In the midst of the COVID-19 pandemic, we’re repeatedly challenged by “the new normal,” and, as M&A advisors, we’ve wondered, “is ‘the new normal’ in ‘the ordinary course of business’”?
A few weeks ago we sent you an alert that included a tool to help sellers track how the COVID-19 pandemic has impacted and is impacting their businesses (2020 Is Hereby Incorporated by Reference). In that alert we focused on identifying and quantifying COVID-19 risks and liabilities so a seller would be in a better position to challenge a buyer’s claims that the COVID-19 pandemic required a reduction in purchase price based on generalized concerns about pandemic-related liabilities and losses. We believe sellers who devote time and effort to specifically identifying the impact of the pandemic on their businesses and aggressively prepare to counter buyers’ claims by pointing to specific facts and data related to COVID-19 will be in the best position to negotiate a higher value for their businesses than those sellers who choose to rely on generalized statements about COVID-19’s impacts and liabilities.
Now, we are turning our focus to buyers and considering a unique COVID-19-related challenge buyers will face during a transaction’s executory period as long as the pandemic and its impact last – specifically, how does the buyer want the target to operate between signing and closing?
Customarily, during the period between signing and closing, a buyer would expect the target to operate in the same manner in which it operated immediately prior to signing – “in the ordinary course of business.” With many businesses adapting, reducing and suspending operations in reaction to COVID-19, requiring a target to operate in the ordinary course of business as it had immediately prior to signing may not in fact be in line with a buyer’s expectations and assumptions underlying valuation. In this new environment, what will buyers’ expectations be about how targets should operate during the executory period? While a buyer may want a target to operate as it did immediately prior to the pandemic (the “old normal”), that may simply not be possible or practical. At the end of the day, our own experience tells us that a buyer’s underlying goal will likely be twofold: (1) steering the target to preserve value when so many businesses are continuing to lose value and (2) beginning to transition back to “normal” operations. We believe the best way to achieve these goals will be for the buyer to come to the negotiating table with its own judgements about the actions seller will be permitted to take, and the actions seller should be required to take, during the executory period. After completing its diligence and considering the seller’s proposed disclosures about the target that specifically identify all of the ways that COVID-19 has impacted the target’s business (See 2020 Is Hereby Incorporated by Reference), a buyer should carefully study customary executory period operational covenants in a market purchase agreement and make its own determinations about how to tailor exceptions to these operational covenants (and build in additional affirmative operational covenants) designed to preserve the value of the business it has agreed to purchase, reduce surprises in how the business responds to the impact of COVID-19 and, thereby, create a “new normal” for the target.
Just as we did with the representations and warranties in our earlier alert, set forth below are common executory period covenants and the issues we think buyers should consider to define their expectations for the operation of a target pending closing and, with the help of their advisors, craft appropriate exceptions to these covenants and negotiate new affirmative obligations for the target.
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Covenant
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Carve-Outs to Consider
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Properties and Assets Covenants
- Maintenance of properties and assets
- Sales and Dispositions of properties and assets
- Mortgages and pledges of properties and assets
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- Are certain properties and assets not being used that should be disposed of or leased?
- Are there maintenance costs and expenses that should be deferred?
- Did the target purchase or lease assets to assist with changing operations (e.g. WFH orders) that it may not need on a going forward basis and that it may make sense to sell?
- Under what circumstances would buyer expect (or encourage) the target to dispose of its properties and assets?
- Should the target be permitted to refinance a mortgage?
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Maintenance of books and records
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- Has the target adopted any emergency board procedures that it should rescind when possible?
- Has the target complied with legal requirements for meetings and board and management actions, especially in light of logistical issues related to WFH orders?
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Accounting
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- Has the target made any one time accounting policy changes?
- Has the target made any changes to its cash management practices?
- Has the target been advised by its accountants on the treatment or categorization of certain expenses related to the pandemic or WFH orders?
- Have performance or payment waivers or deferrals obtained or granted by the target been accounted for appropriately?
- Has the target (or the seller) received a loan under the Paycheck Protection Program? If so, how have they accounted for the loan?
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Taxes
- File or amend tax returns
- Claim tax refunds
- Make or change tax elections
- Settle tax claims
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- Has the target claimed tax credits or made tax elections available under the Families First Coronavirus Response Act (the FFCRA) or the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act)?
- Has the target deferred the payment of payroll taxes under the CARES Act?
