Mind the gap: negotiating representations & warranties in the context of M&A in India
June 2018 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2018 Issue
As M&A transactions become more sophisticated in India, representations, warranties and indemnity clauses remain the most extensively-negotiated clauses. Buyers and sellers negotiate exhaustive lists of representations and warranties, exclusions to the indemnity obligations and other limitations to indemnity liabilities (including caps, de minimis and basket amounts). The representations and warranties sections are often the lengthiest portion of the transaction document. The interests of the buyer and the seller are usually not aligned in this section of the transaction document. The seller wants to narrow the scope of representations and warranties as much as possible in order to reduce the potential for inaccuracy and claims of breach, and the buyer wants the broadest set possible to insulate itself and allocate risk to the seller. At its core, negotiating representations and warranties boils down to an exercise in risk allocation.
Usually, the buyer makes certain fundamental representations and warranties (for example, those pertaining to its ability to contract and payment of purchase price). The seller is generally expected to provide both fundamental (such as those pertaining to its ability to contract and title to the shares or assets) and extensive operational (for example, those pertaining to the quality, condition, value and nature of the assets, business or entity that the buyer is acquiring from the seller) representations and warranties. The type and scope of representations and warranties in a particular deal is a function of a number of factors. The representations vary, based on the circumstances of the particular transaction, including the size of the target company (listed entity or privately-held entity), the stake being acquired (minority or majority) and the type of investor (strategic or private equity investor).
The seller’s representation and warranties serve three very important purposes. First, they provide important disclosures from the seller about the target company and its business, and they are an extension of the due diligence process. Second, they are tested at closing when the seller usually needs to verify and confirm that they continue to remain true and correct and may form the basis of a buyer’s ‘walk away’ rights. Third, they can form the basis of an indemnification claim if the buyer discovers a breach post-closing.
Due diligence and disclosure schedule
The legal due diligence process may widen the scope of the representations and warranties of the seller. Usually, specific representations and warranties are included by the buyer in the transaction documents to address the issues and risks identified during the due diligence. Conversely, sellers can rarely make unqualified representations and warranties. Sellers create disclosure schedules to the transaction document to disclose any known exceptions. A well-drafted disclosure schedule will provide substantial protection to the seller against assertions that the seller breached its representations and warranties. The disclosure schedule is often the point of much negotiation, as the seller tries to make general disclosures that apply to all representations and include the data room provided for diligence, while the buyer seeks to confine disclosure to specific disclosures against specific warranties in the agreement.
Sellers seek to limit the scope of the individual representations and warranties in a variety of ways. Representations and warranties are often qualified in whole or in part by materiality, and actual or imputed knowledge standards.
The materiality qualifier is significant from the seller’s point of view. Buyers frequently accept certain ‘materiality’ qualifiers included by the seller, although this is usually a subject of considerable negotiation. A seller can qualify his representations and warranties by limiting them to ‘material’ compliance, contracts, litigations and so on. The manner in which materiality is defined in the document therefore assumes importance. There are several ways in which a materiality qualifier may be subject to ‘tiering’. For example, indemnification provisions sometimes allow for indemnification only when there has been a ‘material breach’ of a representation. Coupling such a provision with a representation qualified as to materiality can result in tiering of materiality.
Some of the possible compromises in the case of the different perspectives of the seller and buyer, with respect to a materiality qualifier, is to define materiality as having an impact on the financial position of the target company by relying on a specific monetary threshold or to specify that the materiality provisions do not apply to certain specific representations and warranties.
In addition to materiality qualifiers, the seller may seek to limit its representations and warranties by including a knowledge qualifier with respect to certain representations and warranties, thereby forcing the buyer to bear the risk of unknown liabilities or matters. Subsequently, the negotiation process will involve defining the scope and the extent of the seller’s knowledge, including whether the knowledge is actual knowledge or constructive knowledge and the people whose knowledge it is essential to determine the knowledge attributable to the seller. The buyer will opt for constructive knowledge (knowledge based on reasonable, due and careful enquiry) of the seller and often request the selling shareholders and the target company to make the representations and warranties.
Limitation of liability
Representations and warranties are typically backed by an indemnity from the seller. Thus, a seller may be liable for an indemnity claim by the buyer for a breach of such representations and warranties. It is not uncommon for the seller to exclude or limit its liability (both in terms of time and amount) for claims arising out of breach of such representations and warranties. However, such limitation is the subject of extensive negotiations between the parties.
