The White & Case Capital Markets team takes underwriters through some of the considerations when launching and closing deals in the current environment.
Due diligence and disclosure
Due diligence is an essential transaction process by which underwriters manage their legal and reputational risk. Underwriters must now consider both procedural and substantive issues.
Conducting virtual due diligence
Typically, site visits and in-person meetings—in particular for sub-investment grade or infrequent issuers and/or in emerging markets transactions where governance standards are perceived as less developed—have been a bedrock for underwriters conducting diligence. Governmental restrictions on non-essential travel currently make it difficult or impossible to travel to meetings. Even once home-country legal restrictions are lifted, foreign visiting restrictions or quarantine measures may continue, flight schedules may remain disrupted, or deal participants may simply be reluctant or unable to travel.
To date, there has been no real substitute for the ability of deal participants (if not always all parties, at least the lead underwriters in any transaction) to meet with the issuer’s senior management and inspect its facilities. This leads to a range of questions about how to satisfactorily complete due diligence for deals coming to market in the coming months. Specifically, how should underwriters approach an inaugural issuance for a client none of the deal participants has ever met or visited to observe operations? What about a repeat issue? We expect there is a spectrum as to how comfortable deal participants will be proceeding solely on the basis of virtual diligence meetings depending on the circumstances. This is not necessarily inconsistent with past practice; any diligence process is case-specific. For example, where underwriters have done past work for a repeat issuer and maintained a continuing relationship with that issuer, there will likely be less cause for concern than in situations involving a debut issuer that deal participants have not interacted with previously. The latter will potentially require enhanced procedures.
While it will always be deal and fact specific, where underwriters have an existing relationship with a company (through the deal team or institutionally), it should be possible to substitute virtual due diligence for in-person meetings, provided the lines of communication are clear and all questions are appropriately addressed. However, it will be particularly important for diligence participants to be “present” throughout the meetings. Given the physical disconnect, there is a real risk that items may not be fully covered and issues or questions not fully addressed, and so while virtual due diligence can work, it is incumbent on participants to fully engage in the process. Participants should ensure accurate attendee details are taken for future reference.
Where underwriters have no preexisting relationship with a company and, for instance, have not visited its operating facilities, conducting due diligence solely by virtual means will be more challenging, as being able to personally inspect the operations and meet the management team in their offices is an important part of a fulsome diligence process. This does not mean that virtual due diligence cannot happen in the current environment, but these complicating factors should be taken into account when considering relying only on virtual meetings. The increased risks associated with bringing a debut client to market may increase scrutiny from credit committees when obtaining internal approvals as they are likely to weigh the use of virtual diligence when assessing transactional and reputational risk compared to a more typical diligence process in the execution of a transaction.
Once the crisis is over, some of these COVID-19-related protocols may find their way into normal diligence practices as market participants adapt to a “new normal” where physical attendance is not universal on all transactions and there may be an increased push to limit physical meetings due to the benefits of reduced travel and proven ease of communication. However, any such practices (if adopted) must be weighed against the challenges that not holding in-person meetings can present, particularly in higher-risk transactions.
What should the disclosure document say about COVID-19?
In this environment, underwriters should take particular care to help establish processes to ensure that the issuer’s disclosure accurately and completely discloses the impact of the COVID-19 outbreak. As this is a constantly changing landscape and has a material impact on virtually all companies globally, this disclosure should be constantly monitored for updates ahead of launch and during the offering process. This is particularly important given that many companies will have only felt the impact of COVID-19 toward the end of Q1 2020. Therefore, including first quarter financials is unlikely to be the end of the disclosure. Additional due diligence and disclosure should be considered given the post-reporting period impact.
Toward this end, the US SEC posted a series of questions intended to help companies assess COVID-19-related effects. Issues to address with the company (and, if material, ensure are disclosed in the offering materials) include: (i) any impact on the supply chain; (ii) any impacts on counterparties, including customers, suppliers, distributors, debtors and business partners; (iii) any exposure to countries or regions particularly impacted by COVID-19; (iv) any contingency plans in response to outbreaks and impact on internal controls; (v) (if applicable) any actions taken by ratings agencies; and (vi) any other impact of COVID-19, or the reaction to it (including government economic packages or support), on operations. In addition, underwriters should address with the company whether it has contingency plans for subsequent waves of COVID-19 and whether it will incur any costs related to changes to its operations or facilities in response to these contingency plans.
Financial statements provided in the appropriate timeframe with a corresponding auditor review or audit are, of course, key to any securities offering.
The effect of COVID-19 on an issuer’s ability to complete its financial statements will vary significantly due to geography, industry and business structure. However, across industries and jurisdictions, COVID-19 has already had at least some immediate practical disruptive effects on issuers’ financial reporting processes and related controls, including those needed to “close the book”—in particular because, in compliance with public health laws, issuers of all varieties are asking their employees to work remotely.
