Provisions in M&A Deals Crafting Terms to Minimize Transaction Risks and Post Closing Disputes

Transcription

1 Presenting a live 90 minute webinar with interactive Q&A MAC Clauses and Indemnification Provisions in M&A Deals Crafting Terms to Minimize Transaction Risks and Post Closing Disputes TUESDAY, NOVEMBER 29, pm Eastern 12pm Central 11am Mountain 10am Pacific Td Today s faculty features: Todd B. Pfister, Partner, Foley & Lardner, Chicago Jeff J. Litvak, Senior Managing Director Forensic Litigation, FTI Consulting, Chicago Kevin D. Kreb, Partner, PricewaterhouseCoopers, Chicago The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 MAC Clauses and Indemnification Provisions in M&A Deals November 29,

6 Today s Presenters Todd Pfister Foley & Lardner LLP Kevin Kreb PricewaterhouseCoopers Jeff Litvak FTI Consulting 6

7 MAC Clauses and Indemnification Provisions in M&A Deals Agenda Negotiating MAC Clauses Negotiating Indemnification Provisions Reassessing Common Provisions Favorable to Sellers The CPA s Role in Pricing MAC and Benefit of the Bargain Claims M&A Issues From Dispute to Resolution

8 MAC Clauses and Indemnification Provisions in M&A Deals Negotiating MAC Clauses 8

9 Negotiating MAC Clauses What is a MAC? Means of allocating risks between signing and closing Increasingly relevant given turbulent world Terrorist Attacks, Wars, Financial Crises MACs used in different parts of agreement Representations & Warranties Stand-Alone condition Separate representation ti regarding nonoccurrence of MAC since a given date Modify representation regarding given subject to indicate absence of event, etc. leading to a MAC Used alone in about 36% of deals* Closing Condition Back Door condition The Agreement includes an Absence of Change representation and a condition bringing down the accuracy of the seller s representations and warranties. Bringdown condition enables a party (typically the buyer) to terminate the agreement and get out of the deal if the condition is not met Used alone in about 9% of deals* A majority of deals include both Stand-Alone and Back-Door Conditions* *2011 SRS M&A Deal Terms Study, analyzing private-target deals between July 2010 through September 2011 ( 2011 SRS Study ) 9

10 Negotiating MAC Clauses What is a MAC? (cont d d.) Sample closing condition provision: Buyer s obligation i to consummate the transactions contemplated by this Agreement is subject to the satisfaction of the following conditions:... The representations and warranties of Seller contained in this Agreement were accurate as of the date of this Agreement and are accurate as of the Closing Date, except for any inaccuracy that would not reasonably be expected to result in a [MAC]. 10

11 Negotiating MAC Clauses What is a MAC? (cont d d.) Simple MAC definition: Material Adverse Change means any material adverse change in the business, results of operations, assets, liabilities or financial condition of Seller Drafting Issues to Consider Inclusion of forward-looking standard? From July 2007 through July 2010, a forward-looking standard was included in MAC definition 68% of the time* Could be (22%) vs. Would be (61%) vs. other (17%) * Double materiality problem Inclusion of prospects in MAC definition? According to the 2009 ABA Study, prospects included 38% of the time** According to the 2010 SRS Study, prospects included 23% of the time* Less prevalent in public deals where walk away right for MAC - for public deals announced in 2009, only 1% included prospects *** Quantify materiality? According to the 2009 ABA Study, stated dollar amount included in MAC only 2% of the time (down from 8% in 2004)** *Source: 2010 SRS M&A Deal Terms Study, analyzing private-target deals between July 2007-July 2010 ( 2010 SRS Study ) **Source: 2009 Private Target Mergers & Acquisitions Deal Points Study ( 2009 ABA Study ) *** Source: 2010 Strategic Buyer/Public Target Mergers & Acquisitions Deal Points Study ( 2010 ABA Study ) 11

12 Negotiating MAC Clauses What is a MAC? (cont d d.) Inclusions and Carve-outs Included in MAC definition 92% of the time* Disproportionate effect qualifier included in MAC definition 88% of the time* Changes in general economic or political conditions (91%)** Changes affecting industry as a whole (91%)** Changes in GAAP (60%)** Changes in law (66%)** Announcement of Agreement (71%)** Actions contemplated by the Agreement (60%)** Acts of God, war or terrorism (55%)** Case-specific matters, such as pending litigation Percentages even higher for public company transactions *Source: 2010 SRS Study **Source: 2009 ABA Study 12

