Giulia Keese Montanhesi
Lawyer at Marcos Martins Advogados
It is undeniable that the Covid-19 pandemic has greatly affected the financial health of Brazilian companies and families. Brazil has reached unprecedented milestones in terms of permanent company closures, which has made the business sector take a closer look at the market and look for resources to help it survive, one of which is the Mergers and Acquisitions (M&A) market.
According to an article in Folha de São Paulo, the IBGE found that more than 1.3 million companies suspended or permanently closed their activities in the first half of June, with 522,000 reporting that the decision was made due to the pandemic.
Of these, 99% are businesses with up to 49 employees and 1% is attributed to companies considered intermediate (between 49 and 500 employees).
This unexpected economic reality has also hit the M&A market in Brazil hard, with the largest volume of transactions involving small and medium-sized companies, so that this economic scenario has led to the delay or even suspension of many deals that were in the pipeline for completion in 2020.
Purchase and sale transactions in advanced stages have also been affected, as it has become more difficult to reconcile the interests of the parties involved.
The pandemic and all its social, political and economic-financial ramifications have meant that these conditions need to be adjusted or readapted at the various stages of the transactions and require a critical look at price adjustment clauses, force majeure clauses, commitments and guarantees, among many others that are essential to the deal.
Below we will look at controversial issues in this area.
Pricing and impact on future performance/earn-out:
The pandemic has had a profound impact on the turnover, profit, indebtedness and future prospects of business activities. Whether for better or worse, the economic fallout has affected the value of companies whose shares or assets are or were being traded.
In this sense, it is essential to carry out a preliminary study showing the effect of the crisis on the company in order to plan or revisit the purchase price conditions of the share transfer agreement.
Thus, clauses that establish a fixed and determined price can be amended to include more robust price adjustment conditions, pointing out certain specific situations, including the effects of epidemics and pandemics.
Normally these adjustment clauses are used to determine only the base price, with the adjustment being necessary on the basis of the unpredictability of the market and liabilities and contingencies ascertained in due diligence.
The pandemic as a factor inseparable from these issues is a fair reason to strengthen the price adjustment conditions.
On the other hand, extra attention should be paid if the parties agree on a variable or determinable price, which occurs when the price is set over a period of time and is conditional on future events, performance targets, company growth or other obligations established by the parties.
In the current scenario, theearn-out clause , which is already widely used for companies that demonstrate significant growth potential and value generation, is particularly important in the eruption of the crisis, since while it can contract unrealistic targets for the Brazilian situation, it can benefit the seller if its activity indicates exponential growth in the crisis or in the post-pandemic period.
In short, the earn-out clause is used to link part of the price to the fulfillment of targets, improvements in performance, profits and performance indicators, as well as other desirable obligations for the parties, after the closing of the transaction.
Based on these objective and concrete elements in determining the price, it is possible to resolve disagreements about the valuation and balance the parties’ expectations.
It is therefore important to draw up or adjust the earn-out clause with attention to new market trends and economic indicators, especially in rising sectors such as technology, services related to teleworking, information security and cyber security, insurance companies, e-commerce, streaming services, delivery services and fintechs.
Finally, if the agreement aims to set a price that is part fixed and part variable, then there is the “hybrid” or “mixed” form of pricing, which will also condition part of the value on the fulfillment of goals and performance previously defined by the parties.
In this case, both “parts” that make up the price must be analyzed carefully, so as not to tie the purchase and sale to future performance that is bound to shrink as a result of the crisis.
In any case, it is crucial to assess the contract on a case-by-case basis, interpreting it in the light of the specific circumstances of each deal and the impact of the crisis on the corresponding sector.
Condition for closing and interim obligations
Above we discussed a crucial condition for negotiation – pricing – where some debate is still allowed in order to make the deal viable. In this section, we deal with another phase of the negotiation, which is even more delicate. When we talk about closing conditions, strictly speaking, the contract has already been signed, but the transaction itself has not yet been concluded.
In a contract for the purchase and sale of shares, or assets, the closing condition or interim obligations are located in the “interim period”, i.e. after the contract for the purchase and sale of the shareholding has been signed and before closing, normally characterized by the transfer of the shares to the buyer and payment of the purchase price to the seller.
The conditions or obligations can be various. But specifically, the pandemic gives exceptional prominence to the conduct of business clause, which requires the seller to conduct the business during the interim period within the limits of the ordinary course of operations.
