Impact of Brexit on Private M&A deal structure

• United Kingdom

• Brexit
• Corporate
• Mergers and acquisitions

12-07-2017

While businesses continue to operate in an uncertain economic and trading environment waiting to see what Brexit deal will be negotiated, businesses must seek to understand and address Brexit risks head-on.

A clear strategy around managing Brexit-risks in private M&A will be key to making the most of opportunities that arise and ensuring successful post-acquisition integration.

Due Diligence

Set out below are some of the key areas that require greater focus during due diligence as a result of Brexit:

• employment – the buyer should audit the workforce of the target business to determine whether certain areas of the business rely on EEA nationals working in the UK, or UK nationals working in the EEA. If changes to the immigration framework are implemented as a result of Brexit, it is important for buyers to understand the potential impact on a target’s business, whether that relates to the existing workforce in situ, or the impact on recruitment for future growth and business expansion.
• trade issues – WTO rules will be the fall-back position if the UK exits the EU without a free trade agreement. The EU and the UK would then apply duty to goods being imported in accordance with the Most Favoured Nations principle. For example, the EU’s Common External Tariff varies from 0% on cotton, 11.5% on clothing, 25.6% on sugar and confectionery to 45% on certain dairy products. Goods are also subject to non-tariff barriers and businesses may face additional costs of clearing customs and the administrative costs of complying with the EU’s rules of origin. Buyers looking at targets with significant cross-border trade flows between the UK and the EEA will need to understand the likely impact on revenues, but also the customs clearance and other administrative requirements that may result if no free trade agreement is reached. The target may have started scenario planning, so ensuring that this is properly integrated into any Brexit-planning programme the Buyer already has in place will be key.
• material contracts – a target’s key contracts should be reviewed and audited to determine whether the target will have the flexibility to deal with a changing regulatory environment, and importantly to understand whether counterparties are in a position to either revisit terms previously agreed or to terminate the contract as a result of Brexit. In addition, contracts should be reviewed to check whether pricing mechanisms assume no tariffs, quotas or other barriers or assumptions that EU passporting or other authorisations will continue past the Brexit date. We have seen continued volatility in the Sterling as compared to the US dollar, Euro and other currencies since the Brexit vote. Long-term contracts requiring amounts to be paid in other currencies could no longer be profitable for businesses using the Sterling for day-to-day accounting. Contracts will also need to be reviewed to determine whether there are terms that require compliance with a particular EU law that the UK Government may repeal or where regulatory divergence is likely. It may be advisable for the seller to consider renegotiating certain key contracts in advance of a sale process to maximise value.
• intellectual property – certain types of intellectual property rights will be affected by Brexit, and the UK will need to negotiate an agreement with the EU as part of Brexit to ensure that UK rights holders can continue to enforce their IP in the EU. Buyers should complete a full audit of the target’s IP to understand fully what rights reside within the target and whether those rights will be affected by Brexit. This audit will assist with integration planning to determine whether further application or registration will be required in future for maximum protection.
• data protection – the buyer should consider where the target business’s data centre is located and review personal data flows from the EEA to the UK and vice versa. Under EU data protection laws, transfer of personal data is only permitted to countries with an adequate level of protection for EU citizen’s personal data. Post-Brexit, if it is determined that the UK does not meet this adequacy threshold, data flows may be adversely impacted in the absence of putting in place EU model clause contracts or binding corporate rules.
• Licences/passports – the potential loss of passporting or regulatory licences to carry on business is a significant red flag issue and the due diligence should consider what contingency plans the target has in place to address this scenario.
• EU grants/loans – the buyer should diligence whether the target business relies on EU grants or funding, and consider whether that funding will continue to be available post-Brexit.

Transaction Structure and drafting the Sale and Purchase Agreement

In addition to due diligence considerations, businesses will need to give thought to the impact of Brexit on deal structuring and drafting of the transaction documentation.

