Insurance M&A and the Impact of
COVID-19

Material Adverse Effect Provisions and COVID-19

Parties should revisit exclusions to the definition of “Material Adverse Effect” in light of the potential impact of COVID-19 on target businesses.

• M&A agreements usually include provisions entitling an acquirer not to close the transaction if the target suffers a “material adverse effect” (MAE) after signing. 
• The MAE definition will generally list exclusions, the effects of which are to be disregarded for purposes of determining whether an MAE has occurred, except to the extent those effects have a disproportionate impact on the target relative to other companies in the target’s industry. 
• Such exclusions typically include, among other things, the effects of: changes in general economic or market conditions; changes in law; changes in global or national political conditions; natural disasters, acts of terrorism and war; and other force majeure or “act of god” events.
• These exclusions are broadly intended to place the risk of such effects (which are outside the control of the seller) on the buyer.
• In pre-COVID-19 insurance deals, the effects of pandemics and other health emergencies were sometimes, but not invariably, included in the list of exclusions.
• In the post-COVID-19 world, M&A practice has seen an uptick in the use of explicit MAE carve-outs for pandemics, epidemics and similar disease outbreaks, and a number of publicly announced insurance deals have included COVID 19-specific language. For example: 
  • In the Share Purchase Agreement governing Prudential Financial’ s recent agreement to sell its life insurance business in Korea, the MAE definition excludes any fact, change, effect, event or occurrence arising or resulting from any “epidemic, pandemic or other similar outbreak (including the COVID-19 virus) or other force majeure event or material worsening of such matters” in existence as of signing, except “to the extent such fact, change, effect, event or occurrence adversely affects the [target], taken as a whole, in a disproportionate manner relative to the other participants in the industry in which the [target] operates.”
  • In the Business Combination Agreement governing the Willis Towers Watson-Aon transaction, the MAE definition excludes effects arising out of changes in “global health conditions (including any epidemic, pandemic, or disease outbreak (including the COVID-19 virus)) or other force majeure events, including any material worsening of such conditions threatened or existing” as of signing to the extent such effects “do not disproportionately impact [the target] relative to other companies operating in the industry or industries in which [the target] operates…”
• Prevailing market practice (both before and after the COVID-19 outbreak) has been to disregard force majeure (including pandemic) exclusions to the extent the relevant event disproportionately affects the target relative to other industry participants. 
• The “disproportionate impact” exception to the MAE exclusions may pose particular challenges for insurers.
  • To the extent a target is subject to pandemic-related regulatory mandates or guidance from state insurance regulators—or even new state or federal legislation that purports to alter or expand coverage under existing policies—disputes could arise as to the scope of the target’s peer group, if such regulatory and legislative changes affect certain segments of the industry, certain product lines, certain geographic areas / jurisdictions, or specific carriers in a manner that is disproportionate relative to other industry participants.
  • As is generally the case, a buyer will prefer a broader peer group because it should be easier to assert disproportionate impact and rely on the MAE clause; on the other hand, a seller eager to limit closing risk would prefer a narrower comparison group.
• Takeaways
  • Given the many ways in which COVID-19 has affected the national and global economy and the manner in which insurance companies conduct their business, some of the more general, non-pandemic-related exclusions from the MAE definition may be available to sellers seeking to counter a claim that an MAE has occurred. The applicability of exclusions that do not expressly refer to pandemics may, however, be open to question.
  • To limit closing risk and uncertainty as to how the effects of COVID-19 should be treated for purposes of the MAE definition, sellers should consider including a specific exclusion for pandemics, epidemics and similar health emergencies in general, and COVID-19 in particular.
    • Note, though, that even if the effects of COVID-19 on the financial condition of a target do not constitute an MAE (and therefore do not provide the buyer with a termination right), they may nevertheless result in a reduction in the purchase price, given that insurance M&A transactions frequently provide for a balance sheet–based purchase price adjustment.
  • Specific attention should be paid to the “disproportionate impact” exception. COVID-19 has affected many sectors of the national and global economy, and parties should consider the extent to which the exception should be tailored to more specific industry segments and geographical locations. 