In relation to the provisions governing indemnity under the transaction documents, the independent investigation clause is intensely negotiated. An anti-sandbagging provision, which prohibits indemnification claims with respect to any matter that a buyer had knowledge of prior to signing or closing, are also proposed, though less common. While buyers strongly resist the inclusion of this clause, if such a clause is included, the buyer usually attempts to mitigate the effect of the provision by limiting the definition of knowledge to actual knowledge, as opposed to implied or constructive knowledge.
In addition, the definition of loss is also a matter of negotiation between the parties. Typically, the seller restricts the definition to capture only direct and actual losses, and excludes consequential, incidental, non-pecuniary and punitive losses. It is common for the buyer, on the other hand, to insist that the seller indemnifies it for all losses resulting from the seller’s breach of its representations and warranties under the transaction documents.
Sellers often obtain limitations within the indemnification provisions in several ways. Usually, indemnity claims are restricted by a cap on the indemnity amount and claim periods. Caps on the amount of indemnity that the buyer may claim for a breach of representations and warranties generally range anywhere between 10 percent and 100 percent of the transaction value. In India, the time limits for the survival of tax warranties are generally limited to seven years; other warranties are generally limited to three years, except fundamental warranties which may not have a time limit and may extend indefinitely.
Other means used by sellers to limit the liability are through the basket and de minimis provisions. Baskets are minimum thresholds that must be exceeded by the aggregate amount of all losses claimed by the buyer. Most agreements include a basket provision which tends to be set at approximately 0.5 to 2 percent of the transaction value.
The basket provisions are sometimes accompanied by a de minimis threshold (i.e., a minimum threshold that prevents the buyer’s individual claims from being eligible for indemnification unless it exceeds the de minimis amount) – typically between 0.1 and 0.5 percent of the transaction value. De minimis thresholds are less common than baskets and often resisted by the buyer. Recently, both caps and deductible amounts have trended toward a lower threshold.
Certain matters are excluded from limitations of baskets, caps and deductible. For example, these limitations generally do not apply to indemnity claims with respect to a breach of fundamental and tax representations and warranties, breach of covenants, fraud and specific indemnity matters.
Role of insurance
The concept of warranty and indemnity insurance (W&I insurance), which is well recognised globally and used as a mechanism to bridge the gap between the parties’ negotiating positions, is now being evaluated by buyers on a regular basis. Parties to M&A transactions are increasingly inclined to take tax insurance considering the uncertainty around tax laws and retrospective judicial pronouncements. W&I insurance for other warranties is also being used to bridge the gap between the warranty offered by the seller and the warranty desired by the buyer. However, W&I insurance is fairly expensive and comes with certain carve-outs. W&I insurance involves extensive discussion with the underwriters on the terms of the policy (usually less flexible) and the form of the warranties to be covered by the policy. W&I insurance plays a significant role in transactions involving financial investor sellers, who are unable to offer business representations or long-term indemnity protection. Escrows and holdbacks to secure indemnification payments are also utilised to mitigate the risk in circumstances where the seller’s financial ability to back up indemnity obligations is uncertain.
Negotiating representations and warranties
Recently, the Delhi High Court allowed Japanese drugmaker Daiichi Sankyo to enforce an international arbitration award in India to recover approximately $550m from the former promoters of Ranbaxy, an Indian pharmaceutical company. Daiichi Sankyo had alleged that the promoters of Ranbaxy had concealed and misrepresented critical information regarding US Federal Drug Administration and Department of Justice proceedings at the time of the sale to Daiichi Sankyo.
Precedents such as these highlight the importance of well-drafted and negotiated representations and warranties in M&A transactions. In order to negotiate representations and warranties effectively, it is important to have an understanding of the market trends and practices as well as the rationale for these practices. A well-articulated representation and warranty framework, coupled with a careful disclosure exercise, can serve to provide both clarity and protection to the parties in an M&A transaction.
Ankit Majmudar is a managing partner and Shriti Shah is an associate at Platinum Partners. Mr Majmudar can be contacted on +91 22 61 11 19 00 or by email: email@example.com. Ms Shahcan be contacted on +91 22 61 11 19 00 or by email: firstname.lastname@example.org.
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Ankit Majmudar and Shriti Shah