13 Case Law Negotiating MAC Clauses What Does Case Law Teach Us? In re IBP, Inc. Shareholder Litigation (Del. Ch. 2001) ( Tyson Foods ) Delaware court interpreting New York law Tyson sought to terminate deal based upon sharp earnings decline of IBP Court granted specific performance to IBP In absence of specific language, earnings volatility does not constitute a MAC Frontier Oil Corp. v. Holly Corp. (Del. Ch. 2005) Buyer sought to terminate t for MAC based upon threatened t toxic tort t litigation Court found that requisite likelihood of catastrophic result not established to constitute a MAC Potential litigation costs of $15 million to $20 million relative to a deal size of approximately $340 million 13

14 Negotiating MAC Clauses What Does Case Law Teach Us? United Rentals, Inc. v. Ram Holdings, Inc. (Del. Ch. 2007) MAC clause excluded the condition of the credit markets in the United States However, specific performance not granted the merger agreement was ambiguous on the subject and evidence established an understanding between the parties that the merger agreement barred the remedy of specific performance Cerberus acquisition subsidiary required to pay $100 million termination fee Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (Del. Ch. 2008) No financing out Fairly typical MAC out (with limited carve-outs) Reverse break-up fee if buyer breached (no cap, if intentional breach) Heavy burden rests on party seeking to excuse performance and poor earnings must be expected to persist significantly into the future for decline in target s earnings to constitute MAC Court found no MAC; Buyer liable for all damages Case may limit ability of buyers to renegotiate price and terms in turbulent market 14

15 Negotiating MAC Clauses What Does Case Law Teach Us? Key Takeaways Party seeking to invoke MAC to avoid closing bears a heavy burden to show MAC has occurred Parties may reallocate burden of proof in agreement MAC ordinarily will be measured in years, not months (i.e., consequential change to long-term earnings rather than short-term hiccup ) Specific metrics and benchmarks may be warranted reliance on general MAC provision to terminate will be difficult MAC will be viewed in context of entire agreement, not in isolation Buyer s rationale for deal matters Strategic vs. financial buyer may be important 15

16 Negotiating MAC Clauses Drafting Considerations Case law is fact specific and does not provide uniform benchmarks or definitions. However, materiality standard almost certainly higher than securities law materiality threshold Exclusions/carve-outs are critical and must be carefully crafted Buyer typically should insist on appropriate forward-looking component Define your own benchmarks; ambiguous, general language generally works against buyer Self-assess: who is the buyer, what is the purpose of the transaction, and what does the buyer know? Pay attention to choice of law and choice of forum provisions Coordinate representations and warranties (and other agreement provisions) with MAC Language is key! In the world of MACs, one size does not fit all 16

17 MAC Clauses and Indemnification Provisions i in M&A Deals Negotiating Indemnification Clauses 17

18 Negotiating Indemnification Provisions Materiality Scrapes Definition of Materiality Scrape Materiality qualifications in representations and warranties disregarded for all indemnification related purposes or Materiality qualifications in representations and warranties disregarded for calculation of damages/losses, but not to determine whether a breach has occurred or Materiality qualifications in representations and warranties disregarded to determine whether a breach has occurred, but not when calculating damages

19 Negotiating Indemnification Provisions Materiality Scrapes (cont d d.) An increase in materiality scrapes was a product of an increasingly buyer-friendly environment, which is now becoming friendlier to sellers Between July 2010 and September 2011,materiality scrapes were used in about 81% of deals, up from 69% between July 2007 and July 2010* However, only about 21% of materiality scrapes were used to both determine breach and damages while about 69% were used only to determine damages* From 2007 to 2010, about 41% of materiality scrapes were used to both determine breach and damages; 51% of materiality scrapes were used only to determine damages* Sellers could use the presence of materiality scrapes to negotiate for other provisions, i including higher h baskets and true deductibles d Materiality scrapes provide an incentive for sellers to list all items or include a catch-all provision in the disclosure schedules *Source: 2011 SRS Study; 2010 SRS Study

20 Negotiating Indemnification Provisions Materiality Scrapes (cont'd d.) Alternatives to Materiality Scrapes: Use dollar thresholds to determine whether immaterial matters constitute a breach This provides certainty, but also invites arbitrariness Include materiality scrapes only on certain agreedupon representations

21 Negotiating Indemnification Provisions Survival Periods Survival periods increased in the recent buyer s market By 2007, typical survival periods had decreased from 24 months to 18 months*; some only one audit cycle In 2008, the average survival period was 19 months** Survival periods may be decreasing as the buyer s market softens Between July 2010 and September 2011, the average survival period was 17.5 months*** 46% of deals during that period had a survival period of 18 months*** Only 18% of deals during that period had a survival period of more than 18 months*** * 2010 SRS Study ** 2011 Houlihan Lokey Purchase Agreement Study ( 2011 Houlihan Lokey Study ) *** 2011 SRS Study 21

