Back to Corporate and M&A Law Committee publications

Fernando Alfredo Castillo
Brigard Urrutia, Bogotá
fcastillo@bu.com.co

 

Covid-19 has had a profound effect on all economic sectors, affecting the ability of contract parties to perform under all sorts of agreements.

In January 2020, few would have been able to predict a worldwide lockdown with the devastating effects we are still only beginning to anticipate. It is not surprising that many M&A agreements executed early in the year (or before) do not foresee pandemics. In this context, lawyers must figure out if applicable laws provide relief to affected parties. This article explores some of the Covid-related problems that have or may come up in the context of the pandemic, and how the laws of a civil law jurisdiction (Colombia) may apply in the context of two M&A agreements in a private deal context.

The acquisition agreement

Covid-19 raises many questions around acquisition agreement provisions. Two questions seem more prevalent in Colombia:

• how the pandemic affects closing conditions; and

• if an extension of ‘drop dead’ or end dates is possible.

Covid-19 and closing conditions

The most common question in this context has been whether Covid-19 is a material adverse effect (MAE). While this is the most obvious impact of Covid-19 on closing conditions, another valid and frequent question (in Colombia, at least) is whether a party can force closing over a condition that failed because of Covid-19-related circumstances.

Interpretation of MAE provisions in a civil law context

Under civil law, MAE provisions in an acquisition agreement are normally a suspensive condition (or condition precedent, in common law terms). As such, they work as a negative condition precedent – that is, an event, external to the parties, that may or may not happen, and the non-occurrence of which makes the obligation enforceable. Under the MAE condition in an acquisition agreement, the buyer’s obligation to close only comes into existence and becomes enforceable if the MAE does not occur by a set date.

Under Colombian law, conditions must occur in the way the parties intended. This sets forth a contract interpretation rule that may differ from many common law jurisdictions. In Colombia, the extent and scope of the definition of MAE in an acquisition agreement is to be determined considering the parties’ actual intent, even if inconsistent with the language used in the agreement. If the agreement has clear and unambiguous terms, a Colombian court will analyse the words of the contract to ascertain the parties’ actual intentions. But even with ‘clear language’, the parties can prove their actual agreement differs from the written contract. Note that the standard definition of MAE excludes ‘Acts of God’ and ‘general economic conditions’; sometimes pandemics are also expressly excluded. Where the written contract prevails, some circumstances associated to Covid-19 should squarely fall within one of these exceptions and the buyer should be precluded from successfully invoking a MAE. In the civil law context, the party invoking the MAE may hold that these exclusions do not apply to facts or circumstances that, like Covid-19, were not contemplated by the parties at the time of the agreement, and the language of the contract will not preclude this argument.

A second MAE-related question involves the definition of materiality. ‘Material’ is not a legal term in many civil law jurisdictions. In Spanish, the word ‘material’ is not a synonym for ‘important’ or ‘substantial’.^[1] Yet, it is commonly used in acquisition agreements, as are other transplanted English legal concepts. Given the ‘structural’ ambiguity of the term, the meaning intended by the parties shall be determined using the interpretation guidelines in the law. The way these rules interplay with any agreement is highly context-dependent. Two conflicting construction principles seem to be relevant in this context.

Firstly, as mentioned, actual intent prevails. M&A deals are often negotiated by investment bankers and law firms that are familiar with the United States (or other ‘prestigious’ common law jurisdiction) practice. Clients that are repeat players (like funds and strategic players) are also familiar with this practice. Therefore, it is not uncommon for these parties to reference US precedents and interpret MAE as a very high standard – to be measured in years – with effects for a long-term investor. It is plausible for sellers to argue that the actual intent of the parties was to apply MAE as it would be applied by a US court. A local court may consider all available evidence, including references made to US legal concepts during the negotiations, to evaluate this argument. If it is the case, MAE should be construed narrowly, and the standard should be hard to meet.

Another contract construction guideline in Colombia may substantially impact the interpretation of MAE provisions in the opposite direction. The Colombian Supreme Court favours interpretations that conform to the implied covenants of performance in good faith, loyalty, and fair dealing. This has been interpreted by scholars and courts as an obligation to act in a way that ensures the other party gets the benefit it expects from the contract. While this principle has not been applied to conditions – let alone MAE conditions – it seems reasonable that buyers could use it to interpret MAE provisions to get an ‘out’ of a deal that will no longer give them the expected benefit.

