Much has been written about the impact of COVID-19 on prospective and, increasingly, pending M&A transactions, including how risk and uncertainty created by the virus are changing how deals are negotiated and affecting whether deals get to signing and closing. M&A practitioners should also be prepared for potential post-closing consequences of COVID-19, as deal parties evaluate their post-closing rights and obligations in this new economic environment. This Legal Update describes several areas in which post-closing disputes may arise.

Post-Closing Adjustments

The vast majority of Purchase and Sale Agreements (PSAs) governing private M&A transactions include a mechanism for adjusting the purchase price using measures based on closing date financial statements. The most common mechanism is an adjustment based on closing net working capital (NWC), defined generally as current assets less current liabilities.1 Although the specific PSA provisions differ, the basic adjustment measures closing NWC against a defined target based on a historic measure of NWC. If closing NWC exceeds the target, the purchase price is increased; if closing NWC is less than the target, the purchase price is decreased.

The PSA will define how NWC is to be calculated, using some combination of Generally Accepted Accounting Principles (GAAP) either applied consistently with past accounting practices or not, consistently with historic accounting practices and methodologies, and/or specifically identified accounting methods. The differing measures can be more buyer friendly or seller friendly, but whatever the specific measure, the COVID-19 pandemic could have a significant retroactive impact on the calculation of closing NWC and could drive a significant reduction to a purchase price negotiated prior to the emergence of the pandemic.

Buyers will certainly use whatever mechanisms are available to attempt to adjust a purchase price to reflect the new economic reality faced by the acquired company. The closing NWC adjustment—and other post-closing adjustments—present such an opportunity, and as the amount of such adjustments are frequently not subject to a cap, the potential reduction to the purchase price could be significant.

Sellers must be prepared to confront these issues.

To understand the potential impact on the calculation of NWC, it is useful to look at the financial reporting impacts of the COVID-19 pandemic at two points in time—December 31, 2019 and March 31, 2020.  On December 31, 2019, although COVID-19 was impacting parts of China, it had not yet emerged as a global pandemic. To express this in financial accounting terms, the COVID-19 pandemic is viewed as a “subsequent event” for financial statements with a December 31, 2019 year end.  In a recent joint Public Statement on COVID-19 reporting considerations, the SEC and PCAOB indicated companies “need to consider disclosure of subsequent events in the notes of the financial statements” if they had not yet issued their year-end financial report.  Although the potential impact would be disclosed in footnotes, the financial statement balances themselves would not be revised to reflect those impacts.2

But by the time we reached March 31, 2020, the end of the first quarter for calendar year-end companies, the impact of COVID-19 on business operations and financial reporting was the current reality and no longer a “subsequent event.”  The first quarter financial statement balances will reflect the impacts that had begun to occur to the business as a result of COVID-19, the “stay-at-home” orders, and the resulting economic dislocation.

So, for transactions that closed during the first quarter, where the closing date falls between these two bookends, COVID-19 could have a significant impact on the calculation of NWC and the economics of the transaction.

A couple of examples of the potential impact on the calculation of current assets illustrate the issue.  Assume a February 29, 2020 closing date with the closing NWC statement required to be submitted on April 30.  Further assume that, based on COVID-19, some of the acquired company’s key customers have had to shut down their businesses. Consider potential impacts on the following accounts:

  • Accounts Receivable and Bad Debt Reserve: If the company’s customers now cannot pay the amounts they owe (i.e., more bad debts), should that be reflected in the calculation of NWC on February 29?
  • Inventory and related reserves: If the company now cannot sell its inventory, should that be reflected in the inventory valuation component of NWC on February 29?3

These (and similar) issues will result in significant and complex disputes in determining the calculation of NWC and the resulting post-closing adjustments to the purchase price.

Interim Covenant Breaches

In the context of pending deals, given the traditional difficulty of asserting the occurrence of a material adverse change, buyers are looking to other customary, accepted and longstanding provisions of acquisition agreements to assert a covenant breach or other failure of a particular closing condition. The Victoria’s Secret case (SP VS Buyer LP v. L. Brands, Inc.) is the most recent in a developing line of cases in which buyers assert a variety of theories to seek to avoid the obligation to close. The arguments made by the buyer in the Victoria’s Secret case may also lend themselves to post-closing claims, with buyers second-guessing sellers’ emergency management actions and framing this as a claim for breaches of sellers’ interim operating covenants. 

In the Victoria’s Secret case, the acquisition agreement was signed after the emergence of COVID-19 and contained a definition of material adverse effect that expressly carved out effects of pandemics. The buyer nevertheless sent a notice of termination, asserting a breach of the covenant to operate in the ordinary course of business, consistent with past practice.  The buyer generally based its assertion on store closures, employee furloughs and changes to inventory practices. In an apparent attempt to get the most mileage out of these facts, the buyer also asserted that these actions resulted in a breach of certain representations pertaining to operations in the ordinary course of business. Finally, an examination of the buyer’s pleadings indicate alternate arguments: (a) that the seller voluntarily breached its covenants or (b) that COVID-19 forced the seller to breach its covenants thus constituting a material adverse effect (an external event rendering the seller’s performance impossible).

The seller countered that its actions were in the ordinary course of business, given the exigencies resulting from the COVID-19 pandemic. It further asserted that its actions were in the ordinary course of business by reference to current market practices, including, significantly, the practices of the buyer’s other portfolio companies.  Finally, the seller asserted that, in any case, the buyer consented to the seller’s actions in that there was constant and transparent advance communication with the buyer in which the buyer indicated its support for the actions.

The Victoria’s Secret case raises the following questions, which may be relevant for both pending and closed deals:

  • What does it mean to operate in “the ordinary course of business” in the current environment?  Does the qualification of “commercially reasonable efforts” color this question?
  • How strictly will courts enforce “waivers must be in writing” provisions, particularly in cases where the seller has taken actions with the tacit approval of the buyer and, indeed, such actions were understandably taken to protect the business?

