The volume of mergers and acquisitions (M&A) in British Columbia has dropped as the disruption caused by COVID-19 ripples throughout the economy. Many prospective buyers have had to scale back strategic acquisitions to focus on preserving their own core businesses. That is not to say that opportunities do not exist. Well prepared buyers will be facing opportunities in the coming months to seek out deals and expand their portfolios to position themselves for growth in times of economic return.
M&A decision makers who are looking to make an acquisition will have to be cognizant of the added risks caused by COVID-19. The target business (Target) may have had to lay-off workers, reach ad hoc agreements to accommodate supply chain disruptions, or utilize emergency government financial benefits and policies. Greater emphasis at the due diligence stage of a transaction will be required to properly assess the impact of COVID-19 on the Target, including what steps the Target took in response to COVID-19, what risks and liabilities were created as a result of such steps, and the degree to which the Target is positioned to weather a prolonged storm.
We have compiled a non-exhaustive list of COVID-19 related considerations that should be raised at the due diligence stage:
Third Party Agreements
Impacted businesses that are facing difficulty performing their contractual obligations will have carefully reviewed their material contracts for opportunities for relief. Many will have considered relying on “force majeure” clauses which, if available, operate to suspend a party’s contractual obligations when an unforeseen event, beyond the control of either contracting party, prevents a party from fulfilling the terms of the contract. Additionally, some contracts may contain “termination for convenience” provisions, allowing a party to terminate the agreement for any reason after providing notice to the contract counterparty. Even parties who do not have the benefit of these contractual remedies may be hoping to rely on the protection offered by the legal doctrine of frustration if they are unable to perform their contractual obligations.
Inquiries will need to be made to determine if the Target or any of its contract counterparties are in default of their contractual obligations. If so, what is the position of the defaulting party? Does the contract contain any provisions granting relief for non-performance? Is the party taking the position that the contract had been frustrated and is at an end? These questions are necessary to understand the key challenges, risks, and liabilities the Target faces due to non-performance by the Target or its contract counterparties.
Similarly, the Target may have made arrangements to defer or otherwise alter the terms of outstanding contractual obligations. The obvious example in these times is the concept of “payment holidays” granted by lenders and landlords to defer the payment of loan and lease installments. A buyer will need the full details of these arrangements to appreciate what the Target agreed to in exchange for the accommodation, including any added financial burden placed on the Target.
Considering the ongoing uncertainty posed by COVID-19, the material contracts of the Target will need to be reviewed to understand the extent to which the Target can, if necessary, be safely relieved from increasingly onerous contractual obligations and, conversely, the risk of termination or non-performance by contract counterparties.
Supply Chain Disruption
A fundamental component of due diligence will involve an analysis of the Target’s supply chain. Questions should be asked to determine:
- if any suppliers have been unable to meet their obligations (or if the Target has knowledge of any pending or possible default);
- what remedies are available to the Target if a supplier defaulted on its obligations; and
- if there are bottlenecks, how quickly can the Target pivot to another source? Consider the possibility that the Target may be bound by an exclusivity clause preventing it from seeking alternative sources of supply.
A complete understanding of the Target’s supply chain will be necessary to identify any stress points as well as the ability of the Target to adapt in these disruptive times.
Generally speaking, business interruption policies only cover losses resulting from physical damage to the assets or property of the business. Any financial loss resulting from a reduction in services or the closure of the business in response to a governmental order is unlikely to trigger such coverage. That being said, the Target may hold specialized business interruption policies, supply chain disruption policies, or stand-alone business interruption policies that provide some relief from losses caused by the pandemic or its associated effects. As part of the due diligence process, a prudent acquirer will need to carefully review the terms of the insurance policies held by the Target to determine the availability of coverage for ongoing or future losses caused by the pandemic.
As the pandemic swept across Canada, many businesses scrambled to set up IT systems to assemble their workforce remotely. This greater reliance on IT systems has led to a proliferation of scammers, hackers, and fraudsters attempting to exploit vulnerabilities in hastily assembled infrastructure. An analysis of these systems will reveal:
- whether the system in place has sufficient capacity to ensure productivity and to support the required number of personnel;
- what further developments or corrective action is necessary to withstand ongoing business closures; and
- the sufficiency of cybersecurity measures to protect sensitive information.
The effectiveness of IT measures put in place in response to COVID-19 will act as a litmus test for the Target’s ability to respond to future disruption. Despite plans being released by governments to reopen the economy, the fact remains that COVID-19 will continue to act as a source of disruption in the coming months to years. The IT systems established and their sufficiency, scope, and resilience will form a fundamental part of the Target’s contingency plans to quickly respond to further disruption as we continue into the unknown.
Changes to the Target’s workforce in response to COVID-19 will be an important focal point during the due diligence stage. Layoffs, decreased compensation, and changes to employment responsibilities all give rise to the possibility of claims being made against the Target. An assessment of these actions will be necessary to appreciate ongoing employment related liabilities — depending on the nature of the action, the Target may have exposed itself to significant severance obligations, allegations of constructive dismissal, and other related claims.
Employee related health and safety policies of the Target will need to be understood in the context of COVID-19 and the ongoing obligation of employers to ensure the health and safety of their workplace under the Workers Compensation Act. Can clear policies be implemented to ensure the safety of returning employees? This is particularly relevant considering: (i) the plans being released by governments to re-open the economy; and (ii) the increased and, often unforgiving, media scrutiny some employers have faced as a result of the spread of COVID-19 in the workforce.
Government Benefits and Measures
Many business will have sought, or will be seeking, the benefit of government measures and programs implemented to mitigate the impacts of COVID-19 on the economy. While these programs will be a lifeline to many businesses, each come with their own set of qualifications and risks for M&A decision makers.
Take the Canada Emergency Wage Subsidy (CEWS) as an example: businesses that artificially reduce their revenue for the purpose of qualifying for CEWS are subject to a penalty equal to 25% of the subsidy received. Other substantial fines and even criminal penalties may be levied against businesses depending on the severity of the deception. Considering the ever present risk of an audit by the Canada Revenue Agency, buyers will need to seek a listing of all financial benefits received by the Target under government programs, the terms and conditions of those benefits, and assurances that the Target properly complied with the terms of the benefits.
Similarly, both the Provincial and Federal Governments have permitted businesses to defer the remittance of certain taxes until later this year. A buyer will need to ensure that any taxes that have been deferred until after closing are properly addressed in the financial adjustment mechanism in the purchase agreement.
While the ongoing impacts of COVID-19 on the economy and businesses are uncertain, well positioned acquirers will find ripe opportunities for deals. A fulsome understanding of the Target, particularly the unique challenges and complexities created by COVID-19, will provide M&A decision makers with the confidence to proceed and complete deals in this new environment.
Please contact any of the Private Company Transactions Group lawyers at Clark Wilson LLP for further information.