The emergence of the COVID-19 pandemic has forced buyers, sellers, and their advisers to adapt to the rapidly changing environment in which M&A transactions are now being pursued, evaluated, negotiated, and closed.
The ensuing post is the second in a three-part series intended to provide a focused review of certain fundamental considerations applicable to M&A transactions in Western Canada – as impacted by the pandemic. Read part one of this blog series on the topic of: Acquisition Financing. Read part three of this blog series on the topic of Closing Mechanics and Purchase Price Adjustments.
Material Adverse Effect Provisions
It is standard practice for purchase and sale agreements (PSA) to include a “Material Adverse Effect” (MAE) definition (or equivalent). The MAE definition will bear relevance in the PSA in a number of ways, however, the one that has come to the forefront due to the pandemic is the oft-included closing condition that the purchaser does not have to close the transaction if a MAE has occurred since the signing of the PSA.
Most MAE provisions are comprised of three parts. First, the definition will include a broad description of what constitutes a MAE. The second part of the definition will typically carve out a number of events which will, despite the preceding broad definition, not constitute a MAE (typically these carve-outs are events that are outside the reasonable control of the seller). Third, the definition will often include qualifiers to the carve-outs, such that the events that are carved-out will nonetheless be considered to result in a MAE if, as one example, they disproportionally affect the seller compared to businesses operating in the same industry, market, etc. While the impacts of the pandemic are uncertain in both scope and duration, it is clear that the effects certainly exist “today” (and therefore, in many instances, may not constitute an “event” on a forward-looking basis).
For parties who are still negotiating their transaction, special consideration should be given to the MAE definition, especially if the absence of a MAE is a closing condition in favour of the purchaser. While the future impacts of the pandemic remain uncertain, parties at the front-end of their transaction will have the opportunity to benefit from their existing knowledge around the pandemic and its current and forecasted impact on the target. In these situations, we anticipate parties will be better positioned to formulate the MAE definition in a manner that is responsive to a host of different scenarios and can therefore more appropriately addresses their respective closing risks associated with the pandemic (in contrast to MAE definitions negotiated prior to the onset of the pandemic).
For transacting parties who have already consummated but not yet closed their transaction, the MAE closing condition will be static – but is likely now under close scrutiny. The assessment of whether a MAE closing condition has been satisfied is a highly fact-specific inquiry, hinging not only on the drafting of the MAE definition, but also a host of other contextual factors (and not within the scope of this post). With that said, it is worthwhile to note that the courts have generally recognized that in order for a MAE to be found to occur, the event causing the MAE has to be of some permanency – or an event which is durationally significant. As public (and expert) opinion on the duration and impact of the pandemic remains divergent, transacting parties looking to rely on a MAE clause (whether to avoid or ensure closing) will need to address the durational significance of the current pandemic (or lack thereof) – a matter which is clearly, at present, an open issue.
Interim Period Covenants
Aside from “sign and close” transactions (which have no interim period), PSAs will typically contain a host of interim period covenants, which will place both positive and negative covenants on the seller with respect to operation of the target business from the date of signing until the closing date (i.e. the interim period). These interim period covenants are generally designed to maintain and/or enhance the value of the target business until the transaction is closed. Due to the unique operating environment resulting from the pandemic, the interim period covenants of the seller will warrant additional consideration in the circumstances.
With no clear indication of when the pandemic may begin to taper, interim period covenants have taken on added significance in two respects. First, for transactions which require third-party or governmental consents and approvals, we anticipate the time frames for obtaining such consents and approvals will be pushed out in most cases (the extent of which is unclear). Delays associated with obtaining the said consents and approvals will invariably result in lengthier interim periods when contrasted to pre-pandemic market practice. The key takeaway is that the longer the interim period, the more important the interim period covenants are. Second, the unique operating environment presented by the pandemic precludes purchasers from simply requiring the seller to carry on business “in the ordinary course, consistent with past-practice” (a common interim period covenant). For many businesses, “ordinary course” no longer exists and it is too soon to know how courts will interpret the “ordinary course” standard of conduct as a result of the pandemic. As such, purchasers will need to carefully evaluate the target business, associated industries, and other applicable factors to determine the ideal suite of interim covenants to ensure the value of the target business is sustained and/or enhanced throughout the interim period (some or all of which may be in an environment where the impacts of the pandemic are in full effect). Ultimately, we see this playing out through more involved (and potentially contentious) discussions and negotiations between transacting parties with respect to how the business should be operated in the interim period in light of the challenges imposed by the pandemic. The foregoing caution takes on added importance for purchasers acquiring a target via the acquisition of equity interests (shares, units, etc.), where the liabilities of the target are less easily excluded and/or mitigated.
If you have any questions with respect to the above, please reach out to the author(s), any member of the M&A practice group or your current contact at MLT Aikins.
This article is of a general nature only, is not exhaustive of all possible legal rights or remedies and is only current to the date it was posted. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.