Impact of Covid-19 on Chilean M&A transactions
Philippi Prietocarrizosa Ferrero DU & Uría, Santiago
The Chilean government has implemented several measures to tackle the dual impact of the coronavirus outbreak and months of social unrest during 2019, boosting the economy as a way to favour foreign investments.
The government has announced an $11.75bn stimulus package, the biggest in Chile’s history. The package is equivalent to 4.7 per cent of gross domestic product and will widen an already burgeoning fiscal deficit. The Central Bank has already made two cuts in the monetary policy interest rate (the rate used in interbank operations) which leaves it at a 0.5 per cent rate, the lowest level since July 2009. In addition, the Central Bank provided a six-month financing facility for banks that is conditional on an increase in their lending. This special financing facility provides resources and incentives for banks to continue operating and refinancing loans to households and companies, particularly those without access to the capital market. Moreover, the Central Bank’s board softened liquidity requirements in case of national emergencies or other serious exceptional cases, and has also extended its currency sales program, which had been suspended but will now remain in place until 9 January 2021.
Meanwhile, the Financial Market Commission announced measures loosening regulatory requirements for the issuance of securities such as stocks and bonds.Finally, the government has lowered the stamp tax applicable to documents evidencing loans to a rate of zero per cent.
The Chilean government’s efforts to attract foreign direct investment in the wake of 2019’s social unrest meant that, in the first four months of 2020, Chile received $7,156m in foreign direct investment. This represented an increase of 35 per cent over the same period last year. This is 33 per cent above the average for the past five years and 39 per cent higher than the historical average (2003-2020).
M&A activity in Chile
M&A activity in Chile has decreased by 40 per cent in the first quarter of 2020. Although the decrease may be explained in part by the social and political crisis of 2019, there has been a slowdown not only in volume of transactions but also in value.
On one hand, markets relying on inertial demand, such as retail and real estate, have been forced to adjust business plans due to the Covid-19 crisis. However, current conditions are incentivising those companies to divest non-core assets in order to get liquidity. The latter, coupled with the dollar being at an unusually high level and historically low interest rates, may boost the M&A market in Chile. Strategic buyers with a strong financial position are taking advantage and looking for undervalued businesses.
On the other hand, we can anticipate that greenfield projects that are already underway will also be affected. Since new investment projects have a long lead time and a life cycle that can be measured in years, the impact will be more limited than in the case of operations not relying on stock market swings.
Covid-19’s impact on ongoing M&A transactions
Covid-19 may have a different impact depending on the stage of the transaction.
In the case of transactions on a pre-signing stage, a potential buyer may reassess whether to go ahead with the transaction, terminate it or put off the discussions. If a buyer would prefer delaying the deal, they should check the documents discussed and agreed so far, if any (for example, preliminary agreements such as letters of intent, MoUs, term-sheets), and evaluate whether additional arrangements are necessary, such as an extension of exclusivity arrangements.
If termination is the favoured option, and depending on what has been agreed, it is common practice in Chile that preliminary agreements are generally drafted as non-binding documents (other than confidentiality and exclusivity provisions). Such non-binding nature, however, does not imply an absolute liability exemption in case a potential buyer wants to walk away from the negotiations under Chilean law. At this preliminary stage, parties have a duty of good faith, which means that parties may incur high costs during drawn-out negotiations and may – at some point – have legitimate expectations about an agreement being reached. Therefore, a potential buyer may be obligated to compensate the seller (reparatory relief) in case damages are caused as a result of a violation of the principles of good faith. Nevertheless, a potential buyer may implement measures to take the edge off this risk, such as careful communications management in order to control counter party expectations, maintain loyal behaviour and avoid unreasonable disruption of the negotiations.
If the M&A agreement is signed but not yet closed, bring down of representations and warranties, covenants, material adverse changes (MAC) and termination clauses will require a closer look to assess steps to be followed in the transaction. It is common in Chile for buyers to ask for a full set of representations and warranties in the M&A contracts, and such representations and warranties should be true, accurate and correct not only at signing but also at closing.
The Covid-19 pandemic and governmental responses (such as lockdowns) may result in breaches of representations and warranties in addition to the MAC clause. For example, the seller may have provided a representation and warranty in relation to the absence of defaults of its obligations under material contracts.
Moreover, the occurrence of a MAC may give one party a right to terminate the agreement. In light of the Covid-19 crisis, buyers are questioning whether its effects are covered by MAC clauses in M&A agreements. Although a MAC clause may not cause the termination of the agreement in a given post-signing negotiation, it might provide the buyer some leverage to get a price reduction.
It is noteworthy to point out that there is no Chilean case law on MAC clauses. Therefore, whether or not Covid-19 will trigger an existing MAC will depend on the specific language of the MAC clause (for instance, how ‘carve-outs’ and ‘carve-ins’ have been drafted) and the exact effects suffered by the company on the particular case.
To illustrate the fact-driven analysis, let’s use the following example: if a MAC clause has a ‘disproportionately affects’ qualifications, which mitigates the effect of a MAC exception favouring the seller (a carve-out), that would mean that the MAC is triggered only if the target is not disproportionately affected as compared to its market peers by the event allegedly constituting the MAC exception. Therefore, the extent of the impact of Covid-19 on the target and the relevant industry, in conjunction with a careful analysis of the language of the MAC clause, will be crucial to determine whether the MAC clause applies or not.