Interim Operating Covenants – Ordinary Operation in Extraordinary Times?

COVID-19 requires practitioners to think about how compliance with the typical pre-closing obligation to operate the target business “in the ordinary course of business” should be measured, and whether drafting refinements to accommodate the new circumstances are needed. 

• Interim operating covenants (IOCs) generally require that, prior to closing, the target operate in the ordinary course of business, and that the target’s existing business organization, services of employees and relationships with customers, suppliers and other stakeholders be maintained. For these purposes, “ordinary course of business” frequently is defined to mean (or has appended to it the additional phrase) “consistent with past practice”.
• IOCs also prohibit the target from engaging in specific activities without the buyer’s consent, but in some cases subject to the exception that the target may do so if the activity is undertaken in the ordinary course of business. Examples include incurrence of debt, compromise of material claims, capital expenditures and changes to employee benefit plans.
• The failure of a target to comply with IOCs could expose the seller to post-closing damages claims or entitle a buyer to terminate the acquisition agreement prior to closing.
  • The widely publicized dispute between the private equity firm Sycamore Partners and L. Brands, parent company of the Victoria’s Secret lingerie business, is a case in point.  Sycamore sought to terminate its $525 million deal to acquire a majority stake in Victoria’s Secret, on the basis that the target breached its IOCs when it closed stores and furloughed employees in response to COVID-19.  Within two weeks of both buyer and seller filing complaints in the Delaware Court of Chancery, the parties agreed to terminate the transaction.
• For pending deals signed prior to the outbreak of COVID-19, buyers and sellers must determine whether actions taken in response to COVID-19 breach the “ordinary course” requirements, including whether such actions are “consistent with past practice”.
  • Parties will need to consider whether certain extraordinary COVID-19–related actions taken without the buyer’s consent that were intended to protect employee safety and/or the long term viability of the target business (e.g., stay-at-home and other social distancing measures, office closures, borrowing activities and layoffs) were permitted.
  • In part, the analysis will depend on whether there are exceptions to the ordinary course covenants (e.g., one that permits a target to take any action required by applicable law), and on whether the obligation is absolute or qualified (e.g., the target need only use “commercially reasonable efforts” to operate in the ordinary course of business). 
  • The parties should also consider the extent to which actions taken in response to COVID-19 are consistent with a target’s business continuity or disaster recovery plans. Conformity with such plans would strengthen a seller’s argument that such actions do not breach IOCs. 
• COVID-19 may pose unique challenges for the insurance industry in this regard. 
  • Buyers and sellers must carefully analyze the scope and implications of any IOC exception for actions taken in connection with changes in applicable law.
    • As discussed below, state departments of insurance have published extensive directives, guidance and recommendations relating to COVID-19, some of which require specific actions on the part of insurers. 
    • But insurers may also be inclined to take certain actions not explicitly prescribed by such regulation, perhaps to avoid reputational harm or because they are requested to do so by a regulator.
    • Sellers and buyers may disagree on what precisely is “required” by changes in applicable law or regulation.
    • Another important consideration in this regard is whether informal guidance or directives issued by a governmental authority are included in the definition of “Law” or “Applicable Law”.
  • The various social distancing, stay-at-home, shutdown, quarantine and related guidance and orders issued by federal, state and local governments (COVID-19 Guidance) may complicate underwriting practices (e.g., life insurers’ practice of relying on in-person medical underwriting) and claims management functions, especially in an environment that could see a surge in claims.
  • Insurers may need to adapt their investment management strategies to deal with the market effects of COVID-19.
• Takeaways
  • For deals currently being negotiated, sellers should consider including an express exception to interim operating limitations that permits the target to take actions in response to COVID-19 Guidance without being deemed to have run afoul of IOCs.  
  • Another approach is to address with explicit language the interpretation of the term “ordinary course of business” in light of the COVID-19 pandemic. For example: 
    • defining “ordinary course of business” to mean any action taken by the target that is consistent with the target’s past practice, but subject to changes made by the target that are commercially reasonable in light of then-current operating conditions and developments as a result of the COVID-19 outbreak and related economic conditions and regulation.
  • Buyers that are amenable to these constructs in principle, but reluctant to cede excessive autonomy to the target, should consider qualifications such as limiting these exceptions to actions that are required to comply with COVID-19 Guidance, requiring that the actions in question be commercially reasonable and/or generally consistent with those taken by the target’s peer companies, or requiring that any post-signing actions in this regard be taken only after reasonable consultation with the buyer (and that any such actions taken prior to signing be disclosed).

