Managing M&A transaction risk
June 2014 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
The key role of lawyers in any M&A transaction is the management of transaction risk. A lawyer’s role is to identify risk, inform and advise their client of that risk and then, through a variety of means, allocate that risk between the buyer and seller.
The management and allocation of transaction risk is often not properly considered until the fundamental terms of the deal have been agreed between the seller and buyer.
This article will provide a high level overview of the various means by which lawyers manage M&A transaction risk on behalf of their clients.
To simplify the analysis, this article has been prepared in the context of a private treaty M&A transaction in Australia undertaken by the means of a sale of shares. Transaction risk will be analysed from a ‘sell side’ perspective.
Prior to embarking on a sale process, sellers are encouraged to get their ‘house in order’. Sloppy legal (and for that matter financial and commercial) practice is an open invitation to a buyer to identify ‘issues’ to renegotiate the price. A simple fix is to undertake informal or formal vendor due diligence prior to embarking upon a sale process and then to rectify any outstanding legal issues.
A critical risk facing a seller is the management of its confidential information.
The primary instrument used to manage this risk is the Non-Disclosure Agreement (NDA) or Confidentiality Agreement (CA). In reality, the NDA/CA is a fairly ‘blunt instrument’ to regulate and manage this type of risk. It is inherently difficult to prove a breach of confidentiality and, if proved, to then quantify the loss suffered.
The data room
The data room (usually, a virtual data room (VDR)) is of critical importance. Under Australian market practice, all information ‘fully and fairly’ disclosed in the data room would usually qualify the warranties given by the seller. It is therefore imperative that a seller ensures that all relevant information is uploaded into the VDR.
As competitors of the seller may well be given access to the VDR, further practices have developed to enable a seller to control its confidential information. One such practice is the redacting of information from sensitive commercial documents. In addition, a ‘black box’ within the VDR is often established to contain a discrete number of extremely commercially sensitive documents which will only be disclosed to the ultimate buyer immediately prior to execution of a sale and purchase agreement (SPA).
Counterparty risk is often an issue.
At a minimum, a seller needs to obtain some comfort as to the valid incorporation and ‘good standing’ of the buyer.
Quite often a special purpose vehicle (SPV) is established by the buyer late in the transaction to acquire the shares from the seller.
Where an SPV is established by the buyer (or the buyer itself does not have sufficient financial standing) consideration should be given to a deposit being paid by the buyer upon signing the SPA and/or a parent guarantee being provided.
Many deals are not signed and completed on the same day but are subject to a number of conditions precedent (CPs). This immediately creates completion risk for a seller (and possibly the buyer) which must be managed.
A seller should ‘push back’ on open ended CPs such as board approval of the buyer, the buyer undertaking and being satisfied with its due diligence investigation, subject to finance conditions, etc. All of such CPs effectively give the buyer a call option to acquire the seller’s business and should be resisted.
A seller should also push back on CPs relating to material adverse change and breach of warranty between signing and completion of the SPA.
In practice, a seller may be required to live with a certain number of conditions precedent.
Change of control consents should be limited to a small number of key material contracts.
Inevitable regulatory approvals such as foreign investment and competition law clearance may be required.
In recent years completion risk has been increased by provisions contained in the completion deliverables clause of the SPA. In simple terms it has become common market practice to include an ‘unwind’ provision. If such a provision is to be included in the SPA it is strongly advisable that a materiality threshold be included so that the seller or the buyer may not terminate the SPA for a relatively immaterial breach of the completion deliverables clause.
Calculation and adjustment of purchase price
Over the past 10 or so years balance sheet purchase price adjustment provisions have become the norm and have increased in their complexity. This can add risk to both a seller and a buyer in the form of an unexpected adjustment to the purchase price. It is critical that these provisions are checked and signed-off by a seller’s accountants and corporate advisers.
In recent years, private equity has introduced a simplified mechanism referred to as a ‘Locked Box’. Under this mechanism, the accounts are ruled off at a particular date, and after that date all profits and losses of the business are to the account of the buyer. The seller and buyer agree upon permitted and non-permitted ‘leakages’ of cash from the business. The appeal to a seller is that the ‘Locked Box’ provides certainty as to the proceeds they will receive at completion.