In terms of auditors’ review or audit of financial statements, the Public Company Accounting Oversight Board (PCAOB) shared its concern that the rapid change in both working environments and how issuers conduct their businesses could hinder auditors’ work, for example, by eroding monitoring controls and creating a temptation to tolerate manager override. In response, auditors have been encouraged to require new procedures or to modify previously planned procedures when preparing financial statements. A similar statement was issued by the Committee of European Auditing Oversight Bodies (CEAOB) underscoring that it is the auditors’ responsibility to make sure they can still obtain sufficient and appropriate evidence before issuing audit reports. While the CEAOB and the relevant national competent authorities recognize that COVID-19 has required creative solutions to compensate for health law compliance, the emphasis remains on completing high quality audits even if it “may require additional time, which may impact reporting deadlines,” according to a March 24 CEAOB statement. As a result, any new or modified procedures that auditors require could delay issuers’ audited or reviewed financial statements and consequently postpone any planned issuances.
Going concern issues
COVID-19 has also affected how auditors approach certain previously conventional concepts. For example, given COVID-19’s dramatic effect on economies and businesses, auditors will need to reconsider management’s assessment of a “going concern.” The International Auditing and Assurance Standards Board, in its COVID-19 Staff Alert, cautioned that it may be prudent for auditors to reconsider the appropriateness of using a “going concern” basis to prepare financial statements or even modify auditor reports. The CEAOB also pointed out that uncertainty around the forecasts for economies worldwide as well as increased uncertainty around the outlook for many entities should be considered a challenge to auditors’ previous assessment of a “going concern.” If a “going concern” paragraph—such as an emphasis of matter paragraph or paragraph highlighting a material uncertainty or substantial doubt related to a going concern, is included in the financial statements for an offering of securities—due diligence must be conducted as to that paragraph and the issues giving rise to it addressed prominently in the offering document for the securities offering.
Under ordinary circumstances accountants, in their role as auditors, provide letters for underwriters that support the underwriters’ reasonable basis to believe that there are no material omissions or misstatements in the financial information presented in an offering document. However, as highlighted in the above financial statements section, COVID-19 has had a direct impact on auditors’ ability to follow through with auditing procedures both practically, such as the availability of relevant individuals responsible for the issuer’s management accounts, and substantively, in terms of ordinary procedures as guided by the PCAOB and CEAOB. Thus, obstacles to preparing audited financial statements will carry forward to the preparation of comfort letters.
Given these challenges, some auditors have adopted approaches that limit their ability to provide negative assurance comfort unless the issuer is able to perform additional procedures. The point of these additional procedures would be to analyze the impact of COVID-19 on the issuer’s operations, for example, the impact on revenues, the fair value of investments and, in the case of issuers in certain sectors, such as banks, the impact on the loan portfolio and loan loss provisions. Considering that issuers themselves may be adapting to their own practical COVID-19 related hurdles, complying with these additional procedures may not be realistic and result in underwriters having to consider going ahead without negative assurance or planning for delays in order to receive negative assurance.
As in any offering, these challenges may well create a “red flag” around a company’s financial health. All offer participants will need to consider this as part of the overall transaction processes, including what additional procedures and diligence may be necessary to ensure that the offer document does not make a material misstatement of fact or omit to state a material fact necessary in order to make the statements made, given the circumstances under which they were made, not misleading.
MACs and related ‘outs’ in underwriting agreements
MAC and MAE clauses
A material adverse change (MAC) provision would terminate debt commitments when a MAC occurs. MACs are closely linked to material adverse effect (MAE) clauses, which are generally discussed together here.
A market MAC is often included as a closing condition in underwriting agreements executed in Europe, and representation and warranties in such underwriting agreements are often triggered in the event a MAE changes the circumstances subject to the representation or warranty.
MAC provisions are the obvious way that financial institutions could try to protect themselves from market deterioration when signing debt commitments, for instance for a bridge financing. When relying on a MAC or MAE, the drafting of the relevant provision and what it covers is key.
There are generally three types of MAC: (i) a business MAC relates to an adverse effect on some or all of the business, operations, performance, assets or prospects of the issuer, but common law courts have traditionally set a very high materiality threshold and compelling evidence would be needed that the buyer’s business was in fact materially adversely changed; (ii) a payment MAC relates to the issuer’s ability to pay its obligations under a finance document, but to trigger this limb, the relevant creditors would most probably need to establish that the issuer would be unable to make its payment obligations falling due in the following 12-month period, which, particularly given the uncertainty surrounding COVID-19, may be a difficult threshold for lenders to prove; and (iii) a market MAC, which relates to a MAC in either the debt, equity or capital markets (either international or domestic) or a derivative of those terms, and/or may relate to stock exchanges and/or currencies, and may also extend to issues with syndication. There may be more room for discretion on the banks to call a market MAC condition, given they will have more information than the issuer on syndication conditions.
