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03 Sep 2020

Additional areas of due diligence focus in the COVID-19 era

By Anthony Cavallaro, Danielle Crowe, Charis Chan, Samy Mansour, Cilla Robinson, Amanda Lyras, Grace Paton, David Gerber, Crystal Eggleton and Angus Roy

The disruption and instability brought by the COVID-19 pandemic have created the need for all businesses to rapidly adapt in their practices, with the conducting of due diligence being no exception.

The COVID-19 pandemic has brought incredible disruption in 2020, with governments and businesses forced to adapt rapidly to the new norm. This has led to particular changes in how due diligence is conducted in M&A transactions, both for the buy and sell side.

Below are some key issues that buyers and sellers should consider incorporating into their customary due diligence, and some suggested questions to ask.

Corporate and commercial

One area facing particular disruption during (and after) the COVID-19 pandemic and therefore requiring closer attention during the due diligence process is that of supply chain risk. In particular, buyers should apply greater scrutiny to the force majeure provisions of key supply and customer contracts to ascertain what events will or will not be covered. This is significant as the operation of the force majeure clause may have impact across various parts of the supply chain – from production and manufacturing through to distribution. We expect that force majeure definitions and clauses will assume a more prominent role in negotiations between contracting parties.

Another key consideration for buyers and sellers, given the uncertainty of the times, is exclusivity in key contracts and other sources of supply – in particular, the degree to which alternative supply can be sourced. Again, this could have significant ramifications for the entire supply chain of a business.

In addition, parties must be vigilant in monitoring the legal and regulatory landscape as laws – particularly those brought in on a temporary basis to encourage business – are subject to change and may add a further regulatory burden on targets. Buyers will need to monitor not just these regulations, and the target’s compliance with them (including the anticipated costs and implications of such compliance) but also what should happen when temporary laws that assist business eventually fall away.

Property

The National Cabinet Mandatory Code of Conduct – SME Commercial Leasing Principles During COVID-19 and the subsequent introduction of regulations in each State and Territory in relation to the waiver or deferral of rent for eligible tenants mean that additional questions must be asked during the due diligence process, particularly for a buyer acquiring a lease or tenanted property.

It is no longer sufficient to rely on the face of the lease as there may be side agreements (whether documented simply by correspondence between the parties or more formally) that give effect to these arrangements. The due diligence process should disclose the basis of any waiver or deferral and any other concessions, including whether the seller was entitled to the reduction or waiver by virtue of the Mandatory Code of Conduct or whether agreement was separately reached with the landlord.

A buyer will need to consider whether those side arrangements should also be assigned as part of the sale process. For instance, if rent has been deferred (rather than waived) during the pandemic period, it could result in a buyer taking on obligations to pay deferred rent that relate to a period of time prior to the assignment of the lease. The possibility of deferred rent being payable means that this question will remain an important part of due diligence beyond the immediate pandemic period.

In addition to a waiver or deferral of rent, the parties may have agreed to vary the terms of the lease (for instance, an extension of the term). These variations will also need to be disclosed as part of the due diligence process.

Finally, it will be important to understand whether there is any ongoing dispute between the landlord and tenant arising from a failure to reach agreement regarding any rent relief.

Employment

The COVID-19 pandemic has necessitated various adjustments to workforce management. Some of the mechanisms utilised by companies to meet new operational requirements have included issuing "stand down" orders to staff, implementing restructure and redundancy programs, and considering other ways in which to reduce staff cost pressures, such as leave arrangements and negotiated pay reductions. At the same time, there have been a number of new Government laws and regulations introduced, including the Federal Government's JobKeeper scheme and various public health directions. How the seller has responded to the challenges presented by COVID-19 in terms of its workforce management, and its broader compliance with workforce-related legislation and regulation, should be a key focus area for buyers, including for the purposes of valuation and purchase price mechanics.

Against this backdrop, there should also be close scrutiny as to how sellers have managed the heightened work, health and safety (WHS) risks presented by the pandemic. In this context, we are seeing buyers inquire as to the steps target companies have taken to ensure the physical safety of staff in the workplace, including to prevent them from being exposed to the virus and responding to any outbreaks, as well as managing specific risks arising in relation to remote workforce arrangements, such as mental health challenges and domestic violence. As part of this, it is prudent for buyers to review workplace policies and procedures in relation to hazard management and remote working, and to understand how they are implemented by the seller in practice.

From a compliance perspective, while the Fair Work Ombudsman (FWO) has conceded that it will seek to reduce the regulatory burden on those sectors hit hardest by COVID-19, its strategic priorities for 2020-21 include pursuing large corporate underpayments and sham contracting, amongst other things. The FWO's focus on underpayments in particular is an issue of concern for due diligence processes, with buyers and warranty and indemnity insurers alike increasingly requiring audits to be undertaken as part of the diligence process to assess compliance with payment of employment-related entitlements. This is resulting in added cost and time pressures and can lead to the identification of material issues and/or delays to the deal timetable.

