The COVID-19 pandemic has quickly developed from a local to a global crisis with immeasurable human loss and significant detrimental economic impact. The health crisis is having a material impact on businesses and their underlying contractual relationships so we have seen buyers carrying out more extensive commercial due diligence on how the pandemic will impact business models, products and supply chains.
Governments and authorities worldwide have taken swift action in response to the critical health, economic and social concerns and such action is continuing to have a material impact on supply chains, employment, pending M&A and capital markets.
When things stabilise, buyers are likely to capitalize on low valuations or purchase distressed assets. There may be flexible pricing solutions to address market volatility, such as earn outs or other measures. Although buyers will need to accept a level of known pandemic risk going forwards, we should see increased buyer protections such as cheaper W&I solutions and possibly MAC clauses in the medium-long term.
Warranty and indemnity insurance has become increasingly common in the UK M&A market as a way to "bridge the gap" and allocate risk between buyer and seller. As sellers look to obtain a clean break with limited post-completion risk and increased certainty on the transaction proceeds available for distribution, buyers often seek to put in place W&I insurance under which they are insured up to a negotiated limit by paying insurers a premium. The benefits of doing so range from offering a solution to concerns about a seller's financial covenant strength or where limited seller recourse is available, to enhancing the attractiveness of a buyer's bid in a competitive auction process or preserving an ongoing relationship with a seller (where claims against a management team or JV partner may be undesirable).
The terms and coverage cap will always depend on the particular deal, sector and risk profile of the business. The increasing number of underwriters in the market willing to provide insurance has meant cover has in recent years become a cheaper and more attractive option due to the decreasing premiums, excess levels and areas excluded from coverage as insurers face pressure to be more pragmatic and extend their scope of coverage.
COVID-19 is likely to have a significant effect on the W&I insurance market, primarily due to the material impact on transaction volumes, particularly across the most affected sectors such as travel and retail.
This downturn in the M&A market should cause a continued decline in premium levels as capacity in the market increases and W&I insurers have access to fewer deals. While this is beneficial in the short term, prices may increase again in the medium term in response to an increase in claims from insureds, leading to more payouts by insurers and a corresponding lack of appetite for offering new low premiums.
We have found underwriters are looking carefully at due diligence performed in light of COVID-19 and the target's risk profile, which is often apparent from the extent of underwriting questions during the due diligence. Insurers are likely to pay particular attention to warranties relating to a target's business continuity measures, financials, insurance arrangements, employment and material contracts with suppliers and customers. If a particular area has not been thoroughly diligenced, insurers are likely to add exclusions in the W&I policy. Cover for the adequacy of the target's insurance arrangements is becoming increasingly scrutinised by insurers so buyers will need to conduct a thorough due diligence of insurance arrangements.
COVID-19 warranties and exclusions
COVID-19 related warranties can be introduced to warranty schedules to help buyers looking to flesh out disclosure, although most insurers have been seeking to exclude COVID-19 risks from insurance coverage. Buyers should ensure that any such exclusions are narrowly drafted to properly reflect the risks and prevent insurers using it to avoid claims.
Increase in claims
As businesses start to feel the detrimental economic impact of COVID-19, buyers will be keen to recover any losses they can in respect of underperforming businesses. This will likely lead to an increase in claims as a result of the insureds paying close attention to their insurance policies to identify any potential recoveries for warranty breaches, particularly in respect of employment related claims and material contract disputes.
In the medium term, buyers will be looking to take advantage of distressed assets and some insurers have indicated they may be willing to provide synthetic warranty coverage for such transactions. In a distressed sale, the asset must be bought "as is" given that the seller cannot provide warranties regarding the business. In order for insurers to get comfortable, there will need to be extensive due diligence, including some form of disclosure via a Q&A with management and buyers should expect to pay higher premiums.
In the context of a M&A transaction, a "Material Adverse Change" or "Material Adverse Effect" clause applies when there has been a change to the target business between signing and closing. Unless the clause is drafted to provide for express and specific circumstances, a buyer who has entered into an agreement after the onset of the pandemic will have difficulty proving a MAC has occurred given such uncertainty existed pre-signing.
