March 17, 2020 - by Cooley M&A
With last Wednesday’s categorization by the World Health Organization of COVID-19 as a pandemic, schools, places of business and other venues throughout the United States quickly closed in-person locations and moved to remote connectivity as efficiently as possible. On Sunday, the governor of California called for all bars and nightclubs within the state to shut down, restaurants to reduce capacity in half and urged anyone over the age of 65 to self-quarantine at home. The mayor of New York City made a similar announcement and on Monday President Trump addressed the nation with a heightened sense of alarm, advising against any gatherings of over 10 people for the next 15 days, while concurrently suggesting that this crisis could easily continue into July or August. Precedent set by other countries that have effectively slowed the spread of COVID-19 would suggest that more sweeping preventative measures may be on the horizon. As a result of this unprecedented social and economic uncertainty, we are counseling clients interested in mitigating impacts of COVID-19. Highlighted below are key issues that touch governance and M&A matters in our current environment:
Public Company Clients
Dealing with Shareholder Activists and Unsolicited Offers. As stock prices decrease in response to market uncertainty, directors of public companies should be prepared to respond to increasing levels of shareholder activism and unsolicited takeover offers, as opportunistic parties with strong balance sheets look to take advantage of companies in temporary distressed positions. During the 2008 financial crisis, it was reported that the number of proxy fights increased by 14% year over year and the number of unfriendly transactions nearly doubled (unfriendly transactions representing 23% of public deals announced in 2008, as compared to 12.4% of deals in 2007). While the underlying reasons for the market volatility are different now than they were in 2008, and companies and activists may be more risk-adverse given the general uncertainty around the duration and scope of COVID-19’s impact, it would be prudent for directors of public companies to assess current takeover preparedness measures and proactively review fiduciary duties in responding to potential activists and takeover attempts. Among other measures, public companies should review existing rights plans that are “on the shelf” or consider putting a rights plan on the shelf. Companies with large net operating losses should consider whether it would be prudent to adopt a rights plan to assist in preservation of the usability of net operating losses. For additional guidance on preparing for activism and takeovers amid COVID-19 volatility, please see this subsequent post from our team.
Stock Repurchases. Current volatility may stir questions about effecting a stock repurchase, particularly if a company has an otherwise healthy balance sheet. A company may choose to repurchase its stock during a time when it believes the stock is undervalued in the hope that it will signal confidence to the market and increase demand for the company’s shares. There are several ways that a stock repurchase can be effected (i.e., self-tender, open market, stock repurchase program), each of which carries with it different disclosure and reporting obligations and varying timing considerations. Note that stock repurchases can be expensive to administer and will likely be avoided by companies that are expected to be hit the hardest by COVID-19’s impact (e.g., travel, airline and hospitality companies). Also note that some companies have already announced intentions to cancel or suspend previously announced stock repurchase programs (e.g., Delta and MGM).
Going Private. We are aware that some investors are suggesting that management teams consider going private because a company has balance sheet cash and its stock price is depressed. Some participants may be under the mistaken impression that a going-private transaction can be effected rather simply – using the company’s cash to do an issuer tender offer to reduce the number of stockholders below 300 holders, delisting from trading on Nasdaq or the NYSE, and ceasing public reporting requirements and market trading. A going-private transaction is far more complex than some investors may suggest. First, there is a high risk that an issuer tender offer would not be successful. The commencement of the tender offer itself could result in an unanticipated outcome – shining an unwanted spotlight on the company and prompting competing bids or attracting activists opposed to the company strategy. Even if a tender offer can be effected without strategy interruption, there is no guarantee that it will achieve the minimum stockholder levels required for delisting. More importantly, a “going private” is a control transaction and any related board review of this strategy requires a heightened level of board governance and attention, including the immediate creation of a special committee of the board before any substantive economic discussions relating to a potential transaction begin and a very careful vetting process, which should include a fulsome consideration of strategic alternatives. Any special committee formed for this purpose must include the following features: (i) only members that are independent directors; (ii) delegation of full authority of the board to reject or accept proposals and (iii) authority and autonomy to retain outside advisors dedicated solely to the committee. With a “depressed price” fact pattern, boards are well advised to more judiciously approach review of any potential transaction that could result in the stockholders not receiving fair value for their shares. Even if “going private” transactions are undertaken with appropriate governance structures in place, there is a high risk of deal litigation, and plaintiffs will contend that these deals should be scrutinized under the highest level of judicial review. For Delaware companies, this is the entire fairness standard, the application of which can be outcome determinative, as courts will carefully scrutinize the independence of special committee members, as well as the deal process and the resulting price. At a minimum, even if a transaction is ultimately determined to be fair, proving that a transaction is entirely fair will be a costly endeavor. Finally, management-led, going private transactions are subject to higher disclosure burdens under federal securities laws, including the rules under Section 13e-3 and Regulation M-A and are more likely to be reviewed by the Securities and Exchange Commission.
