As the days pass, it is becoming increasingly clear that the 2019 coronavirus health outbreak (Covid-19 Outbreak) is already having and will have substantial impact, including in the long term, on all phases of M&A deals, from due diligence to signing and closing mechanics, and from the purchase price mechanism to the representations and warranties and contractual remedies under an SPA or APA.
The purpose of this alert is to highlight the main legal issues that may arise in an M&A transaction in Italy and to provide some tips and suggestions, bearing in mind that each M&A transaction stands on its own and analysis on a case-by-case basis is always advisable. In particular, we will analyze the following aspects:
Please bear in mind that the abovementioned matters and relevant contractual provisions tend to be closely related and the effects of their individual application may affect each other. In a complex and unpredictable situation such as the Covid-19 Outbreak, there are multiple factors to be evaluated and taken into account and your lawyers and advisors must possess a deep understanding of the underlying industry and the workings of the specific business of the target.
In Deals Under Negotiation
Although many buyers are waiting to see how the epidemic develops before making the appropriate assessments regarding their next M&A deals, the current crisis could be a driver for new acquisitions, especially for those buyers with cash in hand looking to cut a good deal. In this scenario, although we have seen increasing use of the locked box mechanism in recent years, we expect strategic buyers and PE funds will begin to look at this mechanism with a more critical eye and will start reconsidering the “evergreen” closing accounts pricing mechanism as a better way to achieve more balanced allocation of economic risk for as long as outbreak effects are foreseeable.
For the same purpose, buyers may also consider using earn-out payments, albeit with all the relevant complexities (complex negotiations, higher risk of litigation post-closing, and so on) taken into account. Earn-out payments tied to the achievement of certain financial milestones, such as net sales of products or, more generally, revenues or EBITDA generated by the target, could prove a more favorable option for the buyer in the era of coronavirus, when such financial metrics are highly volatile and uncertain. To temper such shift of risk from a seller’s perspective, it is advisable to negotiate and provide specific diligent requirements if earn-out payments are linked to financial milestones relating to 2020. The following are a few examples:
- the adoption of a mitigation and contingency plan agreed upon by the parties that the target shall adopt effectively to face the challenges raised by the Covid-19 Outbreak;
- the ability to earn catch-up earn-out payments if all or any portion are missed for a prior period, such as 2020 due to the Covid-19 Outbreak;
- the provision of proper information rights in favor of sellers to monitor management of the business during the health crisis.
In Deals Waiting to Close
In the interim period between signing and closing, the parties should pay particular attention to monitoring what effect the outbreak could have on pending deals with reference to, among other things, the agreed purchase price mechanism. If such effects appear to be disruptive to their interests by excessively unbalancing the commercial terms previously agreed upon, involvement of legal counsel may be advisable.
For instance, a buyer that recently signed an acquisition agreement providing a locked box mechanism may evaluate whether there are grounds to renegotiate more favorable terms by threatening termination of the agreement through a MAC clause or by applying other legal remedies under applicable law (e.g., hardship, in Italian “eccessiva onerosità sopravvenuta,” which concerns cases where unforeseeable and extraordinary events fundamentally alter the equilibrium of a contract in such a way that performance would become excessively burdensome for one party), if available. As explained in the next paragraph, pursuing this option can be more complex than one might imagine, since it may depend on several factors, such as the scope of the MAC clause, the effects of the outbreak on the target and the relevant industry, and so on.
Furthermore, if you are the seller and your earn-outs are linked to financial parameters for 2020, it might be worth exploring whether you have any legal grounds to protect your interest and challenge before a court the way the buyer managed the business of the acquired company during the Covid-2019 Outbreak if milestones are not met. This is a particularly sensitive topic, especially if the parties are dealing either with a fixed lump sum payable upon the occurrence of a single milestone or with a percentage to be calculated based on the financial results of the target company during the Covid-19 period.
According to Italian law, the parties to an agreement must act based on a “good faith” standard (in Italian esecuzione secondo buona fede) in the performance of their contractual obligations. The “good faith” standard requires a party to (i) protect the interest of the other party regardless of a specific contractual obligation, and (ii) carry out any action aimed at such purpose to the extent that the relevant action does not trigger significant prejudice to the party’s self-interest.
