MERGERS & ACQUISITIONS

Transcription

1 MERGERS & ACQUISITIONS RECENT DEVELOPMENTS OF IMPORTANCE Prepared by: Al Hudec Tel: (604) Fax: (604) Trevor Scott Tel: (604) Fax: (604) & Teresa Tomchak Tel: (604) Fax: (604) Farris, Vaughan, Wills & Murphy LLP 700 West Georgia St, Suite 2500 Vancouver, BC V7Y 1B3 STRATEGIES TO PROTECT M&A DEAL VALUE I. INTRODUCTION This article highlights areas where claims arise post-closing in private M&A transactions and identifies the key terms in purchase agreements that address post-closing issues. The three areas in which post-closing adjustments primarily relate are indemnity claims, working capital adjustments and earn-outs. This article also provides tips and discusses best practices to forestall post-closing issues. II. STRUCTURING AND NEGOTIATING INDEMNITY PROVISIONS TO LIMIT POST-CLOSING CLAIMS A. Indemnification Claims Made In the US, Shareholder Representative Services, an entity in the business of acting as escrow agent or shareholder representative in private M&A deals, has assembled a data base of over 700 deals that provides an interesting statistical profile of the types of post-closing claims seen in private M&A transactions. This data base provides a unique insight into when deals go bad and the reasons why. It is readily apparent from their most recent 2015 study that postclosing price adjustments are more common and frequent than you might think, with post-closing indemnity claims or other price adjustments occurring in about 2/3 rds of deals. Indemnification claims for a breach of a representation or warranty occur in 58 per cent of deals, with an average of 1.6 claims per deal. The claims average 24 per cent of escrow. 5 per cent of claims result in litigation or arbitration. The average claim takes 7 months to resolve. Given the pervasiveness with which indemnification claims are made, and the length of time that it takes to resolve them, great care should be taken when drafting indemnification provisions. The representations that generate the most claims are tax (31 per cent), undisclosed liabilities (11 per cent), intellectual property (13 per cent), financial statements (7 per cent), customer contracts (6 per cent), employees (10 per cent), capitalization (8 per cent), and regulatory compliance (4 per cent). Because of the frequency of post closing indemnification claims, it is extremely important to structure and draft the indemnity provisions of the purchase agreement with care. B. Typical Indemnification Terms There is a very useful set of surveys prepared regularly by the M&A Committee of the American Bar Association Business Law Section (the ABA Deal Surveys ) that provide a wealth of information on at market deal terms. The M&A Committee has for several years done studies of deal terms in the US and Canada. It is particularly interesting to look at trends in the indemnification provisions of purchase agreements over time, as well as at the differences between US and Canadian trends. The most recent 2014 Canadian Private Target M&A Deal Points Study (the Canadian Study ) surveyed 60 acquisition agreements in 2012 and While the most recent US 2015 Private Target M&A Deal Points Study (the US Study ) surveyed 117 acquisition agreements in Twenty years ago, a seller s indemnification obligations in Canada were seldom capped, either in amount or duration. Typical indemnification terms have become much more seller friendly but are still less seller friendly in Canada than in the US Historically, a typical Canadian deal included a three year or more indemnification period with either no indemnification cap or a cap equal to the purchase price. 1. Indemnification Cap In the Canadian Study, the indemnification cap is now less than the purchase price in 60 per cent of deals (up from 38 per cent in 2012 and 35 per cent in 2010). The cap equals the purchase price in only 19 per cent of deals. In comparison, the US Study showed that indemnification caps were less than the purchase price in 88 per cent of deals and equal to the purchase price in only 3 per cent of deals. Indemnification caps are equal to 10 per cent or less of transaction value in 59 per cent of US deals, but only 18 per cent of Canadian deals. Often certain fundamental representations are carved out from the indemnification cap. Examples include fraud (77 per cent of Canadian deals, 82 per cent of US deals), taxes (24 per cent of Canadian deals, 65 per cent of US deals) and title (22 per cent of Canadian deals, 15 per cent of US deals). Often matters such as taxes (53 per cent of Canadian deals, 71 per cent of US deals) and environmental (9 per cent of Canadian deals and 9 per cent of US deals) are the subject of separate stand-alone indemnities. Generally, indemnification obligations are subject to baskets which provide either that the seller will be responsible for losses in excess of some defined threshold deductible; or that the seller will be responsible for all losses from the first dollar once a threshold is crossed. First dollar baskets are more common in Canada (50 per cent of deals (26 per cent in US), compared to deductible baskets in 36 per cent of deals (65 per cent in US)). The median first dollar

