As the unprecedented COVID-19 pandemic engulfs the world taking more and more lives, enormous pressure is being witnessed on all global systems, government machineries and businesses alike. India is no exception to such effects.
With new restrictions being placed on movement of people, goods and services across the country and the world on a daily basis, there has been a decline in the demand for travel, consumer and retail spending, entertainment, petroleum, closure of manufacturing units, and disruption of supply chains, among other things. In the current scenario and given the downturn in economy, investee companies, which are in real need of funding for sustenance, may accede to the demands which they would generally push back on and arguments on what may be a "fair deal" seem mute. Companies that were looking to organically grow through strategic acquisitions will seriously re-consider their position now.
With the growing uncertainty around the COVID-19 situation, parties have begun to evaluate what customarily gets built into transaction documents as a clause relating to material adverse effect or material adverse change ("MAE/MAC"). MAE/MAC clauses are standard elements in investment and acquisition agreements that allow the investors or acquirers to walk away from a transaction prior to completion, should some event have a material adverse effect on the target's business, sector, or overall financial markets. This is because, due to the occurrence of such events, the investors or the acquirers lose the advantage that was to be derived from the transaction. We have examined how the COVID-19 situation might bring the MAE/MAC clauses in transaction documents (which rarely come into play) to the forefront of discussion.
What are the different ways in which MAE/MAC clauses get drafted in the transaction documents?
The scope of the definition of a MAE/MAC clause (and its exceptions) depends on the type of transaction, industry and negotiating power amongst the parties. While the target/seller would always like to limit the scope of its application, the investors and acquirers try to keep it broad.
We have typically seen the MAE/MAC clauses being worded to include, among other things, any event, occurrence, fact, condition, change, development or effect that, individually or in the aggregate, has had or may reasonably be expected to have a material adverse effect on the target company's financial condition, operations, assets, liabilities or business (including ability to continue business in accordance with existing contracts, consents, intellectual property, approvals).
Sometimes, in an investor or acquirer friendly deals, the definitions are also worded to include any material adverse change, event, development, or effect arising from or relating to (i) general business or economic conditions, (ii) national or international political or social conditions, (iii) financial, banking, or securities markets, (iv) changes in generally accepted accounting principles , (v) changes in any applicable laws (including orders or decisions of any government authority); or (vi) the validity, legality or enforceability of the rights or remedies of the investors or acquirers under the transaction documents.
On the other hand, in target or seller friendly deals, we have also seen exceptions being included to the definition of MAE/MAC such that any change or occurrence which is caused by: (i) changes in interest rates, exchange rates or securities or commodity prices or in economic, financial, market or political conditions generally; or (ii) any earthquake, flood, drought, fire, explosion, civil unrest, terrorist attack, or any other natural disaster or other force majeure event (which could also include pandemics/epidemics), is not treated as a MAE/MAC.
What constitutes "material adverse effect" in the context of investment and acquisition transactions? How have courts looked at generic versus specific language for MAE/MAC?
While we have looked at how the MAE/MAC clauses usually get drafted in the agreements, it is very difficult to categorize an event as one which causes a MAC/MAE. The language and guidance in the definition of the MAE/MAC clause is generally used to determine the materiality threshold to measure the negative effect of some event on the target business. Usually, in any MAE/MAC clause in acquisition transactions, the general market or industry risk is allocated to the buyer, and the company-specific risks to the seller. However, what is material is otherwise left undefined. What constitutes a MAE/MAC is then a question that the relevant court has to answer in case a dispute arises, invoking the MAE/MAC clause.
The courts have historically applied stringent standards to deem any event as resulting in a MAE/MAC. Courts have refused to grant reliefs to parties claiming existence of a MAE/MAC even when a party failed to inform the other party about the decrease in the financial health of the Company.
It has been said that the adverse change part of MAC means, evidently enough, a change for the worse. It is 'material' that is problematic, in that it is ambiguous and does not provide any clear guideline on the applicable thresholds. The plain meaning of the term material means of such a nature that the knowledge of the item would affect a person's decision-making process. It has also been opined by courts that MAE should be material when viewed from the longer-term perspective of the reasonable investor or acquirer. Hence, courts may insist that the duration of the effect must be taken into account. Several poor quarters of performance may be insufficient to trigger MAE/MAC. Further, a change could be deemed to be adverse and material if it substantially threatens the target's earning potential in a durationally significant manner. For example, loss of operating income, loss of revenue and cost-cutting measures which, whatever their effect in the short term, may affect the ability of the target to grow the business in the longer term may be deemed to cause a MAE/MAC.
It may also be possible that in some instances, MAE/MAC events may be linked to something more akin to doctrine of frustration of contracts and a party may only be allowed to call out a MAE/MAC for occurrence of such event which is not within the control of any party, and makes it impossible for a reasonable party to perform their obligations.
