Emerging trends in representations and warranties in European M&A agreements

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Nicolas Lafont
McDermott Will & Emery, Paris
nlafont@mwe.com

The SARS-CoV-2 virus (Covid-19 or coronavirus) has had numerous consequences for companies and markets around the world, ultimately leading to a severe economic crisis. This new environment creates risks and challenges in private M&A deal making, which practitioners are beginning to address.

To what extent will we move to a buyers’ market? Can we expect long-lasting effects on deal terms? The new landscape is already shaping up. This article sets out observations as to some of the emerging trends in relation to representations and warranties in European M&A agreements.

Increased risk of inaccuracy

Buyers and sellers must adapt to the circumstances arising out of the pandemic, which include an increased risk of inaccuracy of representations and warranties made by sellers in M&A agreements. As a response to the coronavirus, many target companies had to take bold measures outside of the ordinary course of business, such as furloughs, redundancies or the use of public stimulus funds. In addition, target companies are likely to suffer the consequences of the pandemic on their own business partners, leading – for example – to the disruption of product supply or the bankruptcy of important customers. These events could make a number of standard sellers’ representations and warranties inaccurate, primarily those relating to:

• customers and suppliers;

• material contracts;

• employment;

• health and safety;

• compliance with laws;

• the absence of changes before signing; and

• accounts receivable/accounts payable.

If these ‘corona reps’ are inaccurate at the time of signing of the M&A agreements, they would compel specific coronavirus-related disclosures by the sellers. They could also become inaccurate between signing and closing of the transaction, in which case disclosures may no longer be permitted.

Specific coronavirus language in representations and warranties

Some M&A agreements may continue to rely on traditional representations and warranties language, which is often broad enough to cover the coronavirus and its main consequences. Others will contain specific coronavirus-related language, which we already see emerging.

On the buyers’ side, there is a clear willingness to expand the scope of sellers’ representations and warranties to make sure that the consequences of the coronavirus are fully covered. The purpose of expanding the scope of these ‘corona reps’ is to ensure proper indemnification, but also to obtain more granular disclosures by the sellers as a way to gain knowledge of all the actions taken by the target companies in response to the coronavirus. By way of example, buyers may expand the representations and warranties relating to customers and suppliers to cover the declaration of force majeure by a supplier or a customer, and the reduction of supplies or purchases, using language such as:

'Except as set forth in the Disclosure Schedule, (i) none of the Major Customers or Major Suppliers has within the 12-month period prior to the date of this Agreement notified the Company of the termination of its Contract with the Company or of any declaration of force majeure, delay or suspension of its performance under its Contract with the Company or threatened to take any of such actions and (ii) to the Knowledge of the Company, no Major Customer or Major Supplier is experiencing any material restrictions on its ability to perform under its Contract with the Company pursuant to the terms thereof as a result of Coronavirus and (iii) no Material Customer or Material Supplier has reduced its purchases or supplies from or to the Company by more than [?]% over [comparison period]'.

On the other hand, sellers are trying to reduce their exposure through broad coronavirus-related exceptions. We take as an example the ‘absence of changes’ representation, in which a seller represents that the target company was run in the ordinary course of business between the date of its last financial statements and the signing date. Rather than going through the disclosure of each specific action taken as a response to coronavirus, the seller may try to include a general coronavirus exception, such as ‘except as a result of the recent outbreak of coronavirus’.

Bring-down of representations and warranties

The positive effect of expanding the scope of the ‘corona reps’ can be twofold for the buyers: it improves their indemnification right, and can provide opportunities to walk away before closing, thereby reducing deal certainty for the sellers. The impact on deal certainty results from the practice of making the accuracy of representations and warranties serve both as a trigger for indemnification and as a closing condition (so-called ‘bring-down’, qualified by varying degrees of materiality). If the ‘corona reps’ are broader and the risk of inaccuracy is higher, then the satisfaction of the ‘bring-down’ condition precedent is more uncertain. The bring-down of representations and warranties was found in around half of European deals before 2020.^[1] In a shifting market, we can expect buyers to be in a more favourable position to revisit this trend, leading to an increase in the practice of bringing down representations and warranties in European deals.

Interim period risk allocation

Finally, the ‘corona reps’ highlight the issue of allocation of risk during the interim period. This period is likely to become longer in many deals in light of the increased time for merger review and the focus on screening of foreign investments in Europe.^[2] In order to increase the chance of a successful closing, the parties tend to provide for a longstop date that is further away from the signing date or that can be extended.

For example, we see provisions specifically allowing the parties to postpone the longstop date in case of ‘delays or failure in processing or accepting notifications or in completing the review process by any applicable Competition/Investment Authority due to coronavirus’.

The longer interim period has consequences on deal certainty (increased likelihood that a material adverse change or the inaccuracy of representations and warranties occur), but also on risk allocation. When events happening between signing and closing make representations and warranties inaccurate, one of the parties must bear the associated risk.

We believe there will be an increased focus in European M&A on two aspects of risk allocation: the dating of representations and warranties and the update of disclosure schedules. In most European deals, the representations and warranties must be accurate at signing and at closing. This means that sellers bear the risk of inaccuracies occurring during the interim period, such as a claim brought by a dismissed employee, a tax audit or the termination of a material contract by a customer or supplier. Sellers will increasingly attempt to make more representations and warranties only as of the signing date. Sellers will also try to secure a right to update their disclosures during the interim period. While an unrestricted right to update is unlikely to prosper, the distinction between the disclosure of material facts, triggering a right for buyers to seek indemnification or terminate the M&A agreement, and non-material disclosures, releasing sellers from indemnification liability, may become more prevalent.

Conclusion

In the near future, negotiations around tailored ‘corona reps’, the bring-down of representations and warranties, and risk allocation during the interim period will certainly be hot topics. A number of related issues will also be high on the priority list, including the issue of indemnification.

In the aftermath of the pandemic, one trend appears to be an increased use of escrows for coverage. As far as representation and warranty insurance is concerned, carriers are sending a mixed message: they remain active and ready to provide coverage but are imposing some level of coronavirus risk-related exclusions.