2 basket is 0.64 per cent of transaction value in Canada (0.47 per cent in US), with a median of 0.31 per cent of transaction value for deductible baskets (0.50 per cent in US). 2. Indemnification Survival Periods Survival periods tend to be much longer in Canadian transactions..; with 56 per cent of Canadian deals having a survival period of 24 months or more (only 17 per cent of US deals) and 21 per cent of deals having a survival period of 12 months or less (30 per cent of US deals). The most frequent survival period in Canada is 24 months, compared to 18 months in the US carve outs providing longer survival periods for fundamental representations and for matters such as taxes, environmental and fraud are common. In setting the indemnity survival period and, more importantly, when monitoring for possible indemnity claims post-closing, it is important to realize that contractual limitation periods do not, in many jurisdictions, override statutory limitation periods. For example, in British Columbia, the Limitation Act requires that a claim must be made within 24 months of it becoming discoverable and is silent on the issue of whether this limitation can be waived or extended by private contract. In Ontario, as a result of amendments to the Limitation Act, 2002, parties to business agreements are permitted by contract to shorten, extend, suspend or entirely exclude statutory limitation periods. Given the lack of express authority in the BC statute, the cautious view is that the statutory limitation periods govern. However, if the intent is to abridge a statutory limitation period (or attempt to do so), the agreement should expressly state so. 3. Other Matters There are a number of other indemnification related clauses in acquisition agreements that tend to be highly negotiated. Consequential damages are expressly excluded from indemnification in 44 per cent of Canadian deals (49 per cent of US deals) and expressly included in 11 per cent of Canadian deals (7 per cent in US deals). Care should be taken to exclude loss of profits only as a subcategory of consequential damages and not also in cases where a loss of profits is a direct loss resulting from a breach of representation and warranty. A seller should also exclude indemnity for diminution of value based on some multiple of income, earnings or other valuation multiple. Also, great care should be taken in excluding fraud from indemnity caps, survival period limitations and exclusive remedy clauses. This has become common, but agreeing to include an undefined fraud exclusion in an acquisition agreement can have untoward consequences. Various legal concepts of fraud might be imported into the deal if the word is not defined. It may result in excepting false representations made during the negotiations from the nonreliance provision of the agreement, or serve as the basis of a suit based on equitable fraud where there is no intent to deceive, or be used as the basis for suits on broader theories of fraud such as promissory fraud or concepts of unfair dealings. Accordingly, the scope of the fraud exemption should be specifically limited through a defined term limiting it to situations where the seller deliberately and knowingly, with intent to deceive, misleads the buyer with respect to representations and warranties in the agreement 1. C. Indemnification Mechanics It is dangerous to glaze over details of who controls the defense of third party claims. There is a potential moral hazard problem if the person ultimately responsible to pay a claim does not control the process. Buyers are reluctant to allow sellers to fully control the process where the outcome of the claim may have reputational impacts or liability in excess of indemnification caps. LEGAL BUSINESS A seller can seek a provision that the buyer cannot make claims until the actual indemnifiable loss exceeds a threshold of transaction value. Also, individual claims under a certain size are usually excluded. It is also important to include a non-reliance clause which acknowledges that the seller has not made representations outside of the agreement and that the buyer has not relied on representations except those in the agreement. In addition, the seller can seek a disclaimer that it does not represent the accuracy or completeness of the information provided before signing. A result of the ABA Deal Surveys giving the clause greater exposure, whether or not to include an anti-sandbagging clause in an acquisition agreement, is now more frequently debated. 