Consistent with the FWO's additional focus on sham contracting, buyers and insurers are also asking more detailed questions in relation to independent contractor and casual workforce engagement, including following the Full Court of the Federal Court of Australia's decision in Workpac Pty Ltd v Rossato [2020] FCAFC 84, where it was held that the payment of casual loading in that case could not be effectively offset against permanent employment entitlements found to be due to a casual worker. For companies with large contractor and/or casual workforces, these matters can be material to a transaction and we are seeing circumstances where insurers are refusing to extend coverage to warranties and indemnities concerning these matters where they cannot obtain appropriate comfort from the seller.

Insurance

The response of insurance to losses and liabilities arising from the COVID-19 pandemic will vary greatly. It will mainly depend on the type of insurance cover and the terms and conditions of the relevant policy. A buyer may wish to inquire in the course of their due diligence the availability of insurance for a range of different impacts and exposures arising from COVID-19.

One area that is particularly difficult to assess is the availability of cover for business interruption losses under property insurance policies. There is currently litigation taking place around the world, notably in a large test case in the UK as well as in a test case in Australia, directed to resolving certain contentious property and business interruption insurance coverage issues. It will be important to understand the extent to which the target is covered by insurance for impacts on and exposures to its business and, notably, losses caused by shutdowns and restrictions on movement and operations.

There is a secondary consideration, being the potential for an increase in risk issues emerging indirectly and impacting a variety of different insurance policies. For example, changes to the business operations of policyholders as a result of COVID-19 may have indirectly increased the risk of certain losses, such as in relation to cyber security, work, health and safety, and directors' and officers' liability. Those could give rise to claims under existing policies after completion of the transaction.

Finally, the target's existing insurance program may not be capable of renewal on the same terms (including as to price) in the future. This could occur because the pandemic has changed the risk profile of the target or because the significant impact of COVID-19 on the insurance market will impact the availability, scope and price of insurance covers. The buyer may need to factor into its valuation material changes in operational costs related to insurance, and consider what it means if the target becomes uninsurable in certain areas of its business or unable to insure certain risks for a commercially reasonable price.

Questions to consider

It is important that the below questions are considered in light of the particular circumstances of a transaction, including the specific requirements of a buyer, seller and target. Given this, parties to a transaction should strongly consider engaging with appropriate advisers and representatives to ensure that adequate, tailored due diligence is conducted, as applicable to the relevant industry and one's risk appetite.

Corporate and commercial

Contractual / commercial matters 

Ask

  • Have there been any temporary changes or waivers to contract terms due to COVID-19?
  • Who are the main suppliers and what is the degree of reliance on them?
  • Has the ability of any supplier to provide intended products and services been impacted?
  • Are there any alternative suppliers available?
  • Has the target considered how risks, bought to light by the COVID-19 pandemic, should be reflected in future contracts and negotiations?

Note

Redundancies should be built into the supply chains of targets in this environment, and where possible, buyers should consider the extent to which the target is reliant on a single supplier or source of supply, particularly if the supplier or source is located overseas. Buyers should also consider the availability of alternative suppliers, and the target's current and expected inventory levels and forecasts.


Force majeure  

Ask

  • Are the force majeure clauses in key supply and customer contracts exhaustive or non-exhaustive and do they clearly operate in pandemic-type circumstances? Are these provisions consistent across all of the key contracts?
  • Have any force majeure notices been received or issued by the target in response to COVID-19?
  • Have any material contracts been, or are likely to be, breached or have any material terms of such contracts been waived?
  • Have any COVID-19 laws been passed that would relieve the target or a counterparty of any of its contractual obligations, notwithstanding force majeure or similar provisions in the contract?

Note

You need to be aware of whether force majeure events operate in pandemic-type circumstances and how that impacts the remainder of the supply chain.


Policies and procedures

Ask

Have any new policies or procedures been introduced in response to the COVID-19 pandemic?

Note

It is important to check that any new policies and/or procedures were made under the right authority and understand their impact on the business (including potential liability for new ownership).


Material changes to business

Ask

Have there been any material changes to the target’s ordinary course of business as a result of the COVID-19 pandemic?

Note

It is important to check whether any actions taken by the target in conducting their business during the pandemic breach any of their licences, regulatory approvals, financing or other arrangements.


Material losses 

Ask

Has the target incurred any significant losses as a result of the COVID-19 pandemic, such as any loss of material customers or reduction in price of goods/services sold? Can these be easily quantified or attributed?

Note

Buyers and sellers must be aware of any anticipated significant losses that the target is likely to incur pre and post completion as these will be relevant to the valuation of the target as well as earnouts and purchase price adjustments when it comes to the sale agreement negotiation.

Property

Waiver or deferral of rent

Ask

Has the target negotiated any waiver or deferral of rent with any of their tenants? How are these arrangements documented? Were these arrangements made under the Mandatory Code of Conduct?