For a party to successfully invoke a MAC under English law, it must not be aware of the relevant state of affairs when it enters into the agreement. This awareness includes events which were reasonably foreseeable at the time the contract was entered into otherwise the buyer is treated as having accepted the risk. Notwithstanding the ever-changing current landscape with travel restrictions, lockdowns and national security measures affecting business operations, staffing and supply chains, buyers will likely be treated as having accepted a level of uncertainty in the market caused by COVID-19.
If the inclusion of a MAC clause can be agreed, buyers may choose to link a MAC trigger to a loss of contracts, a decreased ability to meet orders, specific triggers for a general decline in profits or production interruption rather than wording which links to the general consequences of COVID-19. This should also help to reduce uncertainty between the parties and make the clause more enforceable. A seller should seek to exclude these specific triggers and broad market conditions such as COVID-19 and limit any MAC clause to the actual impact of the event rather than any potential future impact.
While there is currently very limited appetite for MAC clauses in Europe, particularly for quality assets, this position may change in future as buyers facing volatile markets and an evolving health crisis may insist on such a provision to protect against material pre-closing issues, notwithstanding the high threshold required to successfully invoke a MAC clause under English law.
As an alternative to the inclusion of a MAC clause, parties may agree to defer a proportion of the purchase price through earn-outs and other mechanisms. Earn-out structures can be based on EBITDA multiples so that a buyer can be adequately protected against a business failing due to COVID-19 but this should be balanced so that the relevant proportion of the purchase price properly reflects the risks.
The arrival of COVID-19 and the related economic consequences saw a shutdown of the European leverage finance markets. Loan syndication ground to a halt and prices in the secondary market dropped to the high 70s1 (by way of comparison, S&P's European Leveraged Loan Index was trading close to par at the end of February). The primary leveraged loan market was essentially closed as borrowers were met by wide market flex provisions reflecting bank weariness to underwrite debt during the period of market uncertainty.
The issues in the leveraged loan market were not limited to borrowers attempting to access new funding. We worked with certain clients drawing under their revolving credit facilities (RCFs) and / or seeking other emergency funding. In some instances, the drawing under the RCF solved the short- term liquidity issue but opened the door to questions around covenant defaults as leverage levels increased (including the application of so called springing covenants under leveraged loans documented on 'Term Loan B' terms). The increased general default risk has been reflected in market forecasts with Fitch updating their 2020 forecasts of European high-yield corporate default rates to 4-5% for bonds and 4% for loans (the equivalent forecasts for 2021 being 8% and 7%, respectively).
What does this all mean for the European leveraged loan market in Q3 and Q4? There are several outstanding questions:
(i) will borrowers still be able to dictate terms and achieve covenant-lite terms as was the case pre-COVID-19;
(ii) will distressed debt investors play a greater role in the market as borrowers start defaulting; and
(iii) if banks and CLO investors are unwilling to provide as much liquidity to the market as was the case pre-COVID 19, will unitranche lenders fill the gap as they did post the global financial crisis?
In relation to (i), generally, the outlook is uncertain, however, as rating downgrades continue, some commentators have noted that there may be continued demand from CLO investors for quality names who are able to demonstrate resilient post-COVID 19 earnings (in particular in light of the pressure placed on CLOs from continued rating downgrades and the increase in their holding of excess B3 and Triple C exposures). A good example of this, was Nomura and JPMorgan's recent 20 May 2020 launching of the syndication of French mortgage broker Financiere CEP's €775m buyout loan (the underwriting documentation was signed pre-COVID 19)2 which was reported as the first steps toward the re-opening of the European leveraged loan market.
In relation to (ii), generally transfers to distressed debt investors is only permitted once an Event of Default has occurred (and in other cases not at all). As the current trend has been that banks have been willing to waive defaults or borrowers have been able to find other forms of liquidity funding (including through government backed schemes), the question has not really been tested but may become more relevant if earnings and liquidity issues continue.