14 per cent of Canadian deals (9 per cent of US deals) include an anti-sandbagging provision excluding liability where the party seeking indemnification had knowledge of the breach prior to closing. Conversely, 15 per cent of Canadian deals (35 per cent of US deals) contain a benefit of the bargain or sandbagging provision that maintains the right to indemnification notwithstanding any knowledge of the indemnity of the inaccuracy of the representation at or prior to closing. The seller s protection needs to go beyond the right to approve a settlement but rather should include the right to participate in the selection of counsel, and in the establishing strategies and budgets. It is often the case that the seller has the right to a seat at the table but not to determine or conduct the defense; although the seller may have the right to conduct the defense if the buyer declines. The seller should ensure that it has access to books and records, and to the employees of the target, as may be reasonably required to resolve the dispute. Escrows are used in 37 per cent of Canadian deals (66 per cent of US deals). With the escrow amount ranging from 1 per cent to 40 per cent of the transaction value in Canadian deals (0.75 per cent to 53 per cent in US deals), with a mean of 11 per cent in Canadian deals (9 per cent in US deals) and a median of 10 per cent in Canadian deals (7.5 per cent in US deals). In a seller friendly agreement, the agreement should specify that resort to the escrow is the exclusive remedy for indemnification claims. There should also be language to ensure a timely release of the escrow. Typically at the end of the escrow period, the buyer can delay the escrow release for claims reasonably likely to result in loss. A seller should tighten up the drafting to define a claim as

3 a filed lawsuit or potential claim arising out of threat letter alleging a specific grievance, acted upon within a specified period of time. A seller may also require that the claim be of sufficient consequence that the buyer is required to accrue in its financial statements. A seller could also include a time by which a third party claimant must take certain steps. III. WORKING CAPITAL ADJUSTMENTS Post-closing purchase price adjustments are very common in deals, with 72 per cent of Canadian deals (65 per cent in US deals) including some form of price adjustment provision. In a typical Canadian private company acquisition transaction, the parties agree on a cash free, debt free price which must then be adjusted post-closing to account for the target s actual cash, debt and working capital. Working capital adjustment provisions are found in the majority of private transactions (70 per cent of Canadian deals and 83 per cent of US deals that had price adjustment provisions) and account for a significant portion of post-closing disputes. Often, the seller (48 per cent of Canadian deals, 89 per cent of US deals) will prepare an estimate of the adjustment for purposes of determining the price at closing, with the buyer usually (61 per cent of Canadian deals, 85 per cent of US deals) calculating the final post-closing adjustment (up in Canada from 52 per cent in the 2012 study and 29 per cent in the 2010 study). Generally, the methodology prescribed in the agreement for calculation of the working capital amount will be defined by reference to the target s existing practices, including existing accounting principles, methods and practices and applicable GAAP. Frequently, however, the methodology applicable to a number of specific line items will be particularized in the agreement. For example, restricted cash required to be held for a specific purpose might be excluded, together with cash in till (since it will be needed for operations immediately after closing). The write down policy for obsolete assets might be specifically defined; and prohibitions on the reversal of reserves may be imposed. The calculation and settling of post-closing working capital takes significant time, and can often lead to frustrations or acrimony. Accordingly, as a substitute for a working capital adjustment, it is sometimes worth looking at the possibility of a locked box transaction, as is common in the UK and EU. In a locked box transaction, the price is set at signing, based on a recent balance sheet (the date of such balance sheet being the Reference Date ). Cash, debt and working capital are known to the parties at that date. The buyer takes on the economic risk of the business from the Reference Date onwards, with interest paid to the seller from the Reference Date to closing. Leakage from the locked box is prohibited and any exceptions must be expressly negotiated for example, management retention bonuses or target transaction costs. The main benefit of the locked box mechanism is price certainty and the elimination of disputes relating to working capital normalization. IV. EARN-OUTS Earn-outs, where a portion of the purchase price is paid post-closing based on the performance of the target business, are becoming more common in Canadian private deals. The Canadian Study shows that 25 per cent of deals included an earn-out, up from 20 per cent in 2012 and 3 per cent in Similarly, 26 per cent of deals in the US Study include an earn-out, though this is up from 25 per cent in 2012 and down from 38 per cent in 2010, illustrating that the frequency of use of earn-outs tends to vary with economic cycles. A. Typical Earn-Out Metrics Earn-outs can be based on financial metrics such as revenues (12 per cent of earn-out clauses in the Canadian study, 19 per cent in the US study), EBITDA (33 