[Anushka Mehul Shah is a 2nd year student in the 3-year L.L.B course at the Government Law College, Mumbai]
The outbreak of COVID-19 has had damaging ripple effects on mergers and acquisitions (M&A) transactions around the globe. This year, global merger activity is at $762.6 billion so far, which is not only the lowest year-to-date amount for deal making since 2013, but it also down by 33% as compared to a year ago. Strict lockdown norms, travel bans, and the switch from physical to virtual environment, have either halted negotiations entirely, or posed serious complications for an eminent aspect of any M&A transaction: due diligence. However, despite the plummeting M&A deals, there are some persisting transactions, which have not been brought to a complete halt. The approach to these ongoing transactions undoubtedly requires alteration, in consonance with the present uncertain circumstances, with special emphasis on tailoring methods of due diligence.
Due diligence is a process of investigation, inquiry and verification of a potential investment opportunity performed by investors. It is a risk management tool, which involves the examination of several aspects like corporate structure, supply chains, litigation, licenses, finance and employment, all under a microscopic lens. It encompasses collecting information, quantifying liabilities, identifying contractual impediments and verifying accuracy of business aspects. It is a time-consuming, but indispensible element of any M&A deal, which not only assists the investor in understanding the extensibility of the potential investment, but also helps the seller in the true valuation of its business.
Challenges posed due to COVID-19
The outbreak of the virus has forced a sudden conversion from a physical to virtual business environment, resulting in challenges with respect to credibility and ability to substantiate information, thereby adversely impacting the very basis of any due diligence. Travel bans have resulted in inability to conduct on-site visits. As a result, company employees are unable to physically inspect key original documents of the target company, which form the subject matter of the due diligence. Certain confidential documents are often mandated to be kept only at the physical workplace of the target company and, in such cases, access to these documents is not viable. Background inspection, interviews and reference checks are also an impossible feat, given the inability to meet in person. The company conducting due diligence must also be aware of the potential abuse by third parties, who may list strict lockdown restrictions and inability to access documents, as an excuse to deliberately dodge costly and demanding due diligence.
The Way Forward
Acclimatization and enforcing suitable norms in response to these challenges is a practical solution. Due diligence is too eminent an aspect to be dispensed with in any M&A transaction, and hence circumventing these challenges is the only way out. The adoption of digitalization while temporarily disposing traditional methods is the only key in such unprecedented circumstances. Protocols for digital documents and digital onsite visits will have to be considered. Firms will need to adopt a process of reviewing authentic digital documents. Assessing credibility via video conferencing or other virtual modes, as well as, virtual on-site visits is the only adequate substitute. Periodic in-person meetings of both parties are to be replaced with virtual meetings and stricter monitoring will be required to prevent third party frauds.
The following are altered approaches to a few broad heads of due diligence, which should be considered in the light of the COVID-19 outbreak:
Corporate Governance: It is pertinent to judge the preparedness of target companies by reviewing the changes made in their corporate governance, in response to the pandemic. This change requirement is of course company and industry specific. However, recommendations received by the target, from specially established committees or regulators, and inspection of the extent to which it acted on such guidance, assumes great relevance.
Financing: Companies are led to re-forecasting their liquidity needs on account of decreasing liquidity and tightening of credit. Therefore, it is important to assess the target’s financial arrangements in terms of loan modifications, agreements with lenders and obligation compliance, any alteration of original contract clauses, or defaults or termination of loans. It is also pertinent to review the possibility of the target being called upon to fulfill a guarantee or security provided by it, and its ability to meet such obligations.
Supply-chain management: Due diligence should involve analyzing the target’s existing supply links, assessing the adverse impact on such suppliers and the target’s ability or potential to find adequate supplier substitutes in a short period of time, to prevent shortage or complete stoppage of supply. Excessive dependence on a particular supplier or even lack of availability of substitutes could indicate a huge red flag for the investor company.
Employees and data privacy: In the light of the shift in work environment, it is relevant to review the target’s new remote working policy and infrastructure, employees’ medical and pension plans and their adverse impact on funding, employee travel restrictions, and periodic monitoring of the target of such restrictions and compliance, all keeping in mind the health and safety of the workforce. The due process of collecting health or any other confidential information from employees, usage of such information and ensuring confidentiality of client information with regards remotely working employees, are all matters that assume great relevance. The target’s evaluation of such cyber security measures and implementation of stricter data privacy norms is what needs careful inspection.
Commercial contracts: Invocation of force majeure or material adverse change clause by the target’s counter parties may not be uncommon, given the impossibility to perform obligations in such circumstances. The target’s agreements should be reviewed in order to anticipate its exposure to non-performance or termination of such agreements. On the other hand, the target may also be party to supplier exclusivity or minimum purchase agreements, which are unfeasible to abide by, given the current scenario. Modes of terminating or altering such agreements in favour of the target are also required to be assessed. Modification or waiving of material terms in light of COVID-19, termination provisions, ability to enforce contracts, and consequences of breach, are all aspects that need to be given special importance during due diligence.
Insurance: Careful analysis of the target’s insurance policies is pertinent, to assess their ambit and possibility of mitigating losses. This is in case of disruption and risks the target is exposed to in force majeure circumstances like the COVID-19 pandemic. In the absence of such policies, the viability of procuring insurance policies to cover such events must also be assessed, in order to be equipped henceforth and to mitigate any such losses in the future. Additionally, the discovery of the absence of such policies and inability to reduce losses may also cause parties to adjust the deal price to factor in such losses.
Real Estate: Agreement negotiations for rent reduction or deferrals and force majeure clauses with respect to lease provisions require emphasis during real estate due diligence. Some temporary alterations with respect to safety and access to such properties also need detailed attention.
Litigation: Due to restricted functioning of courts all across the globe, all litigation matters consequently suffer an inevitable delay. Due diligence should involve assessing impact of such delays on the target’s pending litigation, as well as anticipating future litigation in light of potential invocation of force majeure clauses, breach of contractual obligations or even labour-employment matters.
Other aspects: The target’s ongoing operational activities and compliance with central and state implemented laws to combat COVID-19 must be strictly scrutinized as a part of due diligence. Further, the target’s position with respect to tax payments and deposits, projection of interest expense, and identification of physical location with remotely working employees as a permanent establishment, should all form part of a duly planned, efficient due diligence.
Given the ongoing flux, tailoring the due diligence process and making it more vigilant in order to address all concerns posed by COVID-19 will make it possible for parties to proceed with M&A transactions, even in these challenging circumstances. While preparing for a broad-based scope of due diligence, investors should also consider involving sector-specific experts for conducting this intricate due diligence on the target. The target undoubtedly also has a huge role to play in terms of its duty to co-operate in these testing times by providing the investor with a true and fair account of all possible business alterations and outcomes resulting from COVID-19. To conclude, while it is impossible to forecast the long-term effects of the outbreak, there is still a way out for well-informed parties to continue with their deals: by altering due diligence to serve as means of accelerating the transaction, rather than treating it as an obstacle, on account of the inability to conduct it in the traditional way.
– Anushka Mehul Shah