In respect to (iii), the question for sponsors will be whether they are willing to pay the higher interest rates in order to avoid the current uncertainty of the primary loan market (and potentially wider post-COVID-19 market flex provisions). There are a number of other benefits to using unitranche lenders, for example, potentially access to higher amounts of leverage and the benefits of dealing with a single take-and-hold investor and so any shift from Danish borrowers to using unitranche lenders may in fact end up being a longer term trend rather than a COVID-19 only trend (currently uni-tranche lenders are mostly used by borrowers in the UK, France and Germany).
Force majeure and frustration
Force majeure can be a vital method for a party to justify its non-performance or termination of a contract.
Under English law, force majeure must be an express term in the contract. Accordingly, the ability to invoke force majeure and the consequences arising from doing so depends on the specific terms of the relevant contract. Generally, a force majeure clause will state that neither party is liable for a failure to perform its contractual obligations where that failure is caused by the force majeure event. However, for any company contemplating suspending contractual performance in light of COVID-19 or faced with a counterparty which has suspended performance, the first step should be to carefully review the contract terms.
In the context of supply contract negotiations, a customer may ask for exclusivity and in return expect to commit to purchasing a minimum quantity of products from the supplier per month, quarter or year. Although COVID-19 restrictions may result in the customer being prevented from selling or distributing the products to market consumers, generally this will not of itself constitute a force majeure event preventing performance of the supply contract. In such scenario, any hiatus in contract performance will need to be a negotiation between the parties.
Whether an event constitutes a force majeure is often disputed between affected parties. Contracts will generally follow one of two approaches in a force majeure provision. The narrower approach lists specific events which entitle either party to declare force majeure whereas the broader approach would be to add anything that is beyond the parties' control to the specified list.
A force majeure clause will generally also specify the extent to which the event must have impacted performance in order to qualify as a force majeure event, including a necessity to prove the event has "prevented" performance entirely or alternatively, a requirement to show that the event has "hindered" or "delayed" performance.
Once a force majeure event has been determined, the notification procedure must be fully complied with. The contract may require the party declaring force majeure to notify the other within a specific timeframe of the relevant event or prescribe that the notice must be delivered to a particular address. Parties will typically also be required to mitigate the effect of the force majeure event - a failure to do so may undermine a party's ability to rely on the force majeure clause.
Going forwards, parties considering entering into new contracts should carefully consider whether specific COVID-19 related circumstances such as delivery issues and cancellations should be excluded from the definition of force majeure to limit the contracting parties' future liability for non-performance of the contract. In the context of a new supply contract, customers should pay particular attention to the minimum purchase obligations and consider including specific exemptions where the customer is restricted from trading (arising from changes in law, government regulation or other pandemic related restrictions).
In the event a contract does not include a force majeure clause, the English law doctrine of frustration may still apply to the extent relevant. A contract will be deemed frustrated if an event results in it being commercially or physically impossible to fulfil that contract. It may be possible to argue that COVID-19 has frustrated the contract if it is physically or commercially impossible to fulfil that contract.
The test of whether a contract is frustrated is stricter than that generally included in a force majeure provision. An assessment of multiple factors is required to determine whether such test has been satisfied, including the terms of the contract, the factual background, the parties' knowledge and expectations of risk when entering into the contract and the parties' calculations as to the ability to perform the contract in the circumstances which are said to have frustrated the contract. If a frustration claim is successful, the contract will be automatically discharged by operation of law.
However, parties seeking to rely on an express force majeure contractual provision or the doctrine of frustration should be aware of repudiation. If a party mistakenly asserts a force majeure event or frustration, this may amount to a breach (or anticipatory breach) of the contract. Depending on the materiality of the breach, the innocent party may be entitled to claim damages or terminate the contract.
1S&P LCD News, 20 April 2020, "Europe's leveraged loan market: COVID-19 crisis echoes '08 in depth, not scope"
2Reuters, 22 May 2020, "European Leveraged Loan Market reopens for LBOs".