As the COVID-19 crisis unfolds, each day brings new challenges and announcements on the potential support available to business and individuals or how laws, regulations and rules may be relaxed. With the likely timeframe of the crisis still unclear and more detail on business support yet to come, inevitably many corporate transactions are on hold. However, there are some corporate transactions that are still proceeding. Here we share with you thoughts on some of the questions we have been taking from our private company corporate owner/director and M&A clients on shareholder funding, the impact on transactions and company accounts.
What funding options are available to the business through the crisis?
Bank funding is a route being considered by many and guidance was given on that in our COVID-19 guidance for Banking and Finance. However, not all businesses will qualify for this or they may be seeking a combined approach with other funding means and looking to their existing shareholders to provide support. We are seeing some examples of shareholders looking to inject shareholder funding in the form of further equity or loan notes. It is worth considering with existing investors whether interest payments under loan notes might be delayed and rolled up for example. There are many issues to cover when considering the type of funding, depending on the business, which need to be worked through and documented carefully with lawyers. The terms of existing shareholder and banking arrangements will need to be considered for shareholder consents, pre-emption rights, priority of repayment, covenant breaches, events of default and of course directors' duties.
As a shareholder in a business, am I obliged to provide funding to the company if it needs/requests a cash injection?
You are not obliged to make any further investment or loan to the company unless you have agreed to provide further funding within a shareholders' agreement, by virtue of the Company's articles of association or pursuant to another contractual obligation. If you are a director as well as a shareholder, your obligations as a shareholder are not affected by virtue of your position as a director. However, as a director you must consider your duties and the position of the company – see directors' duties below.
How are my basic duties as a director affected?
The basic framework of codified statutory duties remains unchanged. As the impact of the pandemic continues to unfold, directors must therefore continue to have regard to their statutory duties when navigating the company through the crisis. This includes ensuring that all transactions with the company are disclosed and, where necessary, approved by directors or shareholders under conflicts procedures. It also includes, of course, the fundamental duty to promote the success of the company for the benefit of its shareholders, but taking into account stakeholder interests. Directors will be familiar with these basic duties.
However, in a situation like this, directors must also consider whether the company is approaching insolvency because the usual rules would not apply in the same way. If the company is facing solvency issues, whether on a balance sheet test or because it is not able to pay its debts as they fall due, then it is particularly important for directors to take separate legal advice. In this scenario the duty to promote the success of the company for the benefit of the shareholders flips to a duty to consider or act in the interests of the company's creditors. The exact tipping point is not completely clear but according to case law: "the underlying principle is that directors are not free to take action which puts at real (as opposed to remote) risk the creditors' prospects of being paid, without first having considered their interests rather than those of the company and its shareholders."
This aside, there are a number of other important considerations and traps for the unwary director in such a situation. Directors could, in the event of an insolvency, face a number of other potential claims and actions including disqualification, fines and penalties and liability for the company's debts. The UK Business Secretary has announced that emergency legislation will be introduced to provide a breathing space to consider rescue packages and a temporary suspension of one potential claim against directors – that of wrongful trading. However, this is not the only potential head of action against directors and details are awaited. We will be publishing fuller guidance when more information is available. In the meantime, directors in a potential insolvency situation should seek advice, particularly as it is likely to need to be tailored to the business and circumstances concerned.
Impact on M&A transactions
I have been in negotiations to buy a business. What should I bear in mind from a diligence perspective?
Given the challenges to negotiating and undertaking due diligence (DD) during the current crisis, parties to potential M&A transactions will understandably be considering whether this is the right time to proceed. As noted above, many transactions are already on hold but there are still some where parties are looking to proceed. Where the parties plan to continue negotiations, DD will be challenging, but nevertheless feasible if the parties are able to effectively identify key priorities and manage the risks. As part of its financial DD, a buyer may look to the seller to revise projections and forecasts to account for the effect of COVID-19 on the target. While revised figures may be prepared on the basis of the target's previous financial performance in difficult economic conditions, these are unprecedented times and historic data may not be sufficiently nuanced to accurately predict the days and weeks ahead. So a careful balancing of risk and opportunity will be required. Amongst other issues to consider, buyers should pay particular attention to the impact of COVID-19 on the target's supply chain and review how the target's commercial contracts deal with performance in these circumstances – for example, the counterparty may have the benefit of any termination rights, or force majeure provisions (see our separate briefing on force majeure). Furthermore, where property inspections and site visits are crucial, buyers may look to delay exchange of contracts until these are possible and there is greater clarity on other issues.
If my M&A transaction is proceeding, can I protect myself against the impact of COVID-19 in the contract?
Crafting appropriate contractual protection to deal with the consequences of COVID-19 against an evolving backdrop of potential risks is a challenge. Buyers should consider what should be the remedy for breach of any such provisions. Delayed consideration structures are one option. More typical warranty and indemnity protections will also need careful scrutiny, in particular to ensure the likely continued credit worthiness of the seller. The interplay with any warranty and indemnity insurance to be put in place will also need to be carefully considered, including in particular an assessment of what exclusions there are including for COVID-19 related claims.
If completion of the transaction will be conditional on, for example, obtaining third party finance or consents, the parties may consider agreeing to extend completion deadlines or drafting for automatic extensions to long-stop dates. There is also likely to be careful negotiation around the customary covenant governing the operation of the target business in the "ordinary course" during the period between exchange and completion. Parties will wish to ensure that it does not prevent the business from being able to respond appropriately to COVID-19-related threats to the target business, whilst at the same time giving the buyer sufficient protection.
I have exchanged contracts to buy a business but not yet completed. Can I walk away?
A Material Adverse Change ("MAC"), or a Material Adverse Event ("MAE") provision aims to allocate between the parties the risk of a particular event occurring in the period between exchange and completion which has a significant effect on the target business. These provisions will usually entitle the buyer to walk away in the event that a MAC, or a MAE occurs during this period. Whether the COVID-19 pandemic represents a MAE which entitles the buyer to walk away will usually depend on the impact of the virus on the target business, the wording of the particular MAC/MAE provision in the contract, and what was known by the parties at the point of exchange.
My accounts are due – what particular issues does the pandemic bring?
Companies will also need to consider what COVID-19 disclosures might be needed in year-end accounts. The Financial Reporting Council (FRC) has published guidance for auditors on disclosure of risks and other reporting consequences arising from the Covid-19 pandemic. The guidance acknowledges that some companies will be facing practical difficulties in preparing their accounts. Directors in particular will need to consider whether financial statements can be prepared on a going concern basis – i.e. whether events have occurred after the reporting period which have caused the going concern basis to become inappropriate. Of course, in doing so they will also need to consider their general duties as a director and those that apply in the event of insolvency, as set out above.
Companies affected by COVID-19 can apply for a three-month extension for filing their annual accounts through a new fast-tracked online system. Applications must be made before the company's filing deadline. Note that companies that have already extended their deadline or shortened their accounting reference period may not be eligible for the extension. For further details see the Companies House guidance.
Practical Guidance for COVID-19
Read the latest COVID-19 related updates on our hub.