26 August 2020 by and Corporate & Commercial Alert

Reconsidering ordinary course of business covenants in M&A agreements during a pandemic

In concluding M&A transactions in such volatile times it is more imperative than ever that purchasers commencing new M&A transactions (which cater for an interim period between signing and closing) negotiate further oversight of a target company and certainty into potential exit mechanisms. On the flipside, sellers should seek to obtain flexibility to operate the target company as it deems necessary, taking into account all COVID-19 related responses, so as to not get hamstrung by excessive interference from the purchaser.

In considering potential exit mechanisms, there is often focus on defining and negotiating what constitutes a material adverse change (MAC) in respect of the target company. In light of the often high burden of proof required to prove a MAC has occurred and enforce termination of a transaction agreement on such basis, parties may be better placed in the current prevailing circumstances to consider whether the once innocuous undertaking often placed on a seller to operate a target company “in the ordinary course of business” during an interim period could present a potential exit mechanism. Further, the impact that such undertakings may have on the respective parties’ oversight of and ability to operate a target company during an interim period should be carefully considered.

Although the phrase “ordinary course of business” may vary in complexity, the phrase is typically defined with reference to past policies and practices. Historically, however, parties often viewed the term “ordinary course of business” to be so clearly identifiable, that they did not define it in transaction agreements. How then would a court interpret whether or not conduct in respect of a target company is in the ordinary course of business where such term is defined with reference to past policies and practices (which may currently prove to not offer adequate guidance) or where such phrase is not defined in the agreement?

While we have not yet seen cases arise in South Africa which deal with potential breaches of ordinary course of business covenants, there has already been a number of international cases (some of which are yet to be finalised) which deal with instances where a purchaser claims a breach of interim period undertakings and wishes to terminate a transaction agreement on the basis that the seller has not conducted the target company in the ordinary course of business. One of the more prominent cases relates to the transaction in terms of which Sycamore Partners was to acquire a majority stake in Victoria’s Secret. In this instance, Sycamore Partners filed a lawsuit against L Brands alleging that the seller’s COVID-19 related responses in respect of Victoria’s Secret stores in the U.S. breached its interim period undertaking to operate in the ordinary course of business, breached multiple representations and warranties as well as triggered the MAC clause. The purchase agreement in this instance did not define the phrase ordinary course of business. This case was voluntarily dismissed following mutual agreement by the parties to terminate the transaction and so leaves many questions unanswered.

While South African courts are yet to make a determination in respect of the meaning of the term “ordinary course of business” within the context of transaction agreements, courts have considered the meaning of such term in insolvency cases within the context of whether or not a disposition constitutes a voidable disposition under the Insolvency Act 24 of 1936. One of the more recent cases which sums up the meaning of “ordinary course of business”, is the case of Griffiths v Janse van Rensburg NO (20269/2014) [2015] ZASCA 158, which essentially held that for “a transaction to be considered to be in the ordinary course of business the transaction must be one which would not appear anomalous, unbusinesslike or surprising to the normal businessman in the circumstances”. The question is whether the transaction is one with conventional terms which ordinary businesspeople would normally have concluded under the given circumstances. This unfortunately does not offer sufficient guidance where businesses find themselves having to reorganise operations in order to stay afloat. Would the scaling back of employees’ working hours, the change of product lines or any other non-legislated changes taken by a seller be considered to be conventional in the circumstances or would such actions be anomalous, unbusinesslike or surprising to the normal businessman? It is not clear what conduct would be considered as being conventional during a pandemic.

In light of the above, parties that are in the process of negotiating transaction agreements during or in the aftermath of the COVID-19 pandemic are advised to carefully consider how the term “ordinary course of business” should be defined. Merely referring to the normal day-to-day operations of a target company, which are not inconsistent with the general policies and practices existing and/or applied during a specified past period may not be wholly adequate in the prevailing circumstances.

A seller would in these instances wish to include all COVID-19 related responses within the ambit of the phrase (where such conduct is required to (i) comply with applicable laws, directives, guidelines or recommendations of any governmental authority related to or in response to the COVID-19 pandemic and (ii) continue maintaining the business of the target company and/or each group company as a going concern in light of the COVID-19 pandemic) so as to not stifle the operations of the target company and all group companies.

A purchaser, on the other hand, will aim to exclude specific conduct and measures (including any particular COVID-19 related responses) from the ambit of the phrase and the application thereof to specific interim period covenants and representations and warranties, taking into account the nature of the business being acquired. In addition, a purchaser should also consider the inclusion in a transaction agreement of (i) a closing condition on the basis that the seller has complied with all interim period undertakings and/or, more particularly, has operated or procured the operation of the business of the target company and all group companies in the ordinary course of business, which if not complied with will entitle a purchaser to terminate a transaction agreement prior to closing and (ii) a general undertaking for the seller to provide regular updates to the purchaser on all COVID-19 related measures taken by the seller, whether or not the purchaser’s consent is required in the circumstances.

Should the considerations set out above not be adequately catered for in transaction agreements, we may likely see a flourish of litigation arising from transaction agreements and potentially failed transactions in the coming months, at a time when M&A activity is already in peril. This may lead to dire consequences for businesses that require access to additional capital and/or skills from the incumbent purchaser, in order to continue operating successfully.

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