “Covid-19 Pandemic takes toll on global M&A as $1 Billion Deals Disappear”, Business Standard (April 20, 2020), https://www.business-standard.com/article/international/covid-19-pandemic-takes-toll-on-global-m-a-as-1-billion-deals-disappear-120042000822_1.html. [ii] Section 17 of the Stamp Act, 1899. [iii] Section 23 of the Registration Act, 1908. [iv] Mara H. Rogers, Amelia Xu, and Geetika Jerat, “COVID-19 Impact: Potential Risks and Problems in Signed M&A deals, Harvard Law School Forum on Corporate Governance, https://corpgov.law.harvard.edu/2020/04/20/covid-19-impact-potential-risks-and-problems-in-signed-ma-deals/. [v] Covid-19 Regulatory Package, RBI, https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11902&Mode=0. [vi] MCA Circular on passing of ordinary and special resolutions during Covid-19 dated 08 April 2020, https://www.mca.gov.in/Ministry/pdf/Circular14_08042020.pdf. [vii] Press Note-3 (2020 Series) issued by DPIIT dated 17 April 2020, https://dipp.gov.in/sites/default/files/pn3_2020.pdf. [viii] Zomato, Swiggy, Uber, Deloitte USA to lay-off employees amidst Covid-19, https://economictimes.indiatimes.com/small-biz/startups/newsbuzz/zomato-to-lay-off-13-of-its-staff-as-covid-19-severely-impacts-food-ordering-business/articleshow/75756434.cms. [ix] Andrew M. Herman, Bernardo L. Piereck, Revisiting the MAC Clause in Transaction, Business Law Today, https://www.kirkland.com/-/media/publications/article/2010/08/revisiting-the-mac-clause-in-transaction/article-pdf--printing-allowed--business-law-today.pdf. [x] EBITDA or “Earnings Before Interest, Tax, Depreciation and Amortization” is a common benchmark used for determining fair valuation of a company. [xi] Andre Giesen, MAC Clauses in M&A Transaction Documents and COVID-19 Pandemic, https://www2.deloitte.com/dl/en/pages/legal/articles/covid-19-mac-klausel.html. [xii] How will Covid-19 Losses Impact Valuation in M&A Transactions, Economic Times (10 May 2020), https://economictimes.indiatimes.com/news/company/corporate-trends/to-add-back-or-not-how-will-covid-19-lossesimpact-valuation-in-ma-transactions/articleshow/75656348.cms?from=mdr. [xiii] Section 124 of the Indian Contract Act, 1872. [xiv] Supra Note 1.