Changes to the Due Diligence Process

Parties currently exploring insurance M&A deals should anticipate changes to the substance and process of due diligence. 

• Buyers will need to understand, among other things:
  • The nature and impact of measures taken by target companies in response to COVID-19 and related COVID-19 Guidance;
  • The impact of the pandemic (and resulting disruption to financial markets) on investment performance and capital adequacy;
  • The impact of pandemic-related regulatory mandates, such as retroactive or expanded coverage for losses related to COVID-19, deferral of premiums, premium payment grace periods, refunding of premiums (which some carriers have undertaken on their own initiative) and special enrollment periods;
  • The scope of coverage for pandemic-related losses under certain policies, including the formulation and validity of pandemic-related policy exclusions;
  • Whether claims volume has increased, particularly under policies for health, disability, life, event cancellation, business interruption, travel or workers’ compensation insurance;
  • The extent to which the target’s product distribution network and underwriting practices have been disrupted by the pandemic and COVID-19 Guidance;
  • The impact of the general economic slowdown on overall sales, cancellations, lapses and premium volume;
  • The availability of reinsurance for COVID-19-related claims and the potential difference between the target insurer’s payment obligations to policyholders and what the target’s reinsurance may cover, whether due to ex gratia payments made by the target insurer or because there are gaps in coverage between what the target’s products cover and what the target’s reinsurance covers;
  • Whether the target has implemented or plans to implement modifications to claims procedures, such as increased reliance on photographs and videos taken by insureds in lieu of on-site examinations;
  • The target’s business continuity plans, the ability of the target’s IT systems to accommodate prolonged work-from-home arrangements, disruptions to supply chains and other operational changes prompted by COVID-19; and
  • Force majeure provisions, termination rights, restrictions on performance, covenants requiring that the target exert a level of effort (e.g., reasonable best efforts) or act in a manner consistent with past practice, insurance coverages and performance milestones and metrics in the target’s material contracts.
• Buyers and sellers will need to be alert to the potential for increased scrutiny by insurance regulators, who we anticipate will use enterprise risk management (ERM) reporting, own risk and solvency assessment (ORSA) and other regulatory mechanisms (including more frequent market conduct examinations) to evaluate insurers’ management of the pandemic’s effect on operations and overall capital adequacy. In this regard, buyers will wish to confirm that the target’s senior management and board are appropriately evaluating and addressing the direct and indirect risks created by the current pandemic, especially given this potential enhanced scrutiny from insurance regulators.
• While the impact of COVID-19 raises new issues that could expand the scope of due diligence, buyers and sellers should be prepared for practical challenges:
  • It may be more difficult for sellers to populate datarooms and respond to diligence questions if relevant employees are working remotely and have limited access to company records.  
  • Buyers and sellers alike may be frustrated by the need to conduct due diligence remotely and by the absence of in-person management presentations.

Representations and Warranties in an Era of Change

The fallout from the COVID-19 pandemic may affect the continuing accuracy of representations and warranties that are to be “brought down” to closing for purposes of both closing conditions and post-closing risk sharing.

