We have posted the transcript for our recent webcast: “Activist Profiles & Playbooks.”

– John Jenkins

Most M&A agreements contain provisions obligating the parties to use their “best efforts” or “commercially reasonable efforts” to satisfy contractual obligations.  But how should those efforts clauses be interpreted when dealing with an unprecedented event like the Covid-19 crisis? That’s the question this Goodwin memo addresses.  Here’s an excerpt discussing what those obligations might entail when it comes to closing conditions & interim operating covenants:

Both sides of an M&A transaction frequently must use “best efforts” or “commercially reasonable efforts” to close the deal. But that obligation is not all-consuming. In Akorn, the Delaware Chancery Court concluded that the buyer’s rigorous investigation of the company and ultimate decision to terminate the agreement did not breach the buyer’s “reasonable best efforts” duties because (i) the buyer repeatedly communicated with the seller in order to determine whether the deal would succeed, and (ii) the buyer’s concerns about the seller’s performance were legitimate and justified the buyer’s decision to back out.

Buyers approaching closing during the COVID-19 crisis subject to similar efforts clauses would be wise to likewise communicate actively with sellers about their ongoing operations as closing approaches and, if the crisis places closure of the deal in jeopardy, to thoroughly investigate and document the impacts of the crisis on the ability or obligation of buyers to close.

Most sale transactions include some duties of the seller to operate the business pre-closing with “best efforts,” frequently paired with language describing the duty as consistent with the “ordinary course of business. The emergent and uncertain nature of the unfolding COVID-19 crisis raises dramatic uncertainty in how any operation currently undertaken is in the “ordinary course,” or whether unanticipated, but necessary, changes in operations in response to the crisis.

While under contract, sellers should be mindful of any interim covenants (including covenants not to enter into certain transactions outside the ordinary course of business) and keep lines of communication open with buyers about any significant steps being taken within the business to address the crisis. Sellers should be prepared to explain and justify the reasons for those steps taken to address the crisis, as well as other options considered but rejected and their reasons for rejecting, in landing on the chosen path.

The memo reviews the applicable case law on efforts clauses from Delaware, New York, and California, and notes that each jurisdiction’s standards are highly flexible “and the interpretation thereof depends on the specific challenges faced by the obligated party, its industry, and the market as a whole.”

– John Jenkins 

Many buyers of distressed businesses opt to acquire the target’s assets through a Section 363 sale following a Chapter 11 filing.  But this WilmerHale memo says that the magnitude of the Covid-19 crisis and the volume of distressed sellers that may well result from it might cause some buyers to rethink that approach. Here’s the intro:

When a company faces financial distress and seeks to sell its assets, both the seller and the buyer may prefer to implement the transaction through a Section 363 sale in a Chapter 11 bankruptcy case of the seller. A Chapter 11 sale process provides certain protections to the buyer from fraudulent transfer and other claims of the seller’s creditors, and a seller may be able to maximize the purchase price of its assets through a Section 363 auction process.

But even before the COVID-19 crisis, Section 363 asset sales also came with disadvantages. The Chapter 11 process can be costly, and it does not scale down well for transactions with lower purchase prices. In addition, a Section 363 sale can take several months to implement after the filing of the Chapter 11 case, and that time can also be costly in terms of the seller’s operating costs and the potential diminution in value of the seller’s assets while its Chapter 11 case runs its course. And for a buyer, even where it is a “stalking horse” purchaser with a breakup fee and other bidding protections, a Section 363 auction may invite competition for the seller’s assets that the buyer would prefer to avoid.

In the face of the COVID-19 crisis, when a greater level of financial distress among companies is anticipated, the balance of factors that may push buyers and sellers toward or away from a Chapter 11 sale process may shift. For reasons of risk tolerance, court access, and time and cost, buyers and sellers may be more likely to attempt non-bankruptcy distressed asset sales as a result of the crisis. Here we explore these reasons and analyze why they may cause sellers and buyers to favor out-of-court transaction options such as private sales, Article 9 secured party sales and sales by assignees for the benefit of creditors.

The memo walks through the various considerations identified above that might make a transaction outside of bankruptcy the preferred approach for many buyers & sellers. It notes that determining the right path for a deal is going to depend on an analysis of the facts and circumstances of the particular transaction, but that in the current environment, that analysis might well result a different conclusion than has been typical in the past.

