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:
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:
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.)
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:
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:
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.