It is difficult to anticipate how these provisions will be interpreted in a civil law context. Common law precedents may provide some guidance, but differences in contract interpretation approaches among jurisdictions may yield different results.

Non-occurrence of conditions due to Covid-19

Contractual parties may fail to meet conditions precedent for circumstances linked to Covid-19. In these scenarios, some have argued there is an event of force majeure, and the buyer should be required to close. Due to the definition of force majeure, this argument has little traction in a civil law jurisdiction like Colombia.

Under Colombian law, force majeure is an unforeseen event that cannot be resisted. From this definition, the Colombian Supreme Court has extracted three requirements to successfully invoke force majeure. The event at hand:

• must be unforeseeable at the time of the contract;

• cannot be attributable to the party invoking it; and

• must make performance impossible.

The third requirement is the most relevant, since it shows the degree in which force majeure must affect the contract. Therefore, force majeure is a defence in an action for breach of contract.

The concept of force majeure has no role in the realm of conditions, which must occur before a party is required to perform under the contract. Conditions are either fulfilled or they are not. Except for some ‘clean hands’ concepts in certain jurisdictions – such as Colombia – the reason behind fulfilment or failure is irrelevant. A condition precedent allocates an objective risk, so the condition failing due to a force majeure event should not result in that risk being reallocated.

As a result, in civil law jurisdictions such as Colombia, the party who has the benefit of the condition cannot be forced to close upon failure of a condition – even if attributable to Covid-related circumstances.

Covid-19 and drop-dead dates

Another question in the context of acquisition agreements is if drop-dead dates can be extended due to force majeure events associated to Covid-19. However, when meeting a condition precedent is not rendered impossible but is delayed by Covid-19, postponing the end date would probably not be possible.

As explained above, the effects of force majeure are normally limited to scenarios where a party claims a breach of contract. Colombian law does not provide for a suspension of a contract that cannot be performed due to force majeure. Even in jurisdictions that recognise this ‘suspension effect,’ it is normally used to extend the term of an obligation that has become temporarily impossible to perform. However, force majeure does not extend a term that terminates a contract. In civil law terms, force majeure could eventually extend a ‘suspensive term’ but it does not extend an ‘extinctive term’.

Shareholders’ agreements: Covid-19 and exit strategies

Covid-19 may also affect performance under shareholders’ agreements. For example, in some sectors valuations may be temporarily depressed; parties required to deliver potentially undervalued assets may seek to avoid performance under the contract. A different set of problems arise from a potential lack of liquidity to meet certain contractual obligations. In this case, parties with monetary obligations may seek to suspend their obligations until liquidity strains are manageable.

Drag-along rights and call options: the problem of valuation

The valuation problem seems more prevalent for drag-along provisions and call options. The problem could emerge in call options where the holder of the option has liquidity and wants to take advantage of low valuations to purchase shares at a bargain price. It could also apply when a shareholder benefiting from a drag-along right has liquidity needs and is willing to sell for a price below the valuation of the shareholder being dragged into the sale. In these cases, the relevant question is if the party required to sell has available defences to avoid selling if it deems the valuation is too low. The agreement may answer this question; often these provisions require an independent valuation or set objective parameters to determine the applicable price (or a floor). If the agreement is silent, or the valuation criteria used does not account for the ways in which Covid-19 affects the valuation of the target, the parties shall find a solution in the applicable default law.

In civil law jurisdictions, along with force majeure, the doctrine of ‘economic imbalance’, (imprevision, impracticability, excessive onerousness) may be a potential solution to these problems. Imbalance is subject to different requirements in different jurisdictions but is normally employed to request renegotiation, termination or court adjustment of a contract that can be performed, but at an excessive cost. While these doctrines may seem appealing, their application in this context seems, at the very least, difficult.

To begin with, force majeure seems out of the question in most cases. The party required to sell under the drag-along or call provision normally owns the asset and is, therefore, not required to get it from a third party, so there is no need to raise funds to purchase the asset. In this context, performance under the agreement is not impossible or even extremely onerous; however, the selling party will not get a fair consideration for the shares.