To establish a MAE/MAC is inevitably a highly subjective process with a heavy burden of proof, on the one invoking it, involving careful consideration of the drafting and surrounding circumstances.
Can COVID-19 be treated as an event causing MAE/MAC?
Like we discussed above, in absence of set guidelines for determining the materiality of events that may be treated as MAE/MAC, each instance may be examined by courts basis their unique factual position. The severity and long term impact of the COVID-19 situation in the relevant instance may be an essential criterion that courts may consider to determine whether it will be termed as having a MAE/MAC or not.
Whether COVID-19 qualifies as an event causing MAE/MAC will depend on multiple factors such as the wording of the definition of MAE/MAC, the impact on the business of the relevant target company viz-a-viz other similar business, the impact on the industry that the target company operates in as against other industries or sectors. For example, while travel industry is adversely affected, IT companies and specially those providing services that aid social distancing (e.g. apps for video conferring and UGC sites, among others) may see a boom. Similarly, if wording in the MAE/MAC definition specifically excludes force majeure events, natural disasters, epidemics, pandemics or general impact on financial markets, economic condition, it may be difficult to call out a MAC/MAC for the COVID-19 situation. The burden of proof will lie on the party invoking the MAE/MAC clause to prove that the pandemic has or is likely to materially and adversely affect the transaction in question.
Presently, while the entire world is practicing social distancing, people are trying to work remotely and countries are experiencing an immediate economic slowdown, the long term impact of COVID-19 is yet to be determined. As already stated, the courts have been considering stringent threshold for materiality when it comes to determining MAE/MAC and approach it on a case to case basis. Hence, the manner in which the courts may consider this extraordinary situation is very difficult to predict.
Will investors / acquirer have the ability to walk away from a transaction which has been inked but not completed, citing COVID-19 (as MAE/MAC)?
Usually, transaction documents include non-occurrence of MAC/MAE as a representation from the sellers or target as well as lists non-occurrence of MAE/MAC as a condition precedent to the transaction. Accordingly, a MAE/MAC event gives the investors or the acquirers a right to walk away from the transaction.
As discussed above, whether COVID-19 can be treated as an event causing MAE/MAC will depend on several factors and each case may have to be examined basis its unique factual matrix. Like mentioned above, in relation to the contracts which exclude events related to or caused by natural calamities from the definition of MAE/MAC, it will be very difficult for the investors or acquirers to claim that COVID-19, will result in a MAE/MAC. However, in relation to the contracts which do not carve out such exceptions from the definition of MAE/MAC and include general or specific language on adverse effect on financial conditions, markets or force majeure events being treated as MAE/MAC the investors or acquirers can try to prove that COVID-19 has detrimentally affected or will detrimentally affect the target company's financial condition, operations, assets, liabilities or business. There is no doubt that the pandemic is leading to forced closure or temporary suspension of businesses (which can't operate remotely), reduced demand for several consumer goods and services as well as stress on costs, specially with large part of workforce not being able to contribute to the operations (while the government is urging employers not to lay off the workers or cut their salaries). Accordingly, investors or acquirers, while trying to invoke the MAE/MAC clause might try to argue that the pandemic compromises the growth of the business of the target company basis which valuations were arrived at or the transaction was finalized. The circumstances in each case will have to be closely examined to determine whether COVID-19 can be deemed to cause or have caused a MAE/MAC under those circumstances.
However, there might be instances where an agreement does not include a MAE/MAC clause. In absence of specific MAE/MAC clauses, the parties may resort to clauses relating to force majeure or act of God to seek relief in the current COVID-19 situation. But, most of the time such force majeure clauses are vaguely drafted and sometimes, entirely omitted from transaction documents. While even in such scenarios, force majeure may be sought as an equitable relief, parties may also have to rely on doctrine of frustration or impossibility of performance under Section 56 of the Indian Contract Act, 1972. Nonetheless, the bar to claim any of the aforesaid reliefs is also very high, if not higher than those required to trigger MAE/MAC clauses. Generally speaking, it is unlikely that COVID-19 by itself would result in such impossibility of consummation of an investment or acquisition agreement. In that case, it may be best to look at certain other options that the parties to a transaction can explore some of which we have examined later in this article.
At what stage can the investors or acquirers call out a MAE/MAC related to COVID-19?