• In the case of pending deals that were signed prior to the outbreak, representations and warranties that were accurate at signing may have become inaccurate as a result of changes in the target’s performance and operations as a result of COVID-19.
  • This could affect sellers’ liability to buyers after closing for breaches of representations and warranties, and, if the inaccuracies are sufficiently material, could also raise the specter of unsatisfied closing conditions.
• Customary representations and warranties that may be affected by COVID-19 include those as to:
  • absence of undisclosed liabilities;
  • capital adequacy;
  • compliance with law;
  • compliance with material contracts and status of commercial relationships;
  • indebtedness;
  • employee matters (including as to layoffs); and
  • data security, privacy and HIPAA compliance (especially if the target’s employees have transitioned to remote work arrangements).
• Takeaways
  • Going forward, parties should reconsider the appropriate allocation of risk of changes in facts and circumstances between signing and closing in light of the uncertainties imposed by the COVID-19 pandemic and the potential impact of COVID-19 on the target company’s business and operations. In particular:
    • COVID-19 underscores the need for buyers and sellers to pay close attention to the allocation of the risk of facts and circumstances that arise after signing, and in particular, which representations and warranties should be restated at closing and which should speak only as of the signing date (thus shifting to the buyer the risk of such post-signing changes).
    • Parties should consider whether and to what extent post-signing actions taken by the target in response to COVID-19, or effects on the target business resulting from COVID-19, should be considered or expressly disregarded for purposes of determining whether a representation or warranty that was accurate at signing is accurate at closing.
  • Parties should also keep in mind that COVID-19 exclusions have become standard in representation and warranty insurance policies (although some carriers may be willing to narrow such exclusions on a case-by-case basis). For a more detailed discussion of the implications of COVID-19 on representation and warranty insurance, click here.

Regulatory Considerations

The insurance regulatory review process is likely to be affected by the COVID-19 pandemic.

• It would be prudent for parties to anticipate and prepare for COVID-19¬–related delays in obtaining transaction approvals from state departments of insurance (DOIs), which are likely to be resource-constrained as a result of COVID-19. 
• Remote work arrangements may complicate some longstanding practices of DOIs in reviewing requests for approval. 
  • For example, some DOIs have historically required fingerprints or aspects of change of control (Form A) applications to be submitted and reviewed by staff on paper (e.g., biographical affidavits). 
  • Remote work arrangements complicate the review of documents mailed to state offices and the scheduling and conduct of hearings in states where they are required. 
• DOIs are mindful that COVID-19 poses unique challenges for applicants, and have taken steps to accommodate some of those challenges (e.g., by making exceptions to wet signature and notarization requirements for certain filings). 
• In the context of COVID-19, DOIs may have imperatives that take priority over change of control filings.
  • As Sidley has reported (click here), DOIs have been very active in responding to COVID-19.
  • Nearly all DOIs have issued guidance in the areas of telehealth, consumer outreach, cancellation / non-renewal of policies, premium payment grace periods, special enrollment periods, prescription refills and cost-sharing (co-pays, deductibles and co-insurance).
• Antitrust review processes may also be subject to delays, or early termination may be unavailable.
• CFIUS is still accepting, reviewing and approving filings but the review process may be subject to delay.
  • New CFIUS regulations expand the scope of transactions subject to CFIUS review to include insurance transactions in which “sensitive personal data” may become available to foreign persons.
    • These regulations (implementing the Foreign Investment Risk Review Modernization Act of 2018) took effect on February 13, 2020.
• Takeaways
  • Parties currently negotiating an M&A agreement should consider addressing the prospect of delays in receiving regulatory approvals.
  • These provisions could include simply specifying a period between signing and the outside date that is longer than has been the pre-COVID-19 custom, or including more detailed extension / tolling mechanics that are expressly linked to COVID-19-related delays.
  • Parties could adapt the extension / tolling provisions included in some agreements signed during the Federal government shutdown in early 2019. For example, parties could consider language that:
    • defers the outside termination date to a later date if COVID-19 prevents or delays any required regulatory review; or
    • defers the outside termination date by an additional period of days after the occurrence of certain pandemic-related milestones to be specified in the agreement, such as the lifting of all stay-at-home or similar orders issued by the jurisdiction in which the target’s principal place of business operates.