Clearly, given how broad the “good faith” standard is and the absence of specific case-law guidelines in the context of an M&A deal, it would be difficult to ascertain the correct level of effort that a buyer should exert in order to achieve the agreed upon milestones and maximize the value of the contingent payment post-closing without having negotiated specific diligence requirements and a detailed definition of “commercially reasonable efforts” to be met.
The main purpose of a MAC clause is to grant the buyer the right not to close a deal if a material event negatively affecting consummation of the transaction or the target company’s business, operations, assets, or profits occurs before the closing date. To this aim, a condition precedent by which the buyer’s obligation to close the deal is conditioned upon the absence of a MAC event should be added to the M&A agreement.
As you can imagine, the Covid-19 Outbreak could easily represent a textbook case of an event that may have a material adverse effect on a target company and trigger the exercise of a MAC clause by a buyer.
However, it is not that simple. According to the latest “ABA European Private Target M&A Deal Points Study” (2019 edition), which was coordinated and contributed to by, respectively, my colleague Yan Pecoraro and myself, among other excellent professionals, only 37% of the examined European deals contain MAC closing conditions (a much lower percentage compared to the more sophisticated US market) and only 34% of the deals contain a definition of material adverse effect.
Furthermore, even if a MAC clause is present, the buyer’s right to terminate an agreement if a material adverse effect occurs is generally counterbalanced by a list of other events referred to as exceptions that do not constitute a material adverse change and therefore are aimed at preventing the buyer from leaving the deal. The most common MAC exceptions are events that are outside the control of the target, such as changes in the market or the industry, changes in law or in political or general economic conditions, such as war, calamities, and so on, and events that are partially within the control of the target, such as failure to meet projections, forecasts, or milestones. This means that if the sellers properly negotiated a MAC clause (even without any clue at the time of signing that the Covid-19 outbreak was going to occur), the buyer may not have solid grounds for exercising its right not to close the deal, despite the fact that the target experienced a sudden drop in sales and revenues between signing and closing.
The factors to be evaluated and taken into account for this purpose are multiple, and a deep understanding of the underlying industry and the workings of the specific business is necessary. The concrete application of a MAC clause can raise problems of interpretation and enforceability, especially if the definition of a material adverse event is unclear and too vague. As we mentioned, most acquisition agreements tend to use no definition or a vague definition of material adverse effect with extensive use of carve-outs, and consequently they leave interpretation of materiality to the court to decide in case of litigation.
In light of the above, following are some issues you should take into consideration, either if you want to check the enforceability of the MAC clause in an agreement that has already been signed or if you are negotiating such an agreement right now:
- Since the parties cannot foresee how long the Covid-19 Outbreak and its effects on the economy will last, has a duration been set for an event or has a period of time been determined for it to be deemed to constitute a material adverse event? For instance, is a reduction of the earnings over a two-month period due to the Covid-19 Outbreak sufficient to trigger a MAC?
- Is the materiality standard defined by providing quantitative thresholds, which, if reached or exceeded, indicate that a certain change is material and trigger application of the MAC clause (e.g. target’s earnings drop below a certain monetary threshold, diminished sales in China, the shutdown of a manufacturing facility for more than X months due to the Covid-19 Outbreak, etc.)?
