Could mergers be the solution for businesses doing it tough in the COVID-era? Gavin Robertson of the Pacific Legal Network considers the practicalities, risks and benefits.

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Many companies are under financial pressure in the COVID-19 era as a result of revenue substantially reducing, debts not being paid when due and supply chains being disrupted.

Even companies with financial reserves are finding themselves under pressure, as measures taken by the respective governments to reduce the spread of the virus are expanded and extended.

Pacific Legal Network’s Gavin Robertson

Assets sales are problematic in the current environment, as buyers are difficult to find other than at substantially discounted prices, and the sale of a critical business asset can, in any event, have a long term negative impact on the business.

Similarly, obtaining an injection of fresh capital can be difficult for all but the most credible listed public companies.

A merger between two or more companies may be an attractive option for some. A merger in pre-COVID times may have made sense if there are synergies between the two businesses and the opportunity to achieve efficiencies in overheads. The case for achieving these efficiencies and synergies may be more compelling or even necessary for survival in the current era. In some instances, the stronger balance sheet or the cash reserves of one party to the merger may be what is required for the survival of the other.

Implementation

A merger between two or more entities may be achieved by one entity acquiring the shares in the others in exchange for its shares. Alternatively, a new holding company may be established to acquire shares in the merging entities in exchange for shares in the new holding company.

‘Valuing shares or assets in the current environment is difficult.’

Assets rather than shares may be acquired, in which case the selling entities will become shareholders in the purchaser.

There are many issues to be addressed with any merger …

Valuation

Valuing shares or assets in the current environment is difficult. Past and current performance may not be an indicator of ongoing performance even in the short term.

The problem is significantly reduced but not necessarily eliminated in the case of a merger, as the important issue is the relative values of the merging businesses rather than their actual values.

If merging businesses are in the same or similar industries and each is similarly affected by the pandemic, as long as the same valuation methodology is used for all, the relative shareholdings in the new holding entity should be readily calculable.

Of course, if like is not merging with like, the relative values of the entities and the methods of calculating them potentially becomes more difficult and more controversial in any negotiation.

Accordingly, in some cases it may be desirable to obtain independent expert valuations to support the negotiated consideration for the merger.

Due diligence

Notwithstanding that there may be timing pressures to complete a merger, the parties should ensure that they conduct due diligence on each other.

Where corporate entities are being sold, and shares issued as consideration, emphasis should be placed on determining that there are no undisclosed liabilities – be they actual or contingent. Such liabilities could include circumstances that could give rise to litigation or a regulatory investigation, such as underpaid wages or a breach of covenant in a financing document.

Where shares or assets are being sold, that they are owned by the seller and are unencumbered and not otherwise subject to third party claim must also be checked.

For the reasons outlined below, representations and warranties may not provide sufficient protection against these risks.

Representations and warranties

Representations and warranties as to the accounts and critical aspects of the business are usually provided to a buyer to supplement due diligence investigations.

In a merger, they would typically be given to and taken by all parties with a view to compensating any party that incurs loss as a result of an undisclosed liability or other deficiency in the business.

‘Shareholder approval may be required as a precondition to a merger.’

Of course, representations and warranties are only as good as the capacity of the party giving them to compensate for loss suffered as a result of them being wrong. Where one or more parties to a merger is distressed, the value of warranties given by that party needs to be seriously considered.

The need for more vigilant due diligence is obvious. However, other solutions such as withholding part of the share consideration during the warranty period may be a solution in some cases.

Offering merger shares

The offering of the shares in the new holding entity to the shareholders of the other entities may be by way of a takeover offer, under a scheme of arrangement (in the case of regulated transactions), or by way of private treaty.

Where the offer is by way of an excluded offer, the offer document will typically seek to disclaim liability for misstatements or omissions. However, a failure to identify and address COVID-related risks (including solvency), being risk which is out of the ordinary, may not necessarily attract the protection of disclaimer language, particularly if the directors have acted recklessly in relation to the matter.

Shareholder approval

Shareholder approval may be required as a precondition to a merger. In addition, a company disposing of an asset should consider its constitution, as it may require shareholder approval of the transaction if the assets being disposed of constitute its main undertaking.

In any such case, shareholders will be required to be provided with all information to enable them to determine whether to vote for or against the approving members’ resolution. As with share offer documents, this would require that COVID-related risk (including solvency) be identified and disclosed.

The bottom line

The pandemic era may present some companies with compelling reasons to consider merging, be it to achieve synergies and efficiencies which were not seen as particularly compelling preCOVID, or for the purpose of survival.

The pandemic introduces new issues and risk to merger transactions. However, these issues and risks need not be impediments to their successful negotiation and implementation.

Gavin Robertson is Principal, Corporate Governance, at the Pacific Legal Network. This is an edited version of a piece first published by the Pacific Legal Network. Republished with permission.