– John Jenkins

Seyfarth Shaw recently published the 2020 edition of its “Middle Market M&A SurveyBook”, which analyzes key contractual terms for more than 100 middle-market private target deals signed in 2019. The survey focuses on deals with a purchase price of less than $1 billion. Here are some of the highlights:

– Approximately 25% of the non-insured deals surveyed provided for an indemnity escrow (as compared to approximately 37.5% in 2018). The reduction in the number of deals providing for indemnity escrow is likely as a result of the increase in the number of “no survival” deals.

– Approximately 43% of the insured deals surveyed provided for an indemnity escrow (as compared to approximately 55% in 2018). The reduction in the number of deals providing for indemnity escrow is likely as a result of the increase in the number of “no survival” deals.

– The median escrow amount in 2019 for the non-insured deals surveyed was approximately 10% of the purchase price (consistent with 2018), with approximately 83% of the noninsured deals having an indemnity escrow amount of 10% or less but only approximately 25% of the non-insured deals having an indemnity escrow amount of 5% or less.

– The median escrow amount in 2019 for the insured deals surveyed was approximately 0.6% of the purchase price (as compared to approximately 0.9% in 2018). It is plain to see the dramatic impact that R&W insurance has on the indemnity escrow amount (0.6% versus 10% for non-insured deals). The vast majority of insured deals had an indemnity escrow amount of less than 5% and, of those deals, approximately 91% had an escrow amount of 1% or less.

– The median indemnity escrow period for non-insured deals was 13.5 months and the median for insured deals was 12 months.

The survey also covers other indemnity-related provisions, rep & warranty survival provisions & carve-outs from general survival provisions, fraud exceptions & definitions, and governing law provisions.  One interesting observation is the number of “no survival” deals – approximately 29% of non-insured deals & 41% of insured deals provided that reps & warranties wouldn’t survive closing.

Of course, all of these deals pre-dated the Covid-19 crisis, and as I read the data, I can’t help wondering how different some of it may look in next year’s survey.

– John Jenkins

I’ve previously blogged about the possibility that buyers might try and invoke MAC clauses in order to terminate deals during the Covid-19 crisis, and I’ve also blogged about some of the challenges buyers attempting to claim a MAC under these circumstances might face. Now, this Troutman Sanders memo says that a handful of buyers have decided to see if they can wiggle out of their pre-Covid-19 deals in reliance on a MAC clause.  This excerpt addresses the ongoing back & forth between Bed Bath & Beyond and 1-800-Flowers.Com:

Bed Bath & Beyond filed suit against 1-800-Flowers.Com Inc. seeking to hold it to a $252 million deal in which 1-800-Flowers.Com would buy Personalizationmall.com (Company) from Bed Bath & Beyond.  The purchase agreement was executed on February 14, 2020. It included a typical MAE clause that limits the definition of MAE to an individualized event negatively affecting the Company or a broader event that has “a disproportionate effect” on the Company.  The deal was scheduled to close on March 30, 2020.

A week before the anticipated closing, 1-800-Flowers informed Bed Bath & Beyond that it was unilaterally delaying closing until April 30, 2020 due to COVID-19. 1-800-Flowers represented that it still wanted to close the deal, but that COVID-19 was preventing it from integrating the business and satisfying certain conditions of the deal. While 1-800-Flowers stated it was not terminating the parties’ agreement or invoking the MAE provision, it represented that it needed additional time to “assess” whether an MAE had taken place.

In response, Bed Bath & Beyond filed suit in Delaware Chancery Court seeking to force 1-800Flowers to close the transaction. In the complaint, Bed Bath & Beyond alleges that there has been no MAE because COVID-19 has not had a “disproportionate effect” on the Company. It claims that 1-800-Flowers’ delay is a maneuver to allow it to “wait and see” the ultimate effect COVID-19 has on the Company’s business and to assess whether it can retroactively assert an MAE to terminate the agreement.  According to Bed Bath & Beyond, “even a calamitous event such as COVID-19 does not permit a party to avoid its obligations.”

The memo speculates that more buyers are likely to follow a strategy of seeking to first delay a deal in the hope that business conditions before resorting to an MAC-based termination. The memo also discusses three other pending deals in which buyers’ have sought to call a MAC. Stay tuned, I’m sure there’s much more to come.