Note

It is important to check what arrangements are in place as some arrangements may not be in writing.

It will also be important to see if any arrangements have been made voluntarily between the parties or under the Mandatory Code of Conduct.

Once the buyer obtains all of this information, a decision can be made as to whether the arrangements should be assigned to the buyer and how the parties will deal with the arrears profile of the property.


Variations

Ask

Has the target entered into any variations of the leases at the property? Please disclose fully executed copies of any variations documents, whether these have been made by deed, letter, email or otherwise.

Note

It is important to ask this separate question as parties might have entered into variations to leases that amend the term or change other key aspects of the lease.


Disputes

Ask

Are there any ongoing disputes between the target and any of its tenants? Please provide full details of any dispute and their current status.

Note

Given the new code, the different interpretation by the parties of the need for a fair negotiation has led to landlords and tenants disputing over what concessions should be given. It is important for a buyer to understand all aspects of the current arrangements between the parties.

Employment

Underpayment and misclassification 

Ask

  • Has the target conducted an audit or review of its compliance with payment obligations arising under applicable law, industrial instruments, and employment contracts, with respect to its employees? Please provide full details of, and where relevant a copy of documents relating to, the findings of such an audit or review.
  • Has the target conducted a review of its classification of independent contractors and casual employees, including having regard to the factors that are applied under the common law for each of these categories of workers respectively? Please provide full details of, and where relevant a copy of documents relating to, the findings of such review.
  • Are there casual employees who are employed on a "regular and systematic basis"? If so, please provide a copy of the employment contracts that are in place with such employees. 

Note

Given the complexity of the industrial relations landscape in Australia, it is not uncommon for sellers to discover issues with respect to underpayment and employee classification upon conducting an audit or review. Where such an audit or review has not been undertaken, this may mean there is a disguised risk that has the potential to be material to a transaction. 


WHS

Ask

What workplace policies and procedures are in place in relation to hazard management processes (including temperature checking of employees, social distancing and other infection control measures), working from home arrangements, and managing employee disclosures of mental health or domestic violence issues? Please provide full details and a copy of such workplace policies and procedures. 

Note

COVID-19 poses obvious work, health and safety risks to employees. An outbreak of COVID-19 at the workplace can endanger employees and create significant reputational damage for a company. There is also the potential for serious risks to arise out of remote working arrangements, including in relation to mental health and domestic violence. It will be important for a buyer to understand what measures a seller has in place to assess and manage such risks and for relevant policies and procedures to be relevant and up-to-date. 


Compliance with JobKeeper legislation, public health directions and other rules/regulations

Ask

  • Is the target eligible for JobKeeper wage subsidy payments and, if so, what is the basis for that eligibility?
  • Is the target compliant with the minimum payment guarantee prescribed under JobKeeper legislation?
  • Has the target been subject to any audit by the ATO in relation to the JobKeeper scheme? If so, please provide full details and the outcome of that audit.
  • Has any JobKeeper dispute been filed with the Fair Work Commission concerning the target or proposed to be filed? If so, please provide the relevant documents and a status update or outcome of the dispute.
  • What, if any, public health directions are applicable to the target's operations? Is the target in compliance with these public health directions?

Note

If the target is participating in the JobKeeper scheme, it can be useful for the buyer to understand the basis for eligibility, including the triggering impact to the target's revenue across relevant quarters. Further, as the ATO has announced it is "zeroing in" on fraud and schemes designed to take advantage of the JobKeeper payments, it is important for a buyer to ensure that the target is compliant with the scheme.

Given the rise in JobKeeper-related disputes before the Fair Work Commission, it is also prudent for the buyer to understand any risks arising from employee claims.

Finally, various public health directions are being issued on a rolling basis. These directions have the potential to significantly affect a target's operations and can carry legal and reputational risk where there is a breach. Accordingly, it is also important for the buyer to be satisfied that the target is compliant with these.

Insurance

Insured losses 

Ask

Has any loss or damage or liability been suffered or incurred, or expected to be suffered or incurred, by the target arising out of or in connection with COVID-19 that falls within the scope of cover under an insurance policy?

Note

For the most part, market standard due diligence requests for information will oblige the seller to disclose details that should permit an assessment of the availability of cover under existing insurance policies for known or expected losses and liabilities.

However, that assessment will only be possible if full policy wordings (rather than just certificates of currency) are provided. It would also assist to be specific about COVID-19 related issues that may present particular challenges for insurance recovery.


Claims and circumstances 

Ask

Are there any insurance claims that have been or could be made by the target, or any circumstances that may give rise to third party claims against the target that have been or could be notified to insurers, arising out of or in connection with COVID-19?

Note

Again, market standard due diligence requests for information should draw out relevant information about claims and circumstances related to COVID-19. However, it is worth testing specifically the target's consideration of what could be claimed or notified under insurance policies. 

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Disclaimer

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.