- Are outbreaks, epidemics, health crises, and similar events included as a specific carve-out to the scope of the MAC clause? if yes, did the sellers include disproportionate effects wording in order to temper the application of said carve-out? If disproportionate effects wording is added, the carve-outs provided in favor of the seller will apply only if the target is keeping pace with its industry and its peers. By way of example, if a manufacturing facility is on lockdown because it is located in a “red zone,” that should not be considered an exception to the application of the MAC clause in the event that a shortage of certain excipients or raw materials necessary to produce a drug has disproportionally affected the target’s production because the target was the only one in the industry that had not taken proper measures that other competitors had taken (such as using comparable excipients available on the market for production of the drug or moving manufacturing to a facility outside the “red zone”);
- Are the industry and peer group used as a yardstick for measuring disproportionate effect clearly identified? Indeed, the way you identify the relevant industry and peer group may make it more or less difficult to verify whether or not the target has been disproportionally affected (e.g., think about the different impact a material adverse event such as the Covid-19 Outbreak may have in this regard if the peer group is composed of entities operating in the media industry in general as opposed to entities operating in TV production in Italy);
- If you are acquiring a holding company with subsidiaries and assets all over the world, did the parties clarify whether the event or change can have an adverse effect on only one of the subsidiaries or specific assets to trigger the MAC clause rather than the holding company and all subsidiaries and assets as a whole? By way of example, if a buyer is acquiring a certain number of automotive manufacturing plants, a Covid-19 Outbreak causing the lockdown of one such plant in Italy or China may not be sufficient to qualify as a MAC event if, according to the MAC definition, the event must have an adverse effect on the business of all the assets and subsidiaries as a whole.
The bottom line is the following: Do not use standard wording assuming that one size fits all; a well-drafted MAC clause should be tailored to the deal, the market, and the industry of the target. It is true that MAC clauses are usually catch-all provision providing risk allocation for events not yet addressed and regulated by the acquisition agreement, but if there are any specific areas of concern relating to the business of the target that may arise from the Covid-19 Outbreak, it is advisable to clarify which types of changes should be considered materially adverse. Again, a good lawyer needs to know the industry and understand how your business works to properly address the complexities of a MAC clause or simply check its application if signing has already occurred.
Although a MAC clause is certainly one of the first provisions that springs to mind in the case of a pandemic crisis, it is important for the buyer not to rely solely on said clause but to consider the inclusion of other remedies and protections based on its business, its corporate group structure, its capabilities, and the relevant industry. If the parties have already signed an agreement and are waiting for the closing, we also suggest checking whether the following provisions are contained in your agreement and what they say. (Covid-19 may require that you take specific action as soon as possible.)
- Interim Covenants on Conduct of Business: define specific interim covenants on conduct of target’s business and regular information flows between signing and closing to monitor the target and have the ability (i) to control the impact of the Covid-19 Outbreak on the target’s business and operations and (ii) to require buyer’s advance consent on any major actions outside the ordinary course of business that management of the company needs to take due to the outbreak. At the same time, any advance consent requirement should be structured in such a way as not to impair urgent decisions of the management and an emergency mechanism should be provided; furthermore, it may be advisable to agree upon a contingency plan to mitigate the main issues arising from the outbreak.
- Conditions to Close: evaluate the opportunity to include specific conditions to close (e.g., relocation of manufacturing capabilities outside the quarantine zone, end of the quarantine within a certain timeframe).
- Representations and Warranties: add specific representations and warranties to address issues that may arise from Covid-19 (please also refer to the matters mentioned in the due diligence section); at the same time the seller should be particularly careful to disclose Covid-19 Outbreak–related issues.
- Updated Disclosure Schedule and “Back Door” MAC: include proper protection, such as a “back door” MAC, on the assumption that nowadays it is in the interest of all sellers to include the right to update the disclosure schedule at closing (especially because of the higher risk of new disclosures that may have a material adverse effect on the business, such as, for instance, if certain material contracts are terminated due to force majeure).
- Indemnities: evaluate the opportunity (i) to add a specific indemnity provision on known risks related to Covid-19, if you are a buyer, or (ii) to add ring-fencing exclusion to Covid-19 related claims under indemnity provisions, if you are a seller.
Considering the many challenges that a company may face due to the Covid-19 Outbreak, it is particularly important to adapt the legal due diligence exercise to the specific situation and to pay attention to those specific critical issues linked to the outbreak, your business, and your industry. Among other items, it may be useful to ask and answer the following questions during due diligence:
- Was the target company complying with emergency regulations implemented by the government from time to time?
- What changes in law were under discussion that may have an impact on the business of the company?
- Had the target company implemented appropriate health and safety measures for the benefit of its personnel? Were there any other health issues to be considered based on the specific situation?
- Did the target have the ability and capability to comply with and perform its contractual obligation? If it did not, did the target company have the ability to invoke force majeure or any other similar provision of law to suspend the performance of its obligations?
