As expected, the COVID-19 pandemic has resulted in a significant slowdown in local M&A activity with South African corporates presently focused on balance sheet protection and cost reductions. Yet the EY Confidence Barometer report anticipates a significant increase in global deal flow in the second half of 2020 as businesses look beyond the immediate impact of COVID-19 measures on supply chains, revenue and profitability. The expected eventual increase in M&A activity can be attributed to factors such as lower share prices, distressed assets becoming available and private equity companies with significant funds at their disposal seeking new and creative opportunities.
The pandemic also presents opportunities for the capital markets to come to the assistance of social causes through the creation of social and sustainable debt instruments. Earlier this month, the African Development Bank listed the “Fight COVID-19” social bond on the London Stock Exchange, the largest social bond to date to be issued in the capital markets.
Against this background, what are some of the key legal issues to consider in the context of implementing transactions during COVID-19?
Material Adverse Change Provisions
The outbreak and impact of COVID-19 raises a key question as to whether these circumstances might constitute a “Material Adverse Change” or “MAC” to a seller’s business, allowing a purchaser to walk away from a sale and purchase agreement.
Although COVID-19 has the potential to have a significant and lasting impact on companies, the pandemic itself may not necessarily trigger a MAC. In order to make this determination, the wording of the underlying MAC and related exclusion provisions would need to be scrutinised so as to ascertain whether COVID-19 would result in a specific, material and long term impact on the target’s business. In many agreements, systemic or industry risk and circumstances such as pandemics are excluded in a MAC definition.
Where COVID-19 does not constitute a MAC and the buyer resiles from the agreement, the seller could seek damages and/or specific performance of the agreement to force the buyer to close the deal.
If an agreement does not provide for a MAC clause, the parties may have to look at the common law regarding supervening impossibility to establish whether either of the parties can no longer be required to perform under the agreement where an irresistible force (vis major) or unforeseeable accident (casus fortuitous) has made fulfilment of its contractual obligations objectively and permanently impossible.
COVID-19 is expected to result in buyers undertaking heightened due diligence exercises with significant scrutiny placed on business continuity and the following key operational, financial and contractual risks:
- Operational risks – information technology, security, integrity and reliability of disaster recovery plan and the ability to provide remote network access.
- Solvency and liquidity – the ability to pay suppliers, working capital, general risk of insolvency and liquidity and measures taken or to be taken for the protection thereof.
- Contractual performance – review termination of rights and obligations or suspension of performance obligations due to an event of a force majeure or insolvency.
From a contractual perspective, parties seeking to walk away from an agreement or be excused for non-performance could potentially rely on either the common law defence of supervening impossibility of performance or on a force majeure clause. Determining whether COVID-19 would fall within the ambit of force majeure would require careful consideration of the force majeure clause relied upon, the contractual obligation and the reasons for non-performance.
Warranties and Indemnities
For sale and purchase agreements signed prior to the outbreak of COVID-19 where closing is yet to occur, warranties should be carefully revisited to ascertain the impact of COVID-19 on the factual circumstances relating to the target’s business.
For transactions that are still being negotiated, a buyer is likely to insist on the inclusion of wide ranging warranties covering the impact of COVID-19 on the target’s business and operations, including in relation to its employees and health and safety compliance. A buyer might also consider seeking specific indemnities where significant risks have been identified.
From a seller’s perspective, broad COVID-19 exclusions and disclosure are likely to be requested, including business interruption losses.
Given the limited availability of regulatory services such as the Competition Commission and the Company and Intellectual Property Commission during the national lockdown and the anticipated phased approach to opening the South African economy in the wake of the COVID-19 crisis, buyers and sellers might need to agree to longer outside dates for the fulfillment of conditions precedent of a regulatory nature resulting in likely delays in closing M&A transactions. .
Despite the devastating effect that COVID-19 is having on M&A activity in South Africa, there are signs of increased M&A activity in the latter half of this year as distressed assets become available for companies with existing cash resources. Buyers and sellers anticipating M&A deals in the context of COVID-19 should also be mindful of the evolving legal considerations of the nature referred to above in their transaction planning.