The art of due diligence amidst the COVID-19 pandemic
The current disrupted environment adds unique complexities for due diligence, with key tax and legal considerations for buyers and sellers.
Akin to critiquing an art piece, due diligence helps to reveal subtle details that are at times hidden under glossy veneers. By masterfully extracting important information and understanding the history behind the numbers, significant risks and exposures can be uncovered. We discuss key tax and legal due diligence considerations against the backdrop of the COVID-19 pandemic.
How COVID-19 disruption affects due diligence
The International Monetary Fund estimates that as at 12 June 2020, total fiscal support by governments globally in response to the COVID-19 pandemic stood at nearly US$11 trillion. This comprised direct budget support estimated at US$5.4 trillion and the remaining US$5.4 trillion relating to additional public sector loans, equity injections and guarantees. This means that governments would need to rebuild depleted coffers in post-COVID-19 recovery, signalling possible heightened scrutiny by tax authorities and a potential increase in tax controversies in the months and years ahead.
Due diligence into the target company is a critical first step in ascertaining the key issues that the company faces in the lead-up to the closing of the transaction. It also sheds light on whether and how the management have sought to mitigate the risks identified.
In due diligence undertaken during the COVID-19 pandemic, buyers and sellers should align their review focus, constantly readjust and adapt to the current disrupted environment, and manage their expectations in deal negotiation. Parties may need to adopt a flexible approach, such as structuring the deal perimeter to exclude certain entities in the group should these pose a higher risk to the buyer due to unknown tax liabilities or to even consider an asset deal (as opposed to a share deal) to eliminate taking on historical tax risks linked to the company.
With regard to legal due diligence, there may be specific areas of focus that have now become more critical due to heightened risks arising from the pandemic and consequent economic stress. These may include business continuity, force majeure and termination provisions in key supplier and customer contracts, compliance with covenants in financing documents, and issues related to workforce restructuring. As such, an extended exclusivity period may be required to allow for a more thorough review and due diligence of the target company to understand its financial health and business vulnerabilities going forward, and also to take into account the impact of travel restrictions, work from home arrangements, and requisite regulatory and governmental approvals and clarifications, in getting the deal across the line.
Scoping the due diligence process
Prior to putting paint to canvas, planning the masterpiece is crucial. Similarly, proper scoping of the due diligence is imperative, especially when it is conducted in a fast-paced deal environment with limited resources, as is often the case. The COVID-19 crisis has highlighted priority areas for due diligence and alleviated the need for others.
Often, the scope of the due diligence process is buttressed by a review of in-house functions from the compliance and planning perspectives. This is even more so in the current climate. Has the COVID-19 business environment revealed control weaknesses such as the inability to retrieve key documents such that filing deadlines have not been met? Are the tax and legal functions included in cross-functional COVID-19 strategy planning? Answers to these questions not only provide the buyer with deeper insights into the target group’s COVID-19 impact analysis, it also aids in the buyer’s post-acquisition integration plans.
Another area expected to become a focal point concerns employment-related matters. The unplanned presence of employees due to country border closures could trigger employment-related tax filings, immigration issues and other regulatory considerations, which the target company may not be aware of, resulting in associated risks. If the target group has downsized its workforce, it would be prudent to check that it has complied with relevant employment laws and guidelines on redundancies and retrenchments.
In Singapore, the Jobs Support Scheme – a cash grant automatically computed based on mandatory Central Provident Fund (CPF) contribution data – provides support for eligible employers during this challenging period of economic uncertainty. The Inland Revenue Authority of Singapore (IRAS) has reminded employers to contribute the right amount to bona fide employees based on the actual wages paid. Any abuse may result in stiff action such as imprisonment and fines. The IRAS has established a dedicated team to prevent and combat tax abuses and also leverages data from multiple sources to detect such abuses. Potential buyers may wish to include a CPF review in the due diligence scope or alternatively, undertake a health check promptly after acquisition to ensure there is compliance.
Tipping the balance in negotiation power
It is often at deal documentation and combing through the finer commercial terms that the details identified during the course of the due diligence are appreciated. Depending on the issues raised, it may affect the dynamics between the buyer and the seller.
The target’s compliance gaps and business disruptions within the sector could give the buyer an edge in negotiating for stronger deal terms. Lower valuation, alternative payment methods, enhanced representations and warranties, and increasing the scope of material adverse change and force majeure clauses in the legal documentation are some of the means that buyers use to leverage their position during this pandemic, cushioning them against uncertainties in this crisis.
On the other hand, a target with stable growth forecast, bolstered by healthy cash flow and a reliable supply chain despite the current uncertain economic conditions, reinforces the viability of the business and its ability to emerge stronger from this crisis. Sellers divesting an attractive target like this would be able to negotiate a more favourable deal, thus maximising returns from their investments. Such sellers may be able to negotiate for materiality and knowledge qualifiers in respect of the representations and warranties given to buyers to reduce the effects of unknown risks resulting from this pandemic.
Therefore, care must be taken in scoping the due diligence process. Due diligence is an essential step in the entire transaction process as it sets the tone for deal negotiation and allows for an open conversation between the buyer and seller with regard to pricing and the allocation of risks in the transaction documents.
Ultimately, the mastery in undertaking due diligence is analogous to that of critiquing art – through skilful and in-depth analysis, the true value proposition of the underlying transaction asset is uncovered.
The co-authors of this article are Sandie Wun, International Tax and Transaction Services Partner, Ernst & Young Solutions LLP, and Wan Hong Chan, Director, Atlas Asia Law Corporation (independent member firm of the global EY network). Wan Hong provided the legal input for this article.