Furthermore, M&A agreements may also enable termination in the case of a breach of its terms, such as a breach of warranty or pre-closing undertaking.
Finally, the Covid-19 pandemic and the resultant strategic and dynamic lockdown in Chile, whereby quarantine is applied to some districts and lifted from others according to the epidemiological situation in each location, has made it difficult (if not impossible) to obtain handwritten signatures on documents. However, under Chilean law any agreement may be signed electronically (electronic signature) – even public deeds – with only a few notable exceptions (documents that require personal attendance, such as a solemn will and documents related to family law). Unlike other countries, electronic signatures are valid in Chile insofar the signee is formally identified. The electronic signature is presumed to be valid unless evidence to the contrary is provided.
How Covid-19 is shaping future M&A agreements
As parties negotiate M&A deals amidst the Covid-19 pandemic, they should think through risk allocation and how a target’s risk profile may change over time as the outbreak itself develops. Those factors will have an impact on MAC, valuation, price adjustment mechanisms, interim covenants, representations and warranties, and the due diligence process itself.
Material adverse change definitions often contemplate carve-outs to remove events widely affecting markets and force majeure. Sellers, not surprisingly, have tried excluding pandemics or healthcare crises (including Covid-19 specifically) and their potential effects on the target business in MAC clauses, using such carve-outs to reduce closing risk. In spite of Covid-19 carve outs, ‘disproportionately affects’ qualifications might be included for events of this nature that affect target businesses more intensively than their industry peers, shifting the risk to sellers. In drafting these provisions, the parties should consider whether there are risks associated with the Covid-19 pandemic that they are not prepared to accept and whether the drafting of these provisions allocates those risks in a manner consistent with their expectations.
Lately, it is not rare to see negotiation of earn outs intended to bridge valuation gaps, particularly given current uncertainty, as it is often considered by buyers as a mechanism to handle downside risk while purportedly allowing sellers to obtain full value if the target achieves the milestones agreed. Nevertheless, earn out structures using non-financial milestones, or financial milestones that may be met after the immediate effects of Covid-19 pass, may be more appealing for sellers.
In Chile, where post-closing price adjustments are commonly used as an alternative to the locked-box pricing method, we anticipate that deals will continue to be structured with the former mechanism in view of the greater need to mitigate uncertainty during the pre-closing period. Such mechanisms are usually structured to compensate the relevant party if certain financial measures (paradigmatically, the target's working capital) deviate from a ‘normal’ level at closing. However, such a benchmark might be problematic in current circumstances. To address this issue, parties may consider consisting tendencies, cyclic variations, and management projections to adjust historic averages; sellers may wish to advocate for a similar approach that adjusts the working capital target based on the anticipated impact of Covid-19.
Alternatively, parties may consider limitations to mitigate the risk of fluctuations in working capital due to Covid-19, such as a floor and/or ceiling on the adjustment amount to help limit the impact of swings in net working capital on the purchase price agreed at signing.
Parties will need to consider whether to adjust interim covenant provisions to provide the target with additional flexibility, such as qualifying restrictions with an efforts or materiality standard, including exceptions to allow compliance with government-imposed restrictions and other factors that may affect target’s normal operations and to respond to changing market dynamics. Such flexibility should be balanced with buyer concerns related to a target making imprudent financial decisions, failing to invest in the business, or making irreversible staffing or strategic decisions during the interim period.
Representations, warranties and due diligence activities are likely to take on enhanced scrutiny where Covid-19 has had, or is expected to have, an impact on the target company's business. Buyers may want to place an increased emphasis on representations regarding:
• labour matters;
• customer, supplier and vendor relationships;
• IT infrastructure; and
• cyber and data security.
In addition, valuation of inventory and the quality of accounts receivable are areas worthy of increased examination, both in negotiation and in diligence. Target companies should consider whether certain representations should be limited to dates as of or prior to signing to limit exposure to breaches outside their control during the pre-closing period.
Finally, considering the potential logistical considerations that may impede closing preparations and third-party approvals, parties should consider tempering expectations regarding timing and be careful to choose an ‘outside date’ that provides sufficient time for unexpected delays, which may take the form of automatic extensions for areas particularly likely to affect overall timing, such as regulatory approvals.
In this vein, Chilean regulatory entities have put measures in place to adapt requirements to the current circumstances. In the merger control process context, for instance, the Chilean National Economic Prosecutor’s Office (FNE), has implemented a number of measures, such as allowing power of attorneys to be electronically signed or to be granted by email, and permitting direct email communications with the FNE (eg, notifying mergers by email).
 PwC study published in Diario Financiero, 15 April 2020; Fusiones y adquisiciones en Chile, primer trimestre 2020, Deloitte, April 2020. (www2.deloitte.com/cl/es/pages/mergers-and-acquisitions/articles/fusiones-adquisiciones-primer-trimestre-2020.html, accessed 30 June 2020).