- Did the target company have the right to terminate an agreement that the other party was unable to perform in a correct and timely manner or to exercise any other contractual remedies? Did the suppliers of the target company have such rights and remedies?
- Did the target company receive any termination notices on the grounds of hardship according to Article 1467 of the Italian Civil Code (ITA: eccessiva onerosità sopravvenuta)?
- Was the target company’s supply chain negatively impacted by the outbreak and, specifically, by the imposition of a quarantine zone (as occurred in Italy and in China)?
- Did the target company implement a mitigation and contingency plan to minimize the negative impact of the outbreak?
- Did the target’s insurance policies cover the Covid-19 Outbreak and related events?
- If the target company was party of an M&A deal, was that deal in question due to the possible exercise of a MAC clause by one of the parties?
- Did the target company have any protection in case of an insolvent debtor?
Finally, even if your company is not involved in an M&A transaction process, it may be appropriate to monitor the abovementioned matters. Among other things, it is advisable to map the force majeure clauses in active and passive contracts in order to identify any critical issues (e.g., which contracts contain the clause, its content, its consequences, the law applicable to the contract) and how to deal with them.
This activity normally requires a significant investment of resources/time, even if the number of contracts is not enormous. This could be managed extremely efficiently with the support of artificial intelligence.
Italy has been placed in quarantine, and although notaries continue to perform public services, we do not think it is the best and most prudent choice at the moment to meet in person in a room for a signing and closing. At the same time, this does not mean that your only choice is to postpone a signing and closing if you are concerned about leaving your house or prefer to limit your contact with other people.
Thanks to digitalization and a creative and flexible approach, we have all the tools we need to achieve the same results with safe modalities and in an environment that is as safe as possible without exposing ourselves, your colleagues, and counterparties to the risk of contagion. As a firm, we decided to close our offices three weeks ago, because we knew we could perform our work fully and just as efficiently and professionally from home. The same principles can be applied to accomplish a signing or a closing. Below are a few suggestions, with the caveat that the mechanics of a closing may vary and that case-by-case analysis is advisable:
- A signing can definitely occur remotely without the need to meet in person. You can easily exchange signed documents by certified mail or use electronic signatures if you do not have a printer with you. In fact, due to longstanding tradition (Italy was one of the first European countries to regulate the execution of electronic documents), there are a number of options that you may consider if you do not want to sign documents remotely, such as one time passwords (OTPs), biometric signatures, qualified signatures, etc. Of course, you may want to be sure that the option you choose has the same effects as a handwritten signature, which should be carefully evaluated on a case-by-case basis on the basis of the characteristics of the electronic signature and the type of document to be signed. In particular, when documents that the law requires executed in writing take electronic form, it is important that they be signed using signatures that ensure a higher degree of security and reliability, such as advanced or qualified signatures.
- A closing may be more complex to manage, since it requires the involvement of a notary to notarize the signatures of the buyer and seller in the transfer deed, whether an asset deal or a share deal under Italian law. However, you may still take a prudent and responsible approach:
- First, it is not necessary for everyone involved to gather in front of the same notary, as usually occurs; each party can sign the deed at a different time and in a different place before a different notary. Using digital notarized power of attorney and video-conferencing you can have a closing with parties located all around the world;
Second, during the closing you do not need to have everyone in the same room even if you need to hold a shareholders’ meeting for the approval of new bylaws or board of directors or to vote on a capital increase, etc. According to the latest official note No. 187 (in Italian massima) of the Notarial Council of Milan, “The attendance of the meeting by means of teleconference […] may involve all participants in the meeting, including the chairman, it being understood that the place indicated in the notice of call must be the place where the secretary or notary [are located].” In addition, clauses in Articles of Association that provide for the presence of the Chairman and Secretary in the same place as the meeting are to be seen as relevant for the purposes of simultaneous drafting and execution of the minutes of the meeting by the same Secretary and Chairman. This means that such provisions, even if provided in the Articles of Association, do not prevent the meeting from being held in the form of a video-conference involving all participants and therefore also the Chairman and Secretary, who may be in different places from each other, since the minutes may be signed at a later time.