M&A Negotiations and Deal Terms
Highlighted below are some of the key areas where we expect to see more nuanced negotiations and heightened scrutiny during the course of an M&A transaction as a result of COVID-19’s impact:
Purchase Price Adjustments/Valuation. Most private acquisition agreements contain purchase price adjustments to address fluctuations in a target’s debt, cash and working capital (among other things) between signing and closing. A target’s working capital is typically measured against a peg, set at the time of signing, and based on historical information. However, that historical information may no longer be the best guidepost if the target’s financial situation has been, or is expected to be, impacted by COVID-19. The parties will need to determine how the peg should account for the impact of COVID-19, which will be increasingly difficult given the unpredictable scope and duration of the crisis. Buyers may attempt to discount the overall value of a target as a result of COVID-19’s impact, but we would expect most sellers to reject those discounts on the basis that the underlying value of the target remains unchanged, given that any financial impact would be temporary and non-recurring.
Due Diligence. Conducting due diligence on a target’s business is an essential part of any M&A transaction. Set forth below is a list of certain diligence items we expect buyers to scrutinize more closely as a result of COVID-19:
Force majeure provisions in customer and supplier contracts. Many commercial contracts contain a “force majeure” provision, which excuses a party’s performance due to unforeseen circumstances (typically of a catastrophic nature). If there is an expectation that target or any counterparty that it contracts with will be unable to perform contractual obligations as a result of COVID-19, buyer will want to closely analyze these provisions to understand the target’s rights and remedies in such a scenario. If a counterparty’s performance is excused, buyer will need to understand what impact that has on target’s ability to perform its own contractual obligations. See this Cooley Alert for more information on the applicability of force majeure provisions in this current environment.
Insurance coverage. Sellers should understand and be prepared to answer questions from buyer regarding the scope of target’s insurance policies for losses attributable to COVID-19 and what actions they are taking to preserve target’s rights under those policies. For some helpful guidance on steps companies should be taking on the insurance front, see this post from Cooley’s insurance team.
Cybersecurity. Cybersecurity has become an increasing focus of buyer’s due diligence, and we would expect even greater scrutiny as a result of COVID-19. Employers who have introduced new remote work programs or expanded the scope of their existing remote work programs, may be more vulnerable to cybersecurity attacks than they were in the past. Furthermore, there have already been reports of hackers impersonating various public health agencies in an attempt to capitalize on the instability created by the current environment. #cybersecurity
Employee matters. Buyers will seek to understand any new employee policies that target established in response to COVID-19, focusing on the legality of any restrictions imposed on employees.
Depending on the results of its due diligence efforts, a buyer may also seek to expand the scope of certain representations and warranties about the target’s business, including with respect to (i) performance of material contracts, (ii) undisclosed liabilities, (iii) insurance coverage and (iv) accuracy of financial statements. Relatedly, we would expect sellers to try to limit their exposure by including broad disclosures regarding the impact of COVID-19 on the target’s business.
Timing. The timing of your M&A transaction will inevitability be impacted by COVID-19, giving the rapidly changing environment. Parties should expect delays when seeking third-party consents, whether with commercial counterparties or governmental agencies, arranging and obtaining transaction financing and conducting due diligence. The Premerger Notification Office (PNO) announced that, starting on Tuesday, March 17, all HSR filings will need to be submitted through a temporary e-filing system and that early termination would not be granted for any transactions while the temporary filing system is in place. Understanding these timing considerations, parties should set an outside date that leaves a significant amount of cushion. If an acquisition agreement has already been negotiated and it appears that it may not be consummated by the outside date, any extension rights should be exercised in strict compliance with the terms of the acquisition agreement.
MAE Definition. Most acquisition agreements give buyer the right not to close a transaction if there has been a material adverse effect (an MAE) on the target’s business, operations or financial condition in the period between signing and closing. However, MAEs are notoriously difficult to prove, with Delaware courts finding the existence of an MAE in only one case. As discussed in more detail in our prior blog post, for an MAE to be found in Delaware, a target’s business must have suffered a serious financial decline that was durationally significant (i.e., at least a year) and that was specific to the target company and not the industry at large. Given the requirements described above, it seems unlikely that the impact of COVID-19 on a target’s business would rise to the level of an MAE, but sellers would nonetheless be well-advised to add COVID-19 (and the impact thereof) as a specific exception to the MAE definition. Relatedly, if buyer wants to preserve a closing condition in circumstances where COVID-19 has a greater impact on target’s business than it anticipated, that right should be clearly expressed in the acquisition agreement, rather than relying on the MAE clause.
Interim Operating Covenants. Buyers typically have consent rights over certain actions taken by or on behalf of the target in the period between signing and closing, including any actions taken outside of the ordinary course of business. We would expect sellers to negotiate for an exception to this general rule to allow them to take actions as necessary to quickly respond to the impact of COVID-19, including implementation of measures designed to slow the spread of the virus. Buyer may nonetheless seek to have consent rights over any actions that could have a significant financial impact on target’s business or, alternatively, ensure that the purchase price is adjusted to account for that impact.