per cent of earn-out clauses in the Canadian study and 39 per cent in the US study); or on other metrics (53 per cent in Canada, 58 per cent in the US) such as nonfinancial milestones, e.g. regulatory approval of drug applications, entering into post-closing contracts or the launch of products. Keeping the earn-out metric simple reduces the likelihood of future disputes. It is also important to determine in advance if any adjustments to the accounting measures are appropriate. For example, amounts may be adjusted to exclude administrative and overhead amounts of the buyer allocated to the acquired business, for intercompany transactions not conducted at fair market value, to exclude interest on incremental indebtedness incurred in connection with the acquisition, to include an allocation for services provided by the buyer (e.g. insurance coverage), and for SR&ED credits. B. Covenants to Protect the Earn-Out The buyer and seller of a business will have different incentives after the business is sold. For example, a seller may be motivated to achieve short-term targets that increase the earn-out but which may be inconsistent with the long-term objectives of the buyer. A buyer will generally want to control the acquired business and change certain aspects to integrate it into its business. Earn-outs are complicated to negotiate and to draft because they raise a multitude of questions. Who will run the business postclosing? Will the purchaser make the necessary investments in the business? What assurances are there that the buyer will do what needs to be done to maximize the earn-out provision and will not divert opportunities to its other business units or a competing business acquired in the future? The seller will want to include various affirmative and negative obligations governing the continuing operation of the acquired business during the earn-out period. It will want to control decisions respecting the target business during the earn-out period, but if the buyer is to operate the business, the seller may require that the business be operated consistent with past practice (of the seller, or of similarly situated industry participants) or that the buyer will operate the business in such a way as to maximize the earn-out. If the seller is to continue to operate the business, it might want control over significant strategic and operational decisions, such as making capital expenditures and hiring, firing and directing employees, as well as determining their incentive compensation. In addition, the buyer might be required to provide working capital for

4 operation of the business, and be precluded from consolidating the acquired business with its other operations, selling the business or buying another related business. The Canadian Study shows, surprisingly, that draftspersons seldom provide such covenants. Only 20 per cent of earn-out deals in Canada (3 per cent in the US) included an express obligation on the buyer to run the acquired business consistent with past practice and none contained a stronger express obligation on the buyer to run the business to maximize the earn-out. In Canada, no deals contained an express disclaimer by the buyer of any fiduciary duty to the seller with respect to the earn-out. In the US, it is more common to make such a disclaimer; 13 per cent of deals in the US Study contained such a disclaimer. C. Acceleration of Earn-out The earn-out may be subject to acceleration upon the occurrence of certain specified events, resulting in the payment of the full amount, the present value of the full amount, or some other predetermined amount. A seller will desire acceleration of the earn-out where significant changes in circumstances arise. For example, the seller may have developed a good working relationship with and degree of trust of, the buyer s management during the negotiations and subsequent operation of the acquired business. This relationship could be jeopardized if the buyer experiences a change in control or sells the business before the earn-out period ends. Accordingly, a seller may insist on acceleration of the earn-out upon a change in control. Conversely, the buyer may also negotiate a right to terminate the earn-out and pay the seller a predetermined amount if, for example, the buyer finds that the earn-out would interfere with a desired disposition, acquisition or reorganization. In the Canadian Study, only 7 per cent of deals expressly provided that the earn-out accelerated in the event of a change of control of the acquired business. In the US it is much more common to expressly provide for the earn-out to be accelerated; 23 per cent of deals in the US Study contained such a provision. selection clause (if so, is it exclusive), what limitation periods are applicable (a point which we discussed above), and is there exclusive remedy clauses? Alternative dispute resolution, and in particular arbitration, is a more common choice in Canada than in the US The Canadian Study showed that 30 per cent of all transactions (15 per cent in the US Study) had some sort of alternative dispute resolution of which 94 