Effect of COVID-19 on Private Equity (PE) and Mergers & Acquisitions
As the global pandemic deepens and the human cost of COVID-19 rises, the novel coronavirus outbreak is sending shock waves throughout the world economy. It has already built an enormous pressure on all global systems, government machineries, and businesses alike. Growing uncertainty around the COVID-19 situation has also triggered a host of debates and uncertainties regarding the applicability of provisions pertaining to Material Adverse Change (“MAC”) in PE and M&A transactions.
What is a MAC?
While the definition of MAC varies depending upon the nature of the industry and the underlying transaction, MAC is generally defined to include any change or effect that is considered as materially adverse to the (i) assets, business, financial conditions and/or operations of a company, (ii) the ability of the company and/or its promoters to fulfill their obligations under the agreement, or (iii) the validity or the enforceability of the rights and remedies of the investors or acquirers.
What is the relevance of a MAC clause in PE and M&A transactions?
MAC clauses are standard elements in investment and acquisition agreements that allows an investor or acquirer to terminate the agreement and walk away from a transaction prior to completion or perhaps renegotiate the terms due to impact on the valuation or other dynamics, should some event have an adverse effect on the target's business, industry or overall financial markets in a material manner. This is because, due to the occurrence of such a material event, the investor or acquirer loses the advantage that was to be derived from the contemplated transaction. Typically, the applicability of such provision is between the stage of signing and closing of transaction where due to the occurrence of the material adverse effect, the dynamics of the target have changed substantially changing the investment thesis of the investor or acquirer.
Whether COVID-19 can trigger MAC under the transaction documents?
Whether an event such as COVID-19 can trigger a MAC clause or not is required to be assessed on a case to case basis depending upon how the MAC clause has been specifically worded and the impact of such event on the target company. In the absence of explicit inclusion of the occurrence of events like epidemics and pandemics in the definition of MAC, certain factors will be required to be assessed whether a MAC has been triggered or not, including:
The impact of COVID-19 on the target as well as the specific market or industry in which the target company operates;
Whether it has, directly or indirectly, adversely impacted the business, operation or financial condition of the company materially or the ability of the company to fulfill its obligations;
Whether such events have been specifically excluded from the definition of MAC or if any other typical exclusions such as force majeure, etc. (which could also include pandemics), have been provided for in such definition.
Therefore, unless the COVID-19 pandemic clearly fits into the definition of MAC or, on the other hand, as an exception to the applicable MAC definition, it will be based on the specific facts and judgment of the courts/tribunal as to whether a MAC has occurred or not.
How a MAC clause can be interpreted by courts & under S. 56 of the Indian Contracts Act, 1872?
While courts in India have failed to provide any set guidelines for determining the materiality of events and have limited themselves to opine that any event which will restrict or make it impossible for a party to enter into such transaction will be a material adverse change, an analysis of the precedents concerning the interpretation of MAC clause reveals that the standard to determine whether an event would constitute MAC is extremely high and that the Indian courts have been reluctant in favoring the investors or acquirers to walk away from a transaction. Therefore, investor or acquirer looking to invoke the MAC clause will have the ultimate burden to prove that the said event has adversely impacted the business of the target company in a material manner and such an impact has materially and adversely affected the transaction.
If it can be established that an event has frustrated the key purpose of the contract, the relevant party may seek a termination of contract and absolve themselves of their obligation under the contract by relying on Section 56 of the Indian Contract Act, 1872 (“Contract Act”). On the other hand, where an explicit exclusion (in the form of force majeure event (including pandemic and epidemics) has been provided under the definition of MAC, the parties would be bound by such a clause and would be precluded from relying on Section 56 of the Contract Act to escape performance of the contract. It has been held that where the court gathers as a matter of construction that the contract itself contained, impliedly or expressly, a term, according to which it would stand discharged on the happening of certain circumstances, the dissolution of the contract would take place under the terms of the contract itself and such cases would be outside the purview of Section 56 of the Contract Act altogether.
What safeguards can be built in by an acquirer & a seller going forward in light of COVID-19?
The advent of an event such as COVID-19 has raised the importance of MAC clauses under agreements than ever before. If parties haven’t executed the definitive agreements yet, while conducting due diligence, the investor/acquirer shall focus more on the ability of the target company to perform or not under the existing material agreements and evaluate the target’s preparedness to mitigate the adverse impact of events such as COVID-19. MAC clause should be carefully worded and if it is possible to ascertain the variation in the financial condition of the target indefinite terms (for e.g. deviation of more than 10% in the financial condition), the same may bring certainty for investor/acquirer to invoke MAC, whereas, from sellers/company perspective, they may insist on the inclusion of specific exception of events such as COVID-19 and its impact on business in the MAC clause as well as give specific disclosure of such event in respect of warranties on their behalf.
If the parties have executed the definitive documents (but not consummated the transaction yet), unless there is a clear interpretation available on MAC, parties may mutually agree to defer the proposed investment/acquisition or suspend the relevant contract till the situation is brought under control, or revisit the valuation rather than an outright termination.
Please feel free to reach out to any member of the G&A Team in case you require any clarifications on the above.
Gandhi & Associates