However, it is rare for MAC clauses to be triggered in practice, particularly given the potentially severe reputational risks involved as well as the relatively short period in which the change must occur. Typically, underwriting agreements are signed at pricing (other than in Reg S only debt offerings where it usually occurs closer to settlement), so the period in which a MAC can occur is very limited. It is important to consider the state of affairs when one entered or enters into an agreement containing a MAC clause. Parties entering into new transactions as COVID-19 spreads must consider this carefully, as whether there has been a MAC to any particular circumstances must reference the circumstances at the time of contract. Thus, it may be more difficult for more recent contracting parties to call a MAC based on COVID-19, though of course it cannot be predicted how circumstances will ultimately end up and what further adverse effects on business may occur.
Other ‘outs’ and drafting considerations
A market MAC is often just one of the termination rights available under an underwriting agreement.
A breach of a representation gives rise to a right to terminate. Underwriting agreements provide that representations repeat on the date of the underwriting agreement and the closing date, and occasionally at other times depending on market practices. Careful consideration must be given to representations that seek to test the financial condition of an issuer since the date of the most recent financial statements. In the current environment, a more forensic financial condition representation specifically addressing points raised in management or auditor diligence (for example, liquidity, revenue falls, growing accounts receivables, third party and/or supply chain issues) may be appropriate to focus a more specific lens on a company’s financial health and prospects. This may prove a more powerful termination tool than a market MAC clause which, by its nature, tests from a high level.
In deal documentation governed by English law, a subscription agreement would typically include a force majeure clause that under certain conditions may give rise to a right to terminate. The International Capital Market Association (ICMA) has considered force majeure clauses in light of COVID-19. As ICMA pointed out, these clauses are rarely (if ever) used to terminate a subscription agreement, but could, in theory, be used as an “out” if a change in financial, political or economic conditions were likely to affect the success of the distribution of the securities.
In addition to such contractual outs, legal doctrines with similar effect, such as impossibility or frustration, may apply by common law, even in the absence of a contractual provision. But such doctrines require such a high standard that, absent an event that would likely have triggered an underwriting agreement MAE/MAC in any event, such doctrines are unlikely to terminate an underwriting agreement.
The ’COVID claw’
Underwriters should also consider whether deal terms should incorporate any innovations, such as flexibility for companies to take on indebtedness through loan programs offered by their governments. Going even further than this, some recent deals have included a new optional redemption right that has colloquially been referred to as the “COVID Claw.” See, for instance, the deal documentation for recent issuances by Cleveland-Cliffs Inc. (CCI) in the US and Merlin Entertainments in Europe. The COVID Claw acts similarly to an “equity claw” feature (an equity claw allows for a lower redemption premium to be paid for any bond redemption funded with equity proceeds, with the logic that the equity offering is a credit-positive event for the bonds). As drafted, until 120 days after the issue date, the company may redeem a certain amount (35% in CCI and 40% in Merlin) of the bonds at a certain premium (103% for CCI and 103.5% for Merlin) with the proceeds of any “regulatory debt” received related to the effect of COVID-19, such as (in the case of Merlin) from the Federal Reserve, the European Central Bank, the Bank of England or other federal or central banks or regulatory agencies. In addition, we expect there will be proposals for relevant calculations of covenant metrics (e.g., EBITDA) to take into account lost revenues during the main period of COVID-19 disruption. This will be relevant for both covenants and marketing presentation of those metrics.
Actually getting signatures is a practical, additional challenge around signing and closing deals. There have been significant technological innovations over the last few years—such as Adobe Acrobat Professional’s built-in Fill & Sign tool or DocuSign’s online service—that facilitate signing documentation electronically. However, it is important to ensure such electronic signatures are enforceable in each applicable jurisdiction. The ease and convenience of this type of technology makes it likely to remain relevant in a post-COVID-19 world.
Since the imposition of COVID-19-related public health restrictions across much of the world, many issuers are facing profound challenges. We have highlighted some of the specific impacts on underwriters trying to foster and renew economic activity despite unusual circumstances that challenge conventional deal mechanics. Anchored by new technologies and creative approaches—such as virtual due diligence, increased use of video calls, and innovations in terms and conditions of notes—capital markets deal execution should still be possible. While delays and challenges will persist, it remains possible to navigate these complex challenges while maintaining disclosure standards and adequately managing risk.