For the target company that has been taken by surprise by the pandemic, it is almost impossible to maintain the ordinary course and other commitments without jeopardizing activities. In this sense, could store closures, borrowing, layoffs and other measures that go beyond the day-to-day necessary to respond to the pandemic be seen as a breach of commitments?
Many M&A deals that have passed the signing stage and are awaiting closing may experience this problem.
Generally speaking, and through a systemic understanding, we don’t think so. The aim of clauses like this is not to make business activity unfeasible, but rather to determine that the entrepreneur conducts business in pursuit of prosperity, in order to complete the dealunder ideal conditions.
A literal and even mistaken reading of these terms can lead to unreasonable measures and poor management on the part of the administration, which would fail to promote extraordinary but necessary measures to preserve a clause understood outside its context and function.
Representations and warranties:
Another aspect of the seller’s obligations — in the interim period — concerns the reaffirmation of representations and warranties, here seen from the perspective during the Pandemic.
Since the buyer relies on the information provided by the seller before and during due diligence to make its decision on the acquisition of the company and the details of the transaction, it is essential that there is transparency and reliability of the information to the interested party.
In this sense,pro-sandbagging clauses in M&A contracts have the function of allowing the recipient of the information, usually the buyer, to be indemnified for losses resulting from errors, inconsistencies and inaccuracies in the representations and warranties provided by the seller at any time during the deal.
But what about statements as the pandemic progresses? Is it necessary to reaffirm the representations and warranties due to the sudden and abrupt change, or should the seller pay compensation for any losses resulting from inconsistencies in the representations made to the buyer?
In this case, we believe that the guarantees and declarations are so basic to the price and conditions of the acquisition that, in the event of an exceptional situation that completely changes the course of the company, the guarantees should be revisited in order to guarantee the seller’s security in terms of financial liability for any damages.
As we well know, periods of crisis cause creditors to take their debtors to court in an attempt to increase their own cash flow, which can result in the rapid escalation of many companies’ liabilities.
Again, the analysis will depend on the specific case, since many industries and services have not been affected so drastically, in which case the declarations of these companies will be little affected, if not unchanged.
Material Adverse Change Clause – MAC
Widely used in practice to discuss the allocation of business risks, material adverse effect clauses or MAC, as they are also known, refer to any fact, change or event that has an effect on the business, financial conditions, results of the company or even on the conditions of the seller or other shareholders.
It is understood that all the conditions for carrying out the deal were obtained on the basis of certain economic and financial assumptions which, if substantially modified, could de-characterize the deal, the will of the parties, as well as reducing its price.
In Brazilian transactions, the clauses follow the theory of force majeure in the Civil Code, so that the seller should not be liable for proven losses of an extraordinary nature and those mentioned in the clause.
However, the allocation of these risks will depend on the extent of the clause, its wording and exceptions. The concept of “Material Adverse Effect ” is broad and abstract, and it is up to the parties to list the situations they consider relevant for its characterization, such as changes in economic or political conditions, wars, natural disasters or terrorism, among others.
This detail will leave less room for interpretation in a possible dispute.
According to the majority of doctrine and the most current case law, epidemics and pandemics are unpredictable, unavoidable events and constitute fortuitous events or force majeure in commercial and contractual relations, as well as constituting a significant adverse effect. However, it is imperative to demonstrate the causal link between the crisis and the effect caused on the business, whether positive or negative.
Therefore, for the pandemic to be covered by this clause, it is important to present in detail and concretely how the social and economic effects arising from it affect the market in which the company operates, especially as regards the impact on economic health, assets, liabilities, activity, image, legal situation, etc.
In short, the supervening of the pandemic in the M&A scenario has the power to give rise to various discussions based on these clauses, under the idea of unpredictability.
Therefore, even if we don’t have consolidated decisions or understandings from courts and arbitral tribunals on these controversial issues, we should consolidate all the hypotheses in the contractual clauses of the share purchase agreement, in order to mitigate misinterpretations or disagreements between the parties.
Nevertheless, the uncertain scenario has not scared away bankers and investors, who see signs of recovery and expect more deals in the coming months, especially in startups and the fact that many companies will find it difficult to get back on their feet on their own, embracing the purchase and sale of shareholdings as a way of injecting restructuring capital, sharing a business model, exchanging management experiences and reinserting themselves into the competitive market.
