As the novel coronavirus (COVID-19) pandemic continues to escalate, its impact on the global economy is becoming increasingly clear, and the private M&A market is not immune.
While both global and domestic Canadian M&A activity will invariably be disrupted, there are certain impacts that COVID-19 will have on representations and warranties insurance (RWI) policies that deserve special attention.
Due Diligence
It is safe to assume that insurers will query into the possible effects of COVID-19 on the target’s business operations, and will expect to see that such effects have been sufficiently addressed in the due diligence. This will mean, among other things, that up-to-the-minute diligence reports will likely be required and, depending on the target’s industry, careful consideration of how COVID-19 measures may impact the target’s business operations. For example:
- Is the target an “essential business”?
- In the event of a lockdown, does the target have measures in place to address mandatory facility closures?
- How will COVID-19 affect the target’s supply chains?
- Do the target’s employees have the ability to work remotely and, if so, does the target’s IT infrastructure support work-from-home requirements?
- Has the target turned its mind to workplace health and safety issues and is it prepared to address employee absenteeism in the event that some of its employees contract the virus?
Due diligence reports will also likely be expected to address what limitations, if any, have been uncovered in the target’s operational policies in light of COVID-19, as well as what customary due diligence cannot be undertaken in light of the pandemic (for example, in-person meetings with management, on-site visits, environmental assessments, etc.).
It is also possible that carriers may be unwilling to rely solely on previously prepared quality of earnings (QofE) reports to ascertain the financial health of the target. It may well be that carriers regard the target’s most recent months’ financials as a preferred indicator insofar as they may better reflect the target’s ability to weather the current economic climate.
Transaction Documents
COVID-19 is sure to have an impact on certain representations and warranties in a Purchase Agreement, as well as in respect of certain disclosures made in the Disclosure Schedules. In light of the pandemic, parties will need to consider the extent to which previously drafted and/or customary representations can still be given, specifically:
- Will COVID-19 result in any solvency issues?
- Will any consents be required (which would not ordinarily apply) in respect of operational changes taken in response to COVID-19?
- Will COVID-19 impact any representations regarding the absence of changes?
- Is the definition of Material Adverse Effect (MAE) in the Agreement sufficiently broad so as to capture COVID-19, and what effect will the pandemic have on any MAE representations?
- How, if at all, will representations regarding customers and suppliers be affected by the pandemic?
- Will COVID-19 impact the effort standards in any material contracts (which, potentially, could lead to a breach of a material contracts representation)?
- Depending on the target’s line of business, could COVID-19 have an effect on import-export or on other regulatory compliance representations?
- Has the target taken all necessary steps to comply with recent legislative enactments concerning COVID-19?
Interim Period Considerations
Customary interim period covenants in a Purchase Agreement require that the target continue to be operated in the ordinary course, typically in accordance with past practices. Sellers dealing with an interim period in the face of COVID-19 will undoubtedly face challenges in complying with this obligation given the current market fluctuations and uncertainty. They will be forced to grapple with their ability to bring down their representations and warranties at closing. A prudent seller would carefully monitor the representations and warranties with a view to disclosing any possible breaches at closing. From the buyer’s perspective, any potential breaches would need to be disclosed to its RWI carrier as part of the no-claims declaration process, typically resulting in an exclusion from policy coverage.
RWI Policy Implications
How the RWI market will respond to COVID-19 remains unclear, but it is certain that underwriters of RWI policies will regard the pandemic, at a minimum, as an area of heightened risk. The actual implications to an RWI policy, however, could run the gamut from a full-out exclusion of all losses arising from or related to COVID-19, to tighter or more targeted exclusion related to a specific representation.
Another manner in which insurers may respond to COVID-19 is to include deemed changes to the Agreement in the RWI policy. Although RWI policies certainly included deemed changes pre-COVID-19, there may be an increase to the number of deemed knowledge qualifiers in the Agreement, or read-ins limiting the breath of notice requirements in certain representations to written notices only.
The impact of COVID-19 on the global economy is quickly evolving, and we expect that the impact of the pandemic on M&A generally, and representations and warranties insurance policies in particular, will continue to change rapidly. This article is current only to March 27, 2020. For further information or any questions regarding RWI or M&A, please contact either Michael Caruso or Sara Josselyn.
Miller Thomson is closely monitoring the COVID-19 situation to ensure that we provide our clients with appropriate support in this rapidly changing environment. For articles, information updates and firm developments, please visit our COVID-19 Resources page.