Buyer beware: Emerging transaction risks and how to mitigate them

While the COVID-19 pandemic has contributed to an uncertain and unpredictable environment since the outbreak took centre stage from early 2020, a raft of other risks for businesses have developed (or become more concrete) in the last few years.

Now when considering acquisitions, the scope of risk has broadened to include changes and reform in the following areas:

In this first iteration of our Prosilience newsletter – which aims to look at how organisations can thrive from challenges –  our M&A, Corporate Regulatory, Warranty and Indemnity, and Health, Safety & Environment experts discuss key risks that businesses need to consider when making acquisitions.

Underpayment of Employees and Wage theft

Over the last five years, large and historic liabilities in organisations for the underpayment of employee entitlements have surfaced with intense scrutiny by regulators and the media. By way of recent examples:

• on 14 July 2021, it was reported that a Wage Inspectorate Victoria investigation uncovered more than 4 000 employees which had been underpaid hundreds of thousands of dollars in long service leave;
• during 2019, a large retailer admitted to the Fair Work Ombudsman (FWO) that it was not fully compliant with the general retail industry award and had underpaid approximately 6 000 of its employees, allegedly totalling AUD1.17 million between March 2018 and March 2019; and
• Dinner by Heston, which liquidated in early 2020, did so with an alleged underpayment liability of more than AUD4.5m.

Given the increasing regulatory focus on practices leading to underpayments, purchasers in the last five years have often reassessed their own payment structures and practices, as well as the target’s historic structures and practices. This appears to have led to a substantial increase over the last few years in warranty and indemnity (W&I) claims arising from historic underpayment of employees, where such insurance was acquired for the transaction. According to the fourth annual edition of AIG’s M&A Claims Intelligence Series, there have been claims submitted under 1 in 5 W&I policies globally,  and claims being submitted under 1 in 6 W&I policies in Australia.¹ Operations related and employee-related breaches made up just 13% of notifications, but account for 26% of large claims in the Asia-Pacific region.²

In addition to the renewed vigour shown by regulators with regards to underpayments, on 1 July 2021 the Wage Theft Act 2020 (Vic) came into effect, making it a crime for an employer to deliberately underpay employees, to dishonestly withhold employee entitlements, or to fail to keep proper records of employee entitlements in order to gain a financial advantage. This may indicate a trend to criminalise the practice of purposeful underpayment with substantial penalties on those found guilty.

Given the insidious nature of underpayment, we expect that discovery of historic underpayment practices is likely to continue for some time. To future proof businesses, we recommend that purchasers (or warranty and indemnity insurers underwriting an acquisition) consider a deep dive into the historic employment practices of the target to mitigate the risk of an unexpected underpayment liability being discovered after the fact.

Climate Risk

It is now widely accepted that Australian law requires any material exposure to climate change risks be incorporated into the various financial disclosures mandated by the Corporations Act 2001 (Cth) (Corporations Act), particularly in directors’ reports (s 299 and s 299A(1)), annual financial reports (s 295) and continuous disclosure obligations (s 674).

Relevantly, directors’ reports must include, for example, developments in the entity’s operations in future financial years (s 299(1)(e)) and contain information reasonably required for members to make an informed assessment of the entity’s business strategies and prospects for future financial years (s299(A)(1)(c)).

ASIC specifically requires climate-related disclosures to be included in a company’s operating and financial review under section 299A(1)(c) of the Corporations Act where climate risk is a material issue that affects the company’s achievement of its financial performance. Even where a company forms the view that climate risk is of no present material impact, increasing expectations from regulators might necessitate an explanation of these decisions.³ 

In New Zealand, a mandatory climate-related disclosure regime is proposed.  Disclosures under the proposed regime will apply to most issuers as well as large registered banks and licensed insurers.  These disclosures will be required to be made in accordance with prescribed climate standards that have been modelled in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).⁴ While TCFD is not mandated in Australia yet, many businesses are already adopting this framework as a way of identifying, assessing and managing their climate risk.