– John Jenkins

This Sidley memo notes that ISS’s recent guidance on short-term poison pills suggests that it may not think they’re such a bad idea during a time of significant market disruption.  Here’s an excerpt:

In ordinary times, we typically advise companies to refrain from adopting a poison pill in the absence of a specific activist or takeover threat and instead keep it “on the shelf” (i.e., fully drafted and ready for adoption). That is because ISS, Glass Lewis and many institutional investors generally frown upon the adoption of poison pills in the absence of such a specific threat. What was unclear until ISS issued new guidance yesterday was whether the proxy advisory firms would consider market conditions due to the COVID-19 pandemic a type of threat that may justify the adoption of a poison pill.

As we hoped, it appears that at least ISS understands why the adoption of poison pills may be warranted in these unprecedented times. In its April 8 guidance, ISS reiterated that it would consider situations on a case-by-case basis, and it noted:

“A severe stock price decline as a result of the COVID-19 pandemic is likely to be considered valid justification in most cases for adopting a pill of less than one year in duration; however, boards should provide detailed disclosure regarding their choice of duration, or on any decisions to delay or avoid putting plans to a shareholder vote beyond that period. The triggers for such plans will continue to be closely assessed within the context of the rationale provided and the length of the plan adopted, among other factors.”

The authors don’t expect ISS to penalize boards that adopt pills with a duration of less than a year in response to a sharp drop in their company’s stock price, assuming that the other terms – particularly the trigger threshold – are justified.  In that regard, the memo notes that ISS’s stated position is consistent with its April 3 recommendation to vote “against” the Chairman of The Williams Companies due to the board’s adoption of a poison pill with a 5% trigger in a situation where the poison pill was not adopted to protect the company’s NOLs.

Along the same lines, the memo makes it clear that ISS’s guidance isn’t going to provide companies with a free pass to implement short-term pills, and that a board adopting a pill “needs to communicate clearly the rationale for adoption, and the rationale for any terms that are outside the norm, to all constituencies, including ISS, other proxy advisory firms and institutional investors.”

The memo also suggests that ISS’s guidance indicates that it will take a more skeptical view of activist claims made in proxy contests in the current environment – with ISS noting that activists that move forward with contests this spring will be labeled by management as “opportunistic or unreasonable,” and stating further that, in some cases, “that will not be an unfair characterization.”

– John Jenkins

This Gibson Dunn memo reviews how the Covid-19 crisis is affecting the market for R&W insurance, and considers how the crisis may influence the market over the longer term.  The memo says that  insurers are insisting upon robust Covid-19 related due diligence, and are likely to focus increasing attention on the reps & warranties and pre-closing covenants and conditions potentially implicated by the crisis:

Additionally, we expect that insurers will be particularly focused on certain representations in acquisition agreements (and the related disclosure schedules) that are more likely to be impacted by the pandemic—such as representations regarding customer and supplier relationships, accounts receivable, absence of changes to the target’s business, undisclosed liabilities, financial statements adequately presenting the target’s financial condition, employees, compliance with laws and adequacy of insurance—and insurers will expect to see that buyers have tailored their diligence to confirm the accuracy of those representations.

Insurers have also focused on how the parties have allocated COVID-19 related risks in the acquisition agreement (either explicitly or implicitly) between signing and closing and the related closing conditions. Prior to the pandemic, buyers had largely accepted very narrow closing conditions under which they could only terminate in the event of a “Material Adverse Effect” (which itself was narrowly defined). Insurers are particularly sensitive to efforts of the parties to shift this deal risk to the insurers and generally prefer to see the issue explicitly addressed.

The memo says that insurers are also proposing exclusions for coverage for some COVID-19 related risks even in the absence of specific COVID-19 due diligence issues – and that the breadth of these exclusions is changing on a daily basis.

The memo speculates that the likely increase in distressed transactions will keep demand for R&W insurance high during the short-term, but outside of those transactions, changing marketplace dynamics – such as an increase in buyer leverage – may result in greater reliance on seller indemnities backed by substantial escrows.

– John Jenkins

Aon recently released a study analyzing the approximately 340 claims made on more than 2,450 rep & warranty insurance policies that it placed in North America between 2013 and 2019. Here are some of the highlights:

– More than $350 million above the policy retention has been paid by representations and warranties insurance to Aon clients in North America. More than $525 million in total loss has been recognized (when factoring in erosion of policy retentions).

– 30% of claims have been resolved, 4% have been denied, 54% are active and 12% are inactive to date (ones in which no correspondence has been provided in over a year).

