Global M&A activity has slowed significantly – the total value of M&A fell to US$732.82 billion in the second quarter of 2023, from $1.14 trillion in the second quarter of 2022 according to Dealogic data as of June 29 20231. While there have been fewer ‘marriages’ in the past year, we are seeing an uptick in acrimony and ‘divorces’. By that, we mean M&A related disputes in the context of both ongoing M&A activity and deals that have been completed in recent years. This growth appears to have been prompted by the economic headwinds that have seen all businesses suffer. These include record levels of inflation and high interest rates, coupled with a slower than expected economic recovery by the second largest economy in the world, China, and the continuing conflict in Ukraine. Therefore, obtaining maximum value from M&A ongoing and past activity has never been more important.
This article explores three scenarios in M&A disputes that have come to the fore in recent times, highlighting their implications and possible mitigating measures for businesses and their inhouse lawyers.
Material Adverse Change (mac) And Conditionality Related Disputes
MAC clauses provide a contractual mechanism that may allow the buyer to terminate the acquisition agreement and withdraw from the transaction if, before completion, certain events occur which negatively impact the target company’s value or operations. MAC clauses provide a means for allocating risk between the parties before completion – essentially providing an exit route for buyers in certain, limited, circumstances. Other conditions precedent for the completion of a transaction are also often necessary for regulatory or commercial reasons.
The present global environment has resulted in parties seeking to utilise clauses of this kind as buyers look to extract themselves from or re-negotiate deals. Inevitably, parties may well interpret the clauses differently or the factual matrix which is alleged to have triggered the buyer’s possible escape route. This is particularly in cases where, amongst other things, the MAC clause includes events such as regulatory changes, sanctions, and force majeure events (for example, armed conflicts and a global pandemic) that may affect the target company’s prospects.
MAC disputes invariably revolve around the determination of whether the adverse event meets the threshold for triggering the clause and whether the buyer is justified in seeking to terminate or re-negotiate the deal. Whether or not a MAC has occurred is primarily a factual question, and depends on the express wording of the clause. As such, there is no unified approach or interpretation of the relevant MAC clause making it a ripe area for disagreement and dispute. Further, where a buyer seeks to invoke the MAC clause when it is not entitled to do so, it may be liable to the seller for repudiatory damages. This notwithstanding, a buyer may seek to leverage a MAC clause in order to re-negotiate the contract where it is arguable that a MAC event has occurred.
Because the interpretation of such clauses comes down to the exact wording of the provision, parties must be precise in drafting the MAC clause to mitigate risks of disputes. In particular, this involves specifying the scope of events or situations that would trigger the clause and the impact required to justify termination or re-negotiation. For example, the MAC clause can operate and be linked to specific triggers, objective criteria, duration of an adverse event, etc. From the seller’s perspective, it is common to include carve-outs to narrow the scope of the MAC clause, such as by excluding certain events which are outside of the seller’s control.
Further, parties may consider tailored mechanisms to resolve disputes arising from MAC or condition precedent clauses to provide a structured procedure for addressing disagreements promptly. Apart from litigation or arbitration, the inclusion of an expert determination mechanism could also be an alternative, depending on the specific circumstances.
For sellers, deal certainty is a critical factor in assessing whether to engage in a M&A transaction and this is even more important in deteriorating economic conditions. Sellers should be very careful in accepting a MAC or other conditions precedent for the completion of the transaction (e.g. financing conditions) and such conditions must be tightly drafted to minimise optionality. At a commercial level, even if these conditions are acceptable, sellers should also be looking at the financial condition of their buyers to assess the potential for buyer withdrawal and consider requesting deposits or reverse break fees (if commercially viable) as a commercial disincentive to terminate an agreement.
Earn-out, Deferred Consideration Disputes
Earn-outs, deferred consideration and other similar mechanisms are useful tools that are often included in M&A transactions to bridge valuation gaps and align the interests of the buyer and seller. Under an earn-out arrangement, a portion of the purchase price is contingent upon the future performance of the acquired company. While using an earn-out can help move a deal forward, disputes often arise when the parties disagree on the achievement of post-closing earn-out benchmarks, the calculation of performance metrics, or the buyer’s alleged interference in the acquired company’s operations.