One outcome of the Victoria’s Secret case and others like it might be the inclusion of force majeure provisions, normally not included in M&A acquisition agreements, to excuse the seller’s performance of certain interim covenants in order to address emergencies caused by pandemics, terrorist attacks, natural disasters and other emergency situations that normally are included as exceptions to what constitutes a material adverse effect.

Earnouts: The Effect of Business Decisions Made in Response to COVID-19

The wide-ranging economic effects of COVID-19 will also likely affect earnout provisions that were agreed to under assumptions about the acquired business and prospects that were made without taking into account the possibility of this broad COVID-19 economic downturn.  In many cases, sellers may simply be out of luck if the earnout targets that were agreed to when the acquisition was made are simply no longer achievable.  However, there are several considerations in connection with how the earnout has been structured to keep in mind as buyers react to the realities of the business landscape they now find themselves in.

If, under the terms of the acquisition agreement, buyers have agreed to covenants to operate the business in a specific manner, then they might very well be held to that agreement despite the change in the market more broadly.  Such covenants might include a covenant to operate the business consistently with the past practice of the sellers prior to the acquisition, a covenant restricting any changes to the business that would materially affect the business from achieving the earnout targets, or a covenant to take specific actions or make specific investments in the business post-acquisition.  Buyers and sellers should be aware of any such covenants and ensure that, absent any language disclaiming or modifying the requirements under these covenants, the buyer is adhering to these covenants.

By application of the implied covenant of good faith and fair dealing, courts have found that even absent specific covenants to run the business in a specific way, buyers have an implied duty to run the acquired business so as not to arbitrarily frustrate the achievement of the earnout targets.  In general, affirmative steps taken to frustrate the achievement of the earnout are likely to be found to have violated this implied covenant of good faith and fair dealing.  However, courts have generally found that when buyers have merely not supported a business to the level that sellers would prefer, the implied covenant has not been violated.  Buyers who respond to the new economic pressures resulting from COVID-19 in ways that are not targeted to block the achievement of earnout targets specifically (e.g., moving losses unrelated to the acquired business to the balance sheet used to determine earnout targets, shutting down acquired business lines while leaving similar non-acquired business lines running) and that are applied to the buyer’s business across the board have a much stronger case that they are acting consistently with the covenants of the acquisition agreement, both express and implicit.

Finally, one additional concern for buyers that may be heightened whenever there is a sharp downturn in the economy such as that caused by COVID-19 is that of short-term measures taken by sellers who continue to hold managerial positions with the acquired business.  As it becomes less likely that earnout targets will be met organically, sellers in managerial positions at the acquired business may be more tempted to take short-term measures to boost the achievement of earnout targets that are calculated in the near-term.  Buyers will want to keep an eye on this.

Indemnification; Representation and Warranty Claims

Another potential “re-pricing” risk is the buyer’s right to indemnification for breaches of the seller’s representations and warranties (R&Ws). To recapture value in these uncertain times, buyers may be motivated to more aggressively pursue claims that they may not have otherwise pursued under normal conditions. Sellers may also be incentivized to defend against indemnification claims more vigorously to prevent value erosion. As COVID-19-related indemnification claims begin to emerge, we expect that the R&Ws most likely to serve as a basis for such claims would include those relating to collectability of accounts receivable and appropriateness of bad debt reserves, quality of inventory, financial statements and financial controls, relationships with material customers and suppliers, compliance with material contracts, business continuity and (as incidences of cyberattacks rise in the wake of the pandemic) adequacy of cybersecurity measures. For deals that have already closed, the risk of R&W indemnification claims is likely more pronounced where the transaction was signed before the effect of COVID-19 was felt by the market but was closed afterwards.

Practical guidance regarding such indemnification claims is straightforward and self-evident but bears discussion:

  • Be prepared. Buyers and sellers should identify potential pressure points in the R&Ws in advance and understand how those R&Ws work, including any applicable time windows, materiality and knowledge qualifiers, and whether any of the R&Ws in question are susceptible to a breach for an event arising after signing and/or closing. Sellers should proactively arm themselves with the applicable contractual provisions and underlying facts to strongly rebut opportunistic claims when and as asserted.
  • Follow the terms of the purchase agreement and monitor counterparties’ compliance with the same. Notices should be delivered timely using the procedures outlined in the purchase agreement. Claims and objections to those claims should be outlined as clearly as possible with as much supporting information as possible.

* * *

If you wish to receive regular updates on the range of the complex issues confronting businesses in the face of the novel coronavirus, please subscribe to our COVID-19 “Special Interest” mailing list.

And for any legal questions related to this pandemic, please contact the authors of this Legal Update or Mayer Brown’s COVID-19 Core Response Team at

1 PSAs also frequently include adjustments for closing cash and closing indebtedness, but these adjustments are more straightforward and typically do not involve judgmental accounting issues.

2 Accounting Standards Codification (ASC) 855-10, Subsequent Events, distinguishes between a Type 1 subsequent event, which requires modification of the financial statements balances, and a Type 2 subsequent event, which only requires footnote disclosure of the potential impact but no change to the financial statement balances.  The basic analysis is whether the “new” information related to an event that had occurred prior to the balance sheet date (a “Type 1” subsequent event) or related to an event that occurred after the balance sheet date (a “Type 2” subsequent event).  Needless to say, there are gray areas.

3 There can, of course, be potential impacts going in the other direction.  For example, if the acquired company had to furlough workers prior to the closing date, current liabilities (e.g., accrued payroll) may be reduced. The PSA, however, may limit the ability of the acquired company to make such business changes without the buyer’s consent.