By Gavin Robertson, Principal, Corporate Governance
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.
In Australia, government support such as JobKeeper and the Victorian Governments Business Support Package provide temporary relief but are not a long term solutions. Participating in JobKeeper for an extended period could further damage a company’s financial position as it requires employee entitlements to continue to accrue. This is not a problem that is unique to Australia, and much of the commentary provided below is relevant to any jurisdiction.
Some businesses need to consider more radical solutions. 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 – and then often at a substantial discount to an already depressed market.
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.
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.
Assets rather than shares may be acquired, in which case the selling entities will become shareholders in the purchaser.
These transactions may be implemented by way of private treaty, or if they are regulated under the domestic corporations laws then usually these transactions can be implemented by way of takeover offer, scheme of arrangement or with shareholder approval.
COVID Era Issues
There are many issues to be addressed with any merger. The following issues will be magnified if one or more of the parties to the transaction is in financial distress, or generally because of the pandemic.
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.
The problem is not eliminated in the case of an entity that has expectations of improving its performance in a post-pandemic environment compared to pre-pandemic. This might be the case because it was growing, while the other merger party was a more mature business.
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.
The values to be adopted in a merger transaction should not necessarily result solely from the negotiations of the parties. In Australia, if one or more corporate parties are financially distressed, there is a risk that the merger could subsequently be unwound as an uncommercial transaction under section 288FB of the Corporations Act. Where a court finds that the benefit or advantage gained by the company caused it detriment that could not be explained as normal commercial practice, and the company was insolvent at the time or became insolvent and winding up commenced within two years, it has wide powers to make orders for the benefit of the company’s creditors. Such orders could include unwinding the transaction or varying its terms.
Any part of a merger transaction could be found to be uncommercial, including disposing of shares or assets and issuing the consideration shares. 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, underpaid wages or a breach of covenant in a financing document. However, in the COVID era issues such as whether a COVID-safe work place has been provided and eligibility for schemes such as the Australian JobKeeper (if it has been claimed) as well as solvency will also need to be investigated.
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.
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 (see above) 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 on the merger by the entity which will become the 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), of by way of private treaty.
In Australia, where the merger is by way of a regulated transaction, the Corporations Act requires that prospectus type information be provided to offerees, in a Bidders Statement (in the case of a takeover offer) or in the Scheme Booklet (in the case of a Scheme of Arrangement).
In the case of a private treaty offering, unless it is by way of an excluded offer under section 708 of the Corporations Act, a prospectus will need to be issued.
In such cases, the directors responsible for the relevant document will need to identify and address COVID related risks in the business, as well as its usual risks.
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 mater
Shareholder Approval – shareholder approval may be required as a precondition to a merger. For example, in the case of a Scheme of Arrangement (as discussed above) or by the bidder in the case of a reverse takeover. Chapter 11 of ASX Listing Rules may require shareholder approval in the case where there is a material change to the nature or scale of a listed entity resulting from the merger or the merger involves the sale of its main undertaking. Approval under Listing Rule 7.1 will be required if the 15% rule is triggered. 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 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 pre-COVID, 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.