Successfully invoking an economic imbalance may be difficult in countries where it applies subject to requirements. In Colombia, at least three such requirements are relevant.

The first is that the contract or provision cannot allocate the risk of gain or loss to the party whose performance is required. Drag-along provisions do not seem to fit the bill, but call options may. Indeed, in some cases the holder of the option may have bargained to get the ability to purchase at the then prevailing market value, and therefore the grantor will have assumed the risk of value depression. With Covid, the question is whether the doctrine of economic imbalance allows renegotiation when the materialised risk was not foreseeable at the time of the contract. In Colombia, the Supreme Court has held – in dictum – that a duty to renegotiate may be warranted in this case. However, even if the doctrine applies, two other requirements may pose obstacles.

On one hand, performance under the contract must become excessively onerous for the affected party. The doctrine is conceived to aid parties whose cost of performance goes up. However, in Colombia, the Supreme Court has recognised – in dictum – that the doctrine may also apply in cases where the cost of performance remains unchanged but the value of the other party’s performance goes down. While this second hypothesis seems appealing, it is hard to hold that the consideration is too low when it reflects the valuation of the target: the asset price is low, but merely as a reflection of the target’s economic reality.

Finally, in some civil law jurisdictions this ‘remedy’ may only be used to seek renegotiation or court adjustment of future performance under executory contracts. What has been delivered cannot be adjusted, and the affected party cannot withhold performance while the court decides. In jurisdictions like Colombia where courts are traditionally slow, and are currently closed or working at a portion of their capacity, the probability of getting a timely decision seems low.

Nonetheless, affected parties may try to claim that a sale for a depressed price might result from the purchaser acting abusively or in bad faith. Both ‘abuse of rights’ and ‘good faith performance’ are vague, somewhat flexible legal constructs that may provide relief to parties that cannot rely on force majeure or economic imbalance.

The matter is twofold. First, the application of these principles is much more context-dependent. The actual intent of the parties at the time the call option or drag-along right is exercised, the situation of the obligated party (financial and otherwise) at the time of such exercise, the parties’ expectations at the time of the contract, and even the court’s view of what constitutes proper behaviour, among other factors, will come into play. Second, in Colombia at least, courts and arbitrators seem to be much more willing than their common law counterparts to use these ‘principles’ liberally and imply provisions into the contract to achieve a fair or just outcome. This is, then, an area of increased legal uncertainty.

Put options: the problem of liquidity

The liquidity problem seems more prevalent in put options. It could arise where the holder of the option needs liquidity and forces its counterparty – who also has liquidity needs – to purchase. Assuming there are no specific provisions to address Covid-like circumstances, the question is if the buyer’s breach is excused if it fails to pay the purchase price due to liquidity strains associated to Covid-19.

In this case, a force majeure defence is in all probability unavailable to the buyer. Since force majeure requires that performance becomes impossible, it does not excuse non-performance of monetary obligations. In Colombia, for instance, the Supreme Court has held that no event, whatever its nature, will make it impossible for a contractual party to pay money, therefore force majeure is generally unavailable to excuse non-performance of this type of obligation.

As for economic imbalance, the problem here, as with the valuation issue in call options, is that the holder of the option can argue that:

• the would-be buyer expressly assumed the risk by granting the option; and

• there is no economic imbalance to the extent the buyer is required to pay the current market price.

A different problem may arise if the strike price is set as a fixed sum or through a formula that reflects pre-Covid prices. In this scenario, the buyer may argue that it is being required to pay an excessive price. Nonetheless, this is likely the kind of risk assumed when granting a put option with a fixed strike price.

Again, an affected party may have to resort to broader principles, such as good faith and abuse of rights. As explained above, this is an area of increased legal uncertainty since the application of these principles depends on context and courts may use them quite liberally.

Covid-19, its effects on public health, the resulting government measures, and the aggregated impact of this on the economy, are affecting and will affect contracting parties in substantial ways.

Parties to M&A contracts are no exception. When the agreement is silent or ambiguous on rules applicable to a pandemic, parties will look to their lawyers to find a solution. At this point, the legal system and particularities of the applicable contract law may become relevant, and it should come as no surprise if the same problem is solved in different ways by different jurisdictions.