Minimizing risk in private M&A in the COVID-19 era

After the initial disruption of COVID-19 to M&A activity in March of last year, dealmaking continued to gain momentum.

As 2020 progressed, we saw businesses move from a state of uncertainty to a state of acceptance as markets and economies stabilized. However, both the overall disruption of the pandemic as well as related deal litigation has cast a spotlight on areas of heightened risk in M&A transactions. While the “new normal” continues to evolve (see our Canadian M&A Outlook 2021 for more), in this article, we examine trends and considerations that surfaced in 2020 and will affect M&A going forward.

Areas of heightened risk

Employment: With workforces still reeling from the effects of furloughs and redundancies, buyers need to ensure that any employment actions a prospective target took in the past year—from permanent or temporary layoffs, to salary reductions—were made with the appropriate documentation and in compliance with applicable law. Buyer risk could be heightened in cases where targets did not use appropriate documentation for an employment action.

Tax: Tax-related risk is another issue for transacting parties. Over the past year, there have been instances where sellers have failed to comply with tax reporting obligations. And the increase in government subsidies has led to some discrepancies in the disclosure of revenue generated from the output of the business versus government subsidies. Due to complications with tax reporting, buyers need to do their due diligence and need to assess the target’s long-term revenue prospects without government subsidies, including appropriately tailored quality of earnings diligence. Sellers need to continue adhering to tax reporting obligations.

Tech and cybersecurity: The pandemic has been accompanied by a surge in cybersecurity attacks and threats, buyers will want to apply particular scrutiny to a target’s IT systems and cybersecurity protocols and overarching data governance framework. Sellers may be asked to provide more robust disclosure on this point, including their history and management of cybersecurity breaches. Employees working from home has resulted in a heightened security risk for organizations. Given the increase in risk, prospective buyers may try to negotiate more detailed representations around cybersecurity and policies.

Supply chain and contracts: Significant changes in consumer behavior and supply chains mean buyers need to conduct thorough due diligence to understand the degree to which the target’s supply chain has been impacted by the pandemic. Buyers need to be aware of any disruption in the supply chain, from supplier delays to a customer’s ability to make payments consistently throughout COVID-19. Special examination needs to be paid to the related COVID-19 risks of a target’s operations.

Mitigating risk and getting the deal done

Thoroughly negotiated indemnity regimes, provisions such as lockbox agreements and earnouts, and COVID-19-specific closing conditions are just some of the actions parties are considering to get deals done in this new environment.

R&W insurance under COVID-19. Dealmakers are increasingly asking representations and warranty insurers to review and adjust their policies. We have seen heightened activity for policy exclusions in the below areas:

• losses arising out of failure to protect employees;
• losses arising out the presence or transmission of COVID-19 or any evolution thereof;
• losses arising out restrictions ordered by governmental authorities; and
• losses arising out of business interruption due to COVID-19.

Buyers should negotiate COVID-19 exclusions upfront, before committing to a representation and warranty insurer.

MAE clauses. Litigation around MAE clauses has been limited in Canada; however, in the U.S. it has been more prevalent. We may see a rise in MAE cases that will appear before the courts as a result of COVID-19. Ultimately, courts will review the clause, the contract and the surrounding circumstances to determine what both sides intended the clause to mean. Parties will want to ensure a very thorough and careful negotiation of MAE clauses going forward.

Carve-outs and other provisions. As organizations continue to endure the lasting effects on operations, sellers will want to thoroughly consider COVID-specific contractual carve-outs  or permissions (e.g., more expansive purchaser consent) as part of the M&A process. Buyers will want to be keep in mind how they approach these types of requests from the seller with a view to mitigating potential litigation.