per cent provided for arbitration (72 per cent in the US Study), with the remaining 6 per cent requiring mediation then arbitration (5 per cent in the US Study with 22 per cent calling for only mediation in the US Study). With respect to arbitration expenses, there is a significant divergence between Canada and the US In Canada, in 54 per cent of cases the costs of the arbitration will generally be allocated by the arbitrator or the agreement is silent, in 33 per cent of cases expenses are evenly split, and in 11 per cent the expenses are apportioned. In no case does the loser pay rule apply. In the US, the loser pay rule applies in 42 per cent of cases, in 33 per cent of cases the expenses are evenly split, in 25 per cent the expenses are apportioned and in no cases are they determined by the arbitrator or is the agreement silent. Other important issues relate to the representation of counsel and privilege post-closing. As a result of the recent decision of the Delaware Chancery Court in Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP 2, M&A lawyers are now paying more attention to ways for a seller to protect privilege with regard to its business and the sale process itself. In the Great Hill Equity case, a single law firm represented both the target company and the selling shareholder. After the transaction closed, the buyer and seller ended up in a dispute about an indemnity claim. In the course of the dispute, the buyer found computer files containing communications between the target and the seller s lawyers which it believed supported its claim that it had been mislead. The Court held that the privilege remained with the company that had been purchased, and that the selling shareholder could therefore not claim privilege in the communications from its lawyer. A similar result occurred in Canada in NEP ULC v. MEP OP LLC. 3 LEGAL BUSINESS D. Offsetting Indemnity Payments against Earn-out Generally, a buyer will want the right to offset any claim for indemnification against any amounts due the seller under the earn-out. In the Canadian Study, 40 per cent of deals expressly provide that the buyer can offset any indemnity payments to which it is entitled against any earn -out payments it is required to pay. Only 13 per cent of deals expressly provide that the buyer cannot offset payments, while the balances of deals were silent or indeterminable. It is less common in the US for deals to be silent on this issue, with 80 per cent of all deals in the US Study expressly permitting offsets, no deals expressly preventing offsets and only 20 per cent being silent or indeterminable. V. PROVISIONS DEALING WITH DISPUTES When a dispute arises boilerplate clauses can be fundamental. For example, what is the choice of law, is there a forum There are several ways to deal with this problem. One is to include in the acquisition agreement not only a consent to the target s lawyers continuing to represent the selling shareholders after closing, but also specific clauses designed to retain the privilege. The agreement should make clear that the parties recognize that it would be impracticable to purge all seller s privileged communications from the target s files and that no waiver is intended, and include an agreement from the buyer not to look for or use such communications. Alternatively, the seller and the target could negotiate a common interest agreement prior to closing agreeing to joint rights to the company s privileged communications and prohibiting the use of the privileged communications against each other. It appears that some considerations relating to representation and privilege are making their way into deal terms. The permission for a specified law firm to act for the shareholders representative

5 in the event of a post-closing dispute is granted on behalf of both the buyer and the seller and waiving any conflicts of interest has had a significant increase in the US, with 56 per cent of deals providing express permission, up from 47 per cent in 2012 and only 14 per cent in Similarly, 46 per cent of deals in the US now provide that any privilege relating to the transaction belongs solely to the seller and not the buyer and the buyer may not have access to any such communications, or to the files or the relevant law firm relating to the engagement, whether or not the closing shall have occurred. 5 VI. CONCLUSION The various surveys referred to in this article provide a useful tool to M&A practitioners in indentifying typical at market deal terms and are having a noticeable impact on the terms of acquisition agreements for private companies in Canada and the US. These surveys also help illustrate the strategies that can be undertaken to ensure deal value is protected. 1. That Pesky Little Thing Called Fraud: An Examination of Buyers Insistence Upon (and Sellers Too Ready Acceptance of) Undefined Fraud Carve-Outs in Acquisition Agreements, Business Lawyer, Volume 69, Issue 4, pp Delaware Chancery Court, Nov 26, ABQB No data is available in the Canadian Study 5. No data is available for prior years in the US and no data is available in Canada