• Price adjustment and MACs: Parties may wish to negotiate a price adjustment mechanism to deal with any quantifiable risks identified during due diligence and buyers and sellers need to come to an agreement of the appropriate allocation of Brexit-related risks, including considering whether to include a MAC clause for certain Brexit outcomes. A general MAC clause allowing termination for Brexit effects is unlikely to be effective as the English Courts interpret general clauses narrowly. Therefore, careful drafting would be required to capture any specific consequences of Brexit within the definition of a material adverse change.
• Currency volatility: Price adjustment mechanisms, earn-out provisions and payments of deferred consideration are subject to currency risk if volatility of the Sterling continues throughout the payment periods. Parties will need to carefully consider transactions in which completion accounts or earn-out mechanisms are used that recognise earnings, assets or liabilities in other currencies or where a currency translation is required.
• Warranties and indemnities: Parties must also consider whether additional warranty or indemnity cover is required to address Brexit-specific issues uncovered during due diligence. Sale and purchase agreements may include a limitation on the seller’s liability for a breach of warranty caused by changes in law. Whether it is appropriate to single out specific Brexit-triggered changes to the law as a limitation on liability should be considered on a deal by deal basis, taking into account the target’s sector and what specific EU laws and regulations currently apply.
• Post-Brexit obligations: Sale and purchase agreements that contain restrictive covenants or earn-out provisions which extend past the Brexit date must be carefully drafted. Where a restrictive covenant covers jurisdictions within the EU, care must be taken to ensure that geographies are carefully defined. Where an earn-out provision relies on post-Brexit financial metrics, it will be important to conduct a full analysis to determine the Brexit impact on the target business and how this might affect any earn-out.
• Governing law and jurisdiction: We expect to see English law continue as the choice of law for many cross-border M&A transactions as contract law is mostly unaffected by Brexit; however parties may want to consider whether to include arbitration provisions rather than the jurisdiction of English courts for dispute resolution. Currently, European-wide frameworks such as the Recast Brussels Regulation ensure the recognition and enforcement of UK judgments by the courts of all EU Member States, Iceland, Norway and Switzerland. The UK’s unilateral agreement by way of the Repeal Bill to enforce EU Regulations and Directives such as the Recast Brussels Regulation does not automatically confer an obligation on the remaining EU member states to reciprocate following Brexit. Many of the Regulations themselves refer only to EU member states; and the UK will no longer be one. Whilst it is possible that they would elect to reciprocate, they would not be compelled to do so. Choosing arbitral provisions gives parties certainty of the location and choice of law of their disputes; whereas the current framework with the EU for the use of English courts lacks clarity.
• Merger control: While not a consideration for deals completing in advance of the Brexit date, those transactions with a completion date falling after the UK leaves the EU will need to bear in mind potential changes to the merger control framework. Currently under the EU merger control regime, large international mergers involving UK businesses can benefit from the EU’s ‘one stop shop’ review by the Commission if certain worldwide and EU turnover thresholds are met. Brexit could have important effects on such mergers once the EU Merger Regulation ceases to apply in the UK.

First, the EU Merger Regulation ‘one stop shop’ would no longer apply, meaning that UK merger control could apply alongside the EU Merger Regulation. Second, turnover in the UK will no longer count towards the EU Merger Regulation jurisdictional tests. This means that some deals involving businesses with significant UK turnover may no longer meet the turnover thresholds for notification under the EU Merger Regulation; however these transactions may need to be notified under national merger control regimes not only in the UK but also in other EU Member States and, therefore, the net effect for some deals could be to increase the number of filings required.

For other deals which will still qualify under the EU Merger Regulation, it is possible that clearance may be required under the UK regime as well, raising the prospect of parallel proceedings, duplication of legal cost and inconsistent decisions by the Commission and CMA respectively.

Conclusion

Clearly investigating and understanding those areas of a target’s business that can be impacted by Brexit will allow buyers and sellers to allocate Brexit risks between the parties. This is an area not only for due diligence but also for the drafting of the transaction documentation so that unexpected outcomes do not arise post-completion.