– Claims were made on 22% of all policies placed between 2013 and 2017; however, the percentage of policies notified of a claim between 2014-2016 gradually increased from 18.6% on policies issued in 2014 to 25.3% on policies issued in 2016.

– Claim size trended upwards in 2019, with an average claim payment of $10.7 million and 26% of all claims paid this year exceeding $10 million, largely due to the larger deal sizes (and proportionately larger insurance policies) that Aon worked on in 2017 and 2018.

– Deals valued over $1 billion have yielded a slightly higher claim frequency than smaller valuation bands, although only 9% of total claims made on these deals have resulted in a payment. This is lower than the average for smaller transactions.

Interestingly, the study found no discernible difference in the frequency of claims for transactions that included a seller indemnity (for breaches of any representations and warranties) compared to ones that didn’t.

Overall, Aon’s study found that claims under RWI policies increased by more than 400% between 2014 and 2018. That increase is largely attributable to the rapid growth of RWI policies over this period, but as noted above, the claims percentage rose from 18.6% on 2014 policies to 25.3% on 2016 policies. Due to the lag between closing & discovery of a breach, Aon says it is too early to determine whether the rise in claim frequency will continue for subsequent policy years.

How has Covid-19’s impacted the R&W Insurance market? For the answer, tune in tomorrow – “same bat-time, same bat-channel!”

– John Jenkins

The Covid-19 pandemic has seen previously sky-high M&A valuations plummet, at least for now. As a result, buyers looking to press on and do deals in this environment need to find creative ways to bridge gaps between the value at which deals can get done & what sellers believe their businesses are worth under normal conditions. This Dechert memo discusses strategies that buyers can employ in order to accomplish that objective.

Perhaps the memo’s most interesting suggestion is to look to Asia for insights as to how dealmakers there have approached valuation issues in the current environment. Asian financial markets have dealt with the effect of COVID-19 longer than U.S. or European markets, and have also had experience dealing with SARS and similar market disruptions. As a result, it may be helpful to consider recent valuation trends in those markets. These include:

– The use by sponsors of downside protections typically incorporated in venture capital transactions, given the similarities between the current environment of valuation uncertainty and the valuation uncertainties inherent in venture capital investments. These measures include negotiating for most favored nation clauses, down-round protections and enhanced liquidity and dividend preferences.

– Investors increasingly structuring their investment as a hybrid debt/equity instrument to ensure there is down-side protection, with the prospect of equity upside in the future.

– Investors providing convertible bridge loans with an agreed-upon conversion discount triggered by a subsequent equity investment, which provides initial capital to the target business and also provides the investor with more time to conduct diligence and determine the appropriate equity valuation.

The memo also addresses the possible use of earnouts, noting that while they are often complex and frequently end up in litigation, the can be a useful tool in an economic downturn. In addition, it discusses the possible use of toe-hold and other minority investments, which – if properly structured – can allow a company to obtain needed capital without a full exit at a depressed valuation, and also provide a path to control for the investor.

– John Jenkins

European regulators are becoming increasingly concerned about attempts by non-EU buyers to obtain control over suppliers of essential products – and healthcare products in particular. This Cleary Gottlieb memo says that the European Commission is urging member states to use existing foreign direct investment rules & introduce robust screening mechanisms where they don’t currently exist, in order to protect “critical health infrastructure, supply of critical inputs, and other critical sectors.”  This excerpt summarizes the EC’s message:

The EC’s communication notes that the COVID-19 pandemic could give rise to “an increased risk of attempts to acquire healthcare capacities (for example for the productions of medical or protective equipment) or related industries such as research establishments (for instance developing vaccines) via foreign direct investment.” It further states that “vigilance is required to ensure that any such FDI does not have a harmful impact on the EU’s capacity to cover the health needs of its citizens.”

Because “acquisitions of healthcare-related assets would have an impact on the European Union as a whole,” the communication urges Member States that do not have screening mechanisms, and have not yet implemented the FDI Screening Regulation, “to set up a full-fledged screening system and in the meantime to use all other available options to address cases where the acquisition or control of a particular business, infrastructure or technology would create a risk to security or public order in the EU, including a risk to critical health infrastructures and supply of critical inputs.”

The memo also provides some details on the EU’s new FDI Screening Regulation, which will go into effect in October 2020.  The EC’s communication to member states particular emphasis to the possibility of post-closing enforcement actions under a mechanism introduced by the FDI Screening Regulation.

– John Jenkins