A buyer will often insist that part of the purchase price payable be calculated by reference to the post completion performance of the business. In doing so, a seller’s sale proceeds are at risk for the relevant period if the business does not perform in accordance with expectations. As the buyer will have control of the business for the relevant period, it is critical that the seller’s risk be properly managed. This is achieved in two ways.
First, the buyer will be subject to a set of obligations regarding its conduct of the business during the earn out period. As a general proposition, a buyer should be required to the conduct the target business in substantially the same manner as it was conducted prior to completion.
Secondly, the SPA would usually contain a series of principles which will be applied to ‘normalise’ the earnings in the accounts of the business which will be used to calculate the earn out amount.
Warranties and indemnities
Without doubt, the greatest transaction risk to which a seller is exposed is the risk arising under the warranty and indemnity regime contained within the SPA. It is customary for a buyer to require a seller to warrant the accuracy of a broad range of statements/matters in respect of the business. If any one or more of these statements is incorrect, then a seller may be sued by the buyer for breach of warranty.
There are many means by which a seller may manage its warranty and indemnity risk, including the following.
Financial caps. It is customary for a seller and buyer to agree upon a maximum aggregate ‘cap’ on the seller’s liability for breach of warranties (and claims under specific indemnities such as tax, title, environmental, etc). Historically, the cap was set at an amount equal to the purchase price. With the growth of private equity, buyers (particularly PE buyers) have been prepared to accept caps set at a percentage of the purchase price. Quite often different caps are agreed for different types of warranties/indemnities.
De minimis. To avoid the risk of a seller being subject to multiple immaterial claims for breach of warranty, the parties will agree a ‘de minimis’ or minimum claim threshold. The parties will often also agree on a ‘tipping’ or ‘non-tipping’ basket of claims (i.e., an aggregate threshold that must be reached prior to a buyer being able to recover its losses from the seller).
Time limits. A seller will seek a time limit within which a warranty or indemnity claim can be made by the buyer. Once the agreed time limit expires, no claims may be brought. As with financial caps, differing time limits will often be agreed between the parties in respect of differing subject matter of claims. For instance, tax warranties may have a longer applicable time limit than a claim under a ‘general’ warranty and no time limit may apply to a breach of a title warranty.
Disclosure. A key risk mitigation strategy for a seller is the disclosure of all relevant information to the buyer. Under Australian market practice, matters which are fully and fairly disclosed to the buyer prior to execution of the SPA will not usually be able to form part of a claim for breach of warranty. A seller should ensure that known issues are disclosed to a buyer either through the VDR or by way of a disclosure letter to be issued immediately prior to execution of the SPA.
Actual knowledge. A seller should ensure that any matter which is within the knowledge of the buyer prior to execution of the SPA is not able to form part of a warranty claim. Whilst often a seller will push for ‘constructive knowledge’ of a buyer to be included, at a minimum, actual knowledge of a buyer’s deal team should constitute this limitation.
Publicly available information. A buyer who has conducted due diligence should be required to bear the risk of information discovered during its due diligence investigations. In this regard, any information which is a matter of public record including through searching publicly available registers should be excluded from a claim for breach of warranty.
Other limitations. A customary series of further limitations will often be agreed between a buyer and a seller, including exclusion of liability for consequential loss and liabilities arising where a warranty becomes untrue due to a change which is outside of the control of the parties (for instance, a change in law).
Warranty and indemnity insurance. Another means by which a seller may mitigate its warranty and indemnity risk is through a policy of warranty and indemnity insurance. The use of W&I insurance has increased considerably over the last 5-10 years in response to the growth in private equity. This is a complicated area of law which will no doubt be tested in the courts over the coming years. As a general rule, a seller should push for a ‘buy side’ policy to be taken out by a buyer so that the buyer’s recourse is, subject to certain exceptions, against the insurer and not the seller.
The entry into any M&A transaction will not be without risk to a party, particularly a seller.
It is the job of M&A lawyers to identify each risk, inform and advise their client of that risk and then do their best to mitigate the risk.
John W Mann is a partner and Nick Dahlstrom is a senior associate at K&L Gates Melbourne. Mr Mann can be contacted on +61 3 9205 2011 or by email: firstname.lastname@example.org. Mr Dahlstrom can be contacted on +61 3 9205 2029 or by email: email@example.com.
© Financier Worldwide
John W Mann and Nick Dahlstrom
K&L Gates Melbourne