There have also been a number of legal opinions issued between 2016 and 2021 by Noel Hutley SC & Sebastian Hartford Davis that examine the potential liability of directors for the failure to comply with their duties under the Corporations Act if they fail to account for and act on climate risks. In the Centre for Policy Development's Business Roundtable on Climate and Sustainability on 21 November 2019, the Hon Kenneth Hayne AC QC (former High Court judge and Royal Commissioner) stated that a director acting in the best interests of the company must take account of, and act on, climate change risk, and that the board must report publicly on climate-related risks and issues relevant to the entity.⁵

Where directors fail to do so, it is becoming increasingly apparent that they may be open to personal liability under section 180 (Duty to act with reasonable care and diligence) and section 181 (Duty to act in good faith in the best interests of the company and for proper purposes) of the Corporations Act.⁶ There is also an increasing risk that businesses may become susceptible to actions by third parties if they fail to properly consider climate risks of the business and climate impacts of their activities more broadly.⁷

Anti-bribery and Corruption

The omnibus Crimes Legislation Amendment (Combatting Corporate Crime) Bill 2019 (Crimes Amendment Bill) is still slowly making its way through the Australian Parliament and is currently before the Senate. The Crimes Amendment Bill will introduce amendments to Australia’s foreign bribery offences, introduce deferred prosecution agreements into Australia and replace the existing dishonesty definition in the Criminal Code. An earlier iteration of the Crimes Amendment Bill lapsed when Parliament was dissolved in May 2019.

In relation to foreign bribery offences, the Crimes Amendment Bill will change the scope of the offence by expanding the definition of foreign public official and applying the offence where a personal advantage is sought (in addition to a business advantage). There will also be a new corporate offence of failing to prevent foreign bribery which can be defended by demonstrating that the company had adequate procedures in place to prevent bribery of foreign public officials by associates.

If the Bill is passed, then in an acquisition context, purchasers will need to consider the risks of historical acts or indicators of bribery and corruption, as part of overall due diligence into the target. This is especially so when considering acquisitions in sectors such as oil and gas, and other extractive industries which often carry a higher potential exposure to bribery and corruption, given the involvement of government officials in licensing processes.⁸

Australian regulators continue to investigate allegations of foreign bribery, and work with foreign law enforcement towards prosecutions across jurisdictions.⁹ For example, the AFP is continuing its investigation into allegations that an Australian-based commercial contractor funnelled bribes through entities associated with Iyer-associated companies and Unaoil to guarantee approvals for the Iraq Crude Oil Export contracts. The changes to foreign bribery offences will likely lead to further prosecutions given the new offence of “failure to prevent” bribery.

Changes to the Foreign Investment Regime

From 1 January 2021, new laws making significant changes to Australia's foreign investment laws (the so-called FIRB regime) came into effect.¹⁰

One of the changes introduced into the FIRB regime is an additional mandatory FIRB approval requirement in respect of ‘notifiable national security actions’ by foreign persons. Such actions include the following:

• starting a ‘national security business’;
• acquiring a ’direct interest’ (usually 10% or more) in a ‘national security business’ or in an entity that carries on a ‘national security business’; and
• acquiring an interest in ‘national security land’.

Generally, a ‘national security business’ is a business which is involved in or connected with a ‘critical infrastructure asset’, telecommunications, defence or a national intelligence community (of either Australia or a foreign country), or their supply chains. A ‘critical infrastructure asset’ in turn has the meaning given in the Security of Critical Infrastructure Act 2018 (Cth) (SOCI Act) which on its current terms cover critical assets in the electricity, gas, water and ports sectors.

The SOCI Act has been proposed to be amended in accordance with the Security Legislation Amendment (Critical Infrastructure) Bill (the Bill) introduced into Parliament on 10 December 2020. Amongst other significant changes introduced by the Bill, we see an expanded definition of critical infrastructure sector’, broadening the application of the SOCI Act to 11 classes of critical infrastructure, including:

One of the consequences of the above changes will be to broaden the categories of assets and businesses which are regarded as a national security business under the FIRB regime, with the effect that businesses engaged in those sectors (such as oil or transport sectors which may not have previously been caught by the amendments to the FIRB regime), and which are foreign persons for the purposes of the FIRB regime, should consider whether any acquisitions, expansions of operations, or new ventures which they are undertaking have been caught by any existing FIRB approvals or exemptions which they may have obtained, or whether additional approvals are required.

In our experience, applications for FIRB approval are currently taking in the region of 4 to 6 months from submission of a complete application to approval. Therefore, we would recommend that businesses factor in this potential delay and additional process into actions which may now be caught by the extensions to the FIRB regime