- Should the target be permitted to carryback net operating losses and claim a refund of previously paid taxes? If so, who gets the benefit of such refund?
- Should the target be permitted to adopt and implement permanent teleworking policies that may impact its state tax nexus footprint, potentially changing its filing obligations and overall state and local tax exposure?
- Consider specifically permitting the target to challenge ad valorem property tax assessments that do not reflect the downturn in valuation, whether via a “calamity” provision or otherwise.
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Material Contracts
- Compliance with contracts
- New contracts
- Amendments to contracts
- Termination of contracts
- Changes to payment terms or practices
- Waivers
- Changes to collection practices
- Writing down A/R
- Payment of A/P
- Supply chain interruptions
- Related party contracts
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- Are there categories of contracts that should be excepted from typical restrictions on new contracts / amendments to contracts?
- Should there be materiality thresholds around certain contract covenants that are more (or less) stringent than typical operating covenant restrictions?
- Are there certain agreements that are particularly material to the target’s operations that should not be amended without buyer’s consent?
- Should the target be permitted to enter into new agreements or terminate other agreement to address supply chain disruption?
- Should the target be permitted to enter into new contracts with vendors to re-commence operations?
- Should the target be permitted to draw down additional debt or pledge additional assets?
- Should the target be permitted to seek or grant payment or performance waivers or deferrals?
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Intellectual Property
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- Are there unique instances where the target should have the flexibility to license its intellectual property outside of the ordinary course?
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Employment and Benefit Matters
- Hiring of new employees
- Termination of employees
- Changes to compensation and employee benefits
- Loans to employees
- Labor disputes
- Organized labor matters
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- Should the target be permitted to “hire back” employees who were laid off during shut-downs? Alternatively, should the target be permitted to terminate or furlough additional employees?
- Should the target be permitted to make adjustments to benefits to address changes in its labor force?
- Should the target be permitted to change its compensation arrangements with employees?
- If the target has ceased or reduced operations, under what circumstances may the target ramp back up and, to the extent, this ramping up includes employees physically at office or other sites, what must the target do with respect to return to work practices in order to reduce the target’s liability with respect to outbreaks or sickness? How will the target comply with these on a going forward basis?
- Similarly, to the extent the target has or has always had employees physically at office or other sites, what is the target doing and/or required to do with respect to the health and safety of such individuals in order to reduce its liability with respect to outbreaks or sickness?
- If there is an outbreak or other COVID-19-related issue, when and under what circumstances may the target require employees to work remotely and how will this work?
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Compliance with Laws and Permits
- Continued compliance with Laws
- Maintenance of Permits
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- Should the target’s actions to comply with new pandemic-related legal requirements require notice to, or agreement with, buyer?
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Litigation
- Settlements
- New complaints
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- Does the impact of the pandemic to assert rights or settle claims in order to continue operating?
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Maintenance of insurance policies
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- If coverage of COVID-19 related losses becomes available, should the target be able to purchase such coverage?
- If operations have been materially diminished should the target be able to reduce insurances coverages?
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In addition to considering new exceptions to customary executory period covenants regulating the operation of a target pending closing, buyers should also consider whether any additional or more specific affirmative covenants not included in a typical purchase agreement should be required for targets to address buyers’ concerns related to the pandemic’s impact on the target. For example, buyers may want to consider requirements: (1) to provide updated budgets based on COVID-19 related impacts; (2) as to the management of cash flow, A/R and A/P; (3) to create an operating plan to address resuming operations (and circumstances where the target may have to suspend operations again); (4) related to the health and safety of employees as they return to work on site or are required to work remotely; (5) to provide updated census information on the health and productivity of the workforce; (6) related to heightened data protection to cover risks resulting from employees and contractors working from home; (6) to notify buyer of any requests from customers for deferrals and waivers under material agreements; and (7) to notify violations of pandemic rules and regulations.
Everyone has been impacted by the COVID-19 pandemic differently. Consequently, the chart above and our suggested covenants cannot address all the different issues that a buyer should consider while negotiating executory period covenants for the operation of a target pending closing in these uncertain times. While buyers’ and sellers’ negotiations over executory period covenants will be highly individualized, we believe the chart and additional covenants above can be a useful tool for buyers as they consider how to ensure that the target’s value is preserved until closing and target’s operations keep pace with the changing landscape.
Our final topic in this trilogy of COVID-19-related legal alerts will focus on constructs for indemnification of COVID-19 risks and the appropriate allocation of related risks.
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