Earn-out disputes increase when economic volatility results in business performance falling below expectations. The economic conditions in recent years, including, among other things, the US-China trade war, the COVID-19 pandemic, and the conflict in Ukraine have created this exact volatility. Invariably, this resulted in parties differing in their assessment of the impact of external factors on the acquired company’s performance, leading to disagreements and in some circumstances the potential for formal proceedings. These disputes can have significant financial implications and strain the post-acquisition relationship, highlighting the importance of clearly defined earn-out provisions and robust mechanisms to resolve disputes if amicable outcomes are not forthcoming.
To avoid and/or mitigate the risk of earn-out disputes, where possible, parties should: carefully define the earn-out benchmarks; and specify the performance metrics and indicators against which the earn-out consideration will be calculated, the timing and structure of the earn-out payments, and any restrictions on the target company’s activities during the earn-out period. Buyers and sellers should play out the potential economic scenarios in order to avoid surprises. Sellers, in particular, should be made aware of the contingent nature of earn-out structures, ensure that they are comfortable with this risk and/or consider commercial alternatives. Additionally, apart from having a robust mechanism for resolving disputes, a clear and open channel of communication and an ongoing dialogue between the buyer and seller can help manage expectations and minimise the potential for conflicts and hopefully avoid the need for formal proceedings altogether.
Post-closing Price Adjustment Disputes
Purchase price adjustment mechanisms, such as completion account adjustments for working capital or net assets, are commonly employed in M&A transactions to account for changes in the target company’s financial position between signing and closing. These adjustments ensure that the purchase price accurately reflects the target company’s financial position at the time of closing. Accordingly, the purchase price may increase or decrease to reflect changes in the working capital during the intervening period.
In these challenging times, M&A transactions are more prone to disputes related to purchase price adjustments because of the greater degree of discrepancy between a seller’s pre-closing estimate and a buyer’s actual post-closing working capital. Price adjustment disputes can also arise from the parties’ different interpretations of accounting principles, treatment of specific items, or the calculation methodology, which would affect the final purchase price.
To minimise disputes related to purchase price adjustments, parties should invest resources early in the transaction process to conduct thorough financial due diligence and engage financial experts to pre-emptively identify potential areas of disagreement. Clear and detailed provisions should be included in the purchase agreement, specifying the treatment of key items and outlining the process for resolving disputes (we recommend that the financial experts are also involved in the drafting of these provisions if possible). This will help to ensure a shared understanding of accounting principles and methodologies. As important as drafting purchase price adjustments with care is ensuring that the carefully drafted mechanisms that have been prepared are utilised. Too often, deadlines are missed, leading to disputes which could otherwise have been avoided.
Conclusion
The recent trend of M&A related disputes highlights more than ever the importance of getting ahead of any potential dispute by conducting thorough due diligence to identify areas of risk, precise drafting of agreements to manage those risks, and formulating an effective dispute resolution mechanism at the drafting stage of the relevant contract to map out a clear and robust approach should such a situation arise.
Finally, engaging legal and financial experts early in the transaction process can help identify potential areas of disagreement and facilitate proactive solutions. Effective communication, negotiation, and alternative dispute resolution methods can also play a crucial role in resolving disputes and preserving the value generated by M&A transactions.
Roderick Lai, Partner, Hong Kong
Rod is a Partner in the corporate team of Eversheds Sutherland in Hong Kong, advising clients on cross border M&A, private equity, joint venture and other strategic transactions. Rod has extensive experience working on transactions across a broad range of sectors around the world with particular experience in emerging markets.
Wesley Pang, Partner, Hong Kong
Wesley is a Partner in the Global Litigation and Dispute Management Group at Eversheds Sutherland. He is based in Hong Kong, where he heads the firms’ international arbitration practice in Asia. Wesley has 15 years of experience in advising private and sovereign clients on commercial and investor-State disputes in Asia, Europe, the Middle East and Africa under various institutional rules.
Duncan Watt, Legal Director, Hong Kong
Steven Yuen, Associate, Hong Kong
Steven is an Associate in the Litigation and Dispute Management Group at Eversheds Sutherland. Steven’s practice covers commercial and financial services dispute resolution, banking and finance litigation, and contentious insolvency and asset recovery actions. His experience in dispute resolution extends to contentious proceedings in the courts of Hong Kong, England & Wales, and the People’s Republic of China. Another area of Steven’s focus is financial regulatory investigations. He is experienced in advising financial institutions regarding regulatory compliance and investigations by regulators and enforcement agencies in Hong Kong.