While one may call out a MAE/MAC event at any time prior to closing, in the current scenario, given the knowledge of widespread impact and global exigencies created on account of COVID-19, it is advisable for investors or buyers to call it out at the first possible instance. If the company has already issued the notice of completion of conditions precedent, then the investors or the acquirers can dispute such completion citing the occurrence of MAE/MAC. Again, there isn't much judicial guidance on when a notification for MAE/MAC should be issued. But a parallel can be drawn from instances of notification of force majeure events, where the courts expect a party calling out a force majeure event or impossibility of performance to notify such occurrence as soon as a party becomes aware of the existence of such event, occurrence, or impossibility. Investor or acquirer should be vigilant as to the timing of invocation, as if the completion of conditions precedent is not disputed within appropriate time, then it may crystalize investor's or acquirer's obligation to invest
Can a company or seller seek specific performance in cases where an investor or acquirer terminates/seeks suspension of a transaction citing COVID-19 as MAE?
Given the high threshold for considering COVID-19 as MAE/MAC, a company or a seller while disputing the occurrence of MAE/MAC and depending on the wording of the contract, be able to seek specific performance of investor's or the acquirer's commitment to invest or purchase. Seeking specific performance as relief would mainly depend on the relevant factual circumstances, and will be enforced if the investor or the acquirer is unable to satisfactorily discharge the burden of proof for proving that COVID-19 has caused a MAE/MAC. Targets or sellers should keep in mind that contracts don't exclude any specific performance for pandemics, epidemics (covers COVID-19 situation).
What are the other options available with parties to investment or M&A transactions which have been signed but not closed, to address concerns around the COVID-19 situation?
As mentioned above, the threshold to deem an event as causing MAE/MAC is very high, thus, parties to a transaction may explore other options. Parties may mutually agree to defer the proposed investment or acquisition or suspend the relevant contract till the situation is brought under control. They may also consider amending the transaction document with a prospective understanding as to the performance or financial condition of the target or include clauses to revisit the valuation (depending on how the target does or is expected to do in next 12 months). Parties will need to carefully draw up the instruments and terms attached thereto to create leeway for any such events where adjustment might be required in future.
Parties may also be seen paying greater attention to good old clauses on long stop date to close the transaction as well as standard requirement of completion of conditions precedent to the satisfaction of the investor's or buyer's investment committee, which approves the transaction. Parties may also consider securing a debt for the target. Investors could insist that if such debt is not secured prior to or simultaneous with their equity financing to close funding, they will have a right to walk away and target or promoters will be barred from insisting on specific performance.
How should parties approach any new investment/M&A transaction documents to be executed with knowledge of the existence of COVID-19?
Now that the investors, acquirers, the sellers and target companies have an idea of the COVID-19 situation and the impact it may have on global economy and specific or generic business conditions, it is advisable that parties to an investment or M&A transaction, which is under negotiation or is proposed to be executed, specifically cover or carve out the consequences of potential material and adverse impact that the continuity of COVID-19 situation may have on the transaction. Going forward, parties may also negotiate MAE/MAC clauses to specifically include (from a buyers side) or exclude (from a sellers side) , such events and occurrences which may have economic, political or other adverse impact on the target in similar situations, including force majeure events like an epidemic or pandemic.
Like we have discussed above, an investor or acquirer who chooses to now sign up for a transaction with knowledge of the current situation of COVID-19 may find it difficult to rely on its negative effects later to back out from the transaction. The principle of caveat emptor or buyer beware may apply in the such cases. Thus, to not completely remove but alleviate the effects of further negative impacts that COVID-19 may have on transactions, the parties may agree to adjustment of valuation, deferred payments, or ranching of investment or payouts, linked to meeting of certain financial or revenue numbers in the coming year. On the other hand, the company or the seller can push for inclusion of a floor price or base valuation for such scenarios.
Further, the investors and the acquirers may negotiate commercial terms (including on guaranteed shareholding percentage and financial soundness of the company among other things) such that they will be able to withstand the possible implication arising from such investment. For instance, an investor can specify that if in the future quarter(s), bi-annual, or annual cycle, the financials of the target don't improve or attain a particular milestone, then a downward adjustment to pre-money valuation can be made. Investors or acquirers may also consider seeking representations on compliance by the target company of government directives on COVID -19 and other ancillary aspects such as the target's preparedness to deal with the COVID-19 or a similar situation and true and adequate disclosure of all information which may be material in such situations and may impact the target's business, assets, transaction.
Additionally, parties can consider including a break away fee and the onus for the payment of such fees can be determined upfront. Further, parties, specially the target, should call out for explicit provisions on the consequences in relation to permissible deviations from projections or business plan, taking into account the consequences of COVID-19. Clauses on conduct before closing and interim obligations may also become crucial to negotiate if parties contemplate delays between signing and closing because of the situation prevailing due to COVID-19. The parties may also explore some of the options listed above, such as securing a debt. Hence a more cautious approach may be adopted for next quarters as far as new transactions are concerned.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.