New Market Standards in a Volatile Economic Environment
COVID-19 broke a 10-year-plus market uptrend and brought extreme volatility to markets due to the uncertainty of the economic outlook in many industries. Baker McKenzie, having had one of the leading mergers and acquisitions practices in Hungary and the CEE region for decades, manages a great number of M&A deals even during these extraordinary times and, thus, experiences many forms of such volatility of the markets and the various approaches that market participants take to address the unique challenges brought by the pandemic.
dr. Dániel Orosz, Attorney, M&A Practice Group, Hegymegi-Barakonyi and Partner Baker McKenzie Attorneys-at-Law
The current economic situation has brought into focus several issues regarding the preparation of deals which should give parties pause for thought.
When the legal terms of transaction documents are discussed, the evergreen question raised with lawyers is: what is the market standard regarding material adverse change (MAC), limitation of liability or seller’s warranties? Lawyers’ answers have always been subject to various circumstances but, previously, they included a certain range of options at least, within which the parties could consider their positions. Now, however, answering that question is more challenging.
Is it market standard, for example, to include changes in law or acts of god, like pandemics, into a MAC? Maybe it used to be; but is it still, and if “yes”, then in what form? In recent months, on an almost daily basis, governments have introduced new regulations regarding foreign investment restrictions (such as the very recent one adopted on May 25 by the Hungarian government on the acquisition of stakes in companies operating in strategic sectors, which will affect many transactions), employment, subsidies, taxes and customs, which significantly impact the legal and financial environment of business operations. Who should carry the burden of the risk of such external changes: the seller or the buyer? Toss a coin.
COVID-19 may stay with us; it may morph into COVID-20 and become something we will need to learn to live with, meaning that it may become a standard part of the economic environment. Accordingly, the COVID pandemic may not be deemed to be unforeseeable or unexpected in the future. Sellers will argue (and with due reason) that COVID-related situations should not trigger a MAC. Otherwise, what would be the point of signing a binding contract, which could be cancelled at any moment as the pandemic waves come and go at a moment’s notice?
Risks and financial consequences (which are inevitably the parties’ primary concern) can be allocated or split between the parties in many ways and can be reflected in the legal terms and conditions in different places within transaction documents.
Purchase price can be structured to handle future variables by purchase price adjustments and earn-out mechanisms which may be used if the parties cannot price in the future changes of the target business. However, such mechanisms will thereby become much more complex and will involve heavy negotiations. Considering the volatility of FX rates, purchase prices should be hedged if the currency alters from the currency of the target’s business.
Although it will be hard for sellers to guarantee the target’s future revenues, strong warranties related to the target’s contractual relationships and legal and financial conditions, including warranties regarding material contracts, legal disputes and outstanding payment defaults, can mitigate the risks to the target’s future incomes and operations for buyers.
Warranty and indemnity insurances will be more often used, which can be procured to cover potential outstandings of the transaction and to exclude the risk of the seller’s future financial insolvency. It’s important to note that the coverage potentials of such instruments are limited and may cause the parties to price undisclosed risks into the purchase price.
Keeping in mind the wide range of available tools for risk allocation, and being flexible on their use, can help resolve sticking points during negotiations and efficiently contribute to the successful conclusion of deals.
Nevertheless, legal drafting will not protect against all risks and cannot grant a financial recovery in each case, or at least not immediately. What is extremely important in the current climate is that parties act responsibly when they decide on making a deal. Buyers should consider the various aspects which may impact the transaction. It is more important than even to run thorough due diligences on material issues and the potential risks of the target business, as well as its legal and economic environment, including the positions of suppliers and customers, regulatory matters, international trade and financing conditions.
At the same time, a seller’s transparent approach, including complete disclosure of information and financials, can provide comfort for buyers. Such an approach may make all the difference by supporting the smooth preparation and execution of a transaction and facilitating the chemistry between the parties, even in this unprecedented environment.
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