The transactional slowdown reported in 2019 has prolonged into 2020, thereby affecting the volume of M&A transactions in Costa Rica, albeit with certain variations. COVID-19 and its resulting economic consequences have certainly contributed to lower levels of deal flow, but the discussion of new regulatory policies and economic recovery factors have also contributed to the overall decline in M&A activity.
However, despite the continued health threat of COVID-19, there have been early signs of recovery in 2021 and a gradual increase in M&A activity for certain sectors.
Notably, there has been an increase in business groups selling off their companies – or partial shareholdings – to pursue the opening of family offices, or to develop local and regional growth with stronger international players. This has been an upward trend since 2020. There is also an expectation that M&A activity involving assets under distress will increase, particularly in the real estate and hospitality industries.
The most common trend in M&A in Costa Rica is industry consolidation with a view to M&A-driven growth
Multinational companies continue to be attracted to highly specialised manufacturing and shared services operations that are channelled through the Costa Rican Free Trade Zone Regime, its robust and skilled work force, a full business continuation record during the pandemic, and the country's extensive network of free trade and tax treaties.
These attributes will be useful to strengthen the country's position as the main platform for penetrating the Central American and Dominican Republic region covered by the Dominican Republic-Central America Free Trade Agreement (CAFTA-DR) with the US. These factors promote and contribute to the increase of M&A activity derived from international transactions that involve these operations.
Almost all M&A transactions concern privately held companies in Costa Rica. The reality of the market is that stock exchanges are incipient and very few companies are listed. Often, one point of connection is when a public company listed abroad gets into an M&A transaction, thereby involving a local subsidiary or branch, which are to a certain extent impacted by regulated market rules. Hence, the local component of the transaction is also subject to said rules.
The most common trend in M&A in Costa Rica is industry consolidation with a view to M&A-driven growth. This has notably been the case in the telecommunications and retail sectors, along with strategic purchases for certain supply chains and facilities for the production and processing of raw materials.
Transaction structures have been subject to corporate reorganisations, in view of updated fiscal regulations, stronger corporate governance and financial considerations, when implementing financial agreements and collateral arrangements.
Private equity (PE) fund activity has increased and this trend is supported by a more open environment among local businessmen and entrepreneurs to sell their businesses to strive to be more competitive through M&A-driven growth. The other types of entities that have become active in the M&A market in the region are family offices or PE funds created by family groups that want to compete for the acquisition of attractive businesses. These family groups have previously sold their own businesses or disinvested out of operations that they acquired in the past as part of diversification strategies. As a result of those sales, they have fresh funds that they are willing to invest in the acquisition of businesses outside their traditional core areas.
The major sources of examination in M&A deals going forward will be the impact that tax reforms will have on deal structuring, along with the recently enacted reform to the antitrust legislation, which strengthened antitrust controls and regulations. The new antitrust rules enable full ex-ante control of M&A transactions by the Anti-Trust Authority (Coprocom). These reforms will have a substantial effect on deal structures and deal implementation. The low approval thresholds for transactions set forth in the law will require that most deals be reviewed and approved by Coprocom, which raises questions concerning the necessary clearances, interpretation and application of the new legislations.
Legislation and policy changes
The main regulatory body for M&A transactions is Coprocom (Comisión para Promover la Competencia), which is regulated by the antitrust legislation contained in the Ley de la Promocion de la Competencia y su Reglamento (Law No. 7472), its amendments in Law No. 9736 (collectively, the Anti-Trust Act and its by-laws), and further rulings issued by Coprocom itself. It can be assumed that the by-laws to Law No. 9736 are still a work in progress.
The other key legislation is the Costa Rican Commerce Code and its amendments and interpretations as to certain legal concepts or figures, by rulings of the civil courts and resolutions issued by the Costa Rican Tax Administration.
In November 2019, substantial and material amendments to the Anti-Trust Act entered into effect. The main impacts are the required ex-ante approvals, the new reporting thresholds based on the value on the transaction and sales volumes taken together of the parties (or related parties) involved in the transaction, stronger powers for the regulator, and steeper penalties for breach of the regulations.
COVID-19 mainly impacted labour legislation, with Costa Rica relatively well-prepared in comparison to its neighbours. The authorities had enacted legislation regulating remote work and overtime in September 2019, making it the first country in the Central American region to do so, along with the possibility of suspending labour contract and allowing for shift variations.
During the pandemic, working remotely was not a government mandate but a recommendation for the private sector. To apply it, employers had to have a policy that regulated how the work-from-home alternative would be applied, and create a written agreement signed by each employee setting forth the terms and conditions applicable to each case.
Further changes to the regulatory framework regarding M&A are likely to arise once Coprocom further interprets and applies the new antitrust regulation.
Common market practice misconceptions in Costa Rica concern the varying degree of understanding about the reach of the antitrust regulations, the application of the new tax regulations on deal structures, and the payment of a fiscal tax based on the value of a transaction.
Given the impact of the new tax legislation, parties to a transaction must prepare for tax planning structures that could require corporate reorganisations. Companies should also plan structures to secure successful entry and exit strategies and to include provisions to secure a successful post-closing and transition period. This includes plans for issues related to post-closing obligations that will facilitate full compliance with applicable regulations in general, as well as labour law provisions.
In terms of the incorporation of technology into legal practice, Costa Rica is increasingly seeing the use of certain tools in the form of artificial intelligence (AI) and bot automation, especially for due diligence procedures. These have changed the normal format and scope of traditional due diligence processes, with an emphasis on security, speed, accuracy and the presentation of information and findings in dashboards.
The Costa Rican Stock Market Regulatory Law (Law No. 7732) establishes in Article 36 that anyone who intends to acquire, directly or indirectly, in a single act or successive acts, a volume of shares or other securities of a public company – and thus achieve a significant participation in the share capital – must formulate a takeover bid (TOB) directed to all the shareholders of the target company.
Costa Rica’s competitive advantages will continue to attract investment
Article 102 of the Regulation on the Public Offering of Securities defines "significant participation" as "a percentage equal to or greater than 25% of the outstanding and voting capital of the company". When the bidder intends to reach a participation equal to or greater than 25%, but less than or equal to 50%, the offer must be made on a quantity of shares representing at least 10% of the share capital of the company. If the bidder's intention is to reach a participation greater than 50%, the offer must be made for a number of shares that will allow the bidder to reach at least 75% of the share capital of the company.
The TOB must comply with several requirements listed in Article 107 of the Regulation on the Public Offering of Securities and must be submitted to previous authorisation before the General Superintendence of Securities (SUGEVAL), before going public.
When submitting for TOB authorisation, the bidder must prove to SUGEVAL that it has issued guarantees covering 100% of the offer.
On the other hand, the recent amendments to the Anti-Trust Act included a new Article 27, paragraph a), which mandates that SUGEVAL must notify Coprocom of any business combination in its knowledge that has "monopolistic tendencies" and that involves entities supervised by Financial Super-Intendency. In turn, Coprocom must send a copy of the notification to the National Supervisory Board of the Financial System (Conassif) and request information on the business combination. Conassif will determine if it can issue a final resolution to authorise the business combination or not. If Conassif considers that it should not issue the final resolution on the business combination, Coprocom will issue the resolution.
The trend in the Costa Rican market, leveraging off the expertise of more sophisticated investment bankers, has been to use mechanisms for setting the final purchase price, along with its allocation, disbursements, premiums, etc. Locked-box mechanisms, and earn-outs, have been used more frequently for certain transactions.
Escrow agreements to guarantee contingencies, and liabilities usually identified in a due diligence process, have become the norm in the drafting of the closing documents for an M&A transaction.
Moreover, warranty and indemnity (W&I) insurance is becoming more common at a regional level, but it is often used by certain transnational companies or sophisticated private funds.
The conditions for a private takeover usually involve obtaining shareholder and/or board of director approval pursuant to the articles of incorporation of the company. For certain transactions, parties must comply with the minority shareholder safeguards enacted by an amendment to the national Commerce Code of 2016. These safeguards require approval for a sale of the assets of the target.
It is a general standard practice to submit to buyer corporate resolutions issued in a shareholders' assembly meeting to approve an offer, as the shareholders' assembly is the supreme organ of local companies. Such resolutions are also required to complete a takeover transaction.
The general terms and conditions of the offer are generally standard and are contained in a letter of intent negotiated by the parties, subject to due diligence, price negotiations, warranty mechanisms, etc.
Moreover, the above-mentioned antitrust regulations are increasingly creating a need for pre-emptive analysis of the impact of the regulations on a potential transaction. Choice of law and choice of forum provisions are common. It has become common practice to provide for foreign laws and/or jurisdictions in the agreements in the applicable law and dispute resolution clauses. Given that US companies are the most frequent participants in local M&A transactions, New York law has been widely selected as the applicable governing law, expect for those matters that require the application of Costa Rican law (for instance disputes related to property, etc.).
The exit environment is certainly more limited than in other jurisdictions with developed capital markets. Local businessmen often aim to sell their operations to targeted companies, and in some cases – depending on the type of operation – to PE funds.
Industry consolidation, PE fund activity and opportunities in the acquisition of distressed assets will likely assist in increasing Costa Rica's deal flow in 2021. Moreover, Costa Rica's competitive advantages will continue to attract investment and make its local companies strong targets for M&A activity.
The legal practice continues to become more sophisticated, more attuned to international standards and more focused on key areas of M&A practice, including cross-border and local tax issues. Reacting to demand, a further trend in the legal practice has seen leading companies instil stronger corporate governance and compliance frameworks.
Investors and clients will continue to look for comprehensive multidisciplinary approaches to their transactions and projects, while also seeking reassurance through legal advisors who are more comfortable in using digital resources to support their work.
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Fernando Vargas-Winiker is a partner at EY Law in Costa Rica. He acts as a general corporate strategic counsel for transnational, regional and local companies doing business in Costa Rica and the rest of Central America.
Fernando focuses on cross-border corporate matters including M&A, joint ventures, corporate reorganisations, foreign investment and market entry issues, compliance and corporate governance. He also participates in structuring projects for energy generation, telecommunications and infrastructure, as well as in the set-up of manufacturing and shared services operations for global companies in Costa Rica under the Free Trade Zone Regime, including several Fortune 500 clients.
Fernando has been admitted to the Costa Rican Bar since 1995, holds a LLM degree from the Georgetown University Law Centre, and is recognised by several international publications as a highly-regarded and top-ranked practitioner, who is praised by clients for his knowledge, commitment and responsiveness.
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