22 Negotiating Indemnification Provisions Survival Periods (cont'd d.) A 2008 case has illustrated the importance of clear survival period provisions A survival period must be explicit and is to be construed against the party invoking the provision (Western Filter (9 th Cir. 2008)) The 9 th Cir. found the provision to be ambiguous and to only limit the time period for which a breach could occur or be discovered The court found that the provision did not serve as a contractual statute of limitations Practice point, make clear that the survival period is meant to cut short the statute of limitations However, a 2011 case provides more support for enforcing survival periods and declined to extend the strict construction principle applied in Western Filter The court held that agreements to shorten the statute of limitations do not violate public policy and are enforced if reasonable (Zalkind v. Ceradyne, Inc. (App. Ct. 2011))

23 Negotiating Indemnification Provisions Sandbagging Anti-sandbagging provision limits the Seller s liability for losses resulting from breaches of representations or warranties if the Buyer had knowledge of the breach before the closing Pro-sandbagging provisions (knowledge savings clauses) expressly provide that remedy is not affected by any knowledge of the Buyer

24 Negotiating Indemnification Provisions Sandbagging The 2011 SRS Study showed pro-sandbagging in 63% of deals. * About the same as 2010 (66%), and still up from 2009 (54%)* 35% of deals had anti-sandbagging language* The compromise position is to remain silent; note that in some jurisdictions, silence can be interpreted to result in an imputed anti-sandbag. Between July 2010 and September 2011, only about 3% and 2% of deals, respectively, were silent* This is down from 8% in 2009 and 5% in 2008* *2011 SRS Study 24

25 Negotiating Indemnification Provisions Baskets Basket amounts have been stable For the years 2008 through 2010, the mean basket was approximately 0.8% of fthe Purchase Price* Pi Expected studies would show more first-dollar baskets instead of deductible baskets, but studies have some conflicting information 2011 Houlihan Lokey Study - 81% deductible baskets 2011 SRS Study - only 33% deductible baskets Buyers may also request: Baskets that only relate to breaches of reps and warranties, and not to specific indemnity provisions Materiality scrapes related to the basket The inclusion of carve-outs in the basket, in addition to capitalization, due organization, due authority, and ownership of shares/assets About 93% of deals in the 2011 SRS Study had carve-outs; these deals had an average of 6 carve-outs** *Source: 2011 Houlihan Lokey Study ** Source: 2011 SRS Study

26 Negotiating Indemnification Provisions Caps Caps increased with the emergence of a buyers market and seemed to soften after an initial surge The 2011 Houlihan Lokey study found the average cap was 17% in 2007, 14% in 2008, and 10% in 2009* The SRS Study reflected an average cap of 13.68% from ** 2010** However, caps appear to be rising again The 2011 Houlihan Lokey Study found that the average cap was 12% in 2010* The 2011 SRS Study reflected an average cap of 17% between July 2010 and September 2011** *Source: 2011 Houlihan Lokey Study ** Source: 2011 SRS Study

27 Negotiating Indemnification Provisions Caps (cont d d.) If cap is less than 100% of purchase price, buyer may push hto include carve-outs: For Seller s breach of covenant or fraud Last year, about 90% of deals included a carve-out for fraud; 65% for non-willful breach of covenant; 58% for intentional breach of rep* For specific indemnity provisions Capitalization, taxes, due authority, and share ownership are popular p carve-outs For certain reps and warranties The most common carve-outs are for the following representations: ti capitalization ti (71%); due authority (66%); share ownership (64%) and taxes (59%)* * Source: 2011 SRS Study 27

28 Negotiating Indemnification Provisions Escrow Importance of Escrow or Set-off Rights Buyer s indemnification claims are unsecured claims This has heightened relevance if seller files for bankruptcy post closing Escrow Portion of purchase price may be placed in escrow Procedures for drawing escrow funds are critical Escrow provide funds for all indemnification amounts? First or final amounts? Escrow limited to certain types of claims, e.g. environmental Term of escrow account

29 Negotiating Indemnification Provisions Escrow (cont d) Set-off Rights Allow buyer to deduct d indemnification ifi amounts against future transaction payments or earn-out payments Procedures for identifying setoff payments are critical Time period of payments v. time of allowable indemnification claims Limited to certain types of claims, e.g. environmental Thresholds / materiality yqualifiers Joint and Several Liability Impact on buyer Impact among sellers

30 Negotiating Indemnification Provisions Escrow (cont d) Escrow periods continue to increase 20 For 2010, the average period was 20 months according to the 2011 Houlihan 19 Lokey Study* 18 The SRS Study also saw an increase in escrow periods, up to 18.3 months in from 15.9 months in 2009** 16 Escrow Period (months)* Escrow amounts remain high, but sellers have been pushing back with some success since 2009 In 2010, the average amount was 7.5%, reflecting a slight increase from 2009, but remaining lower than 2007 and 2008* For July 2010 through July 2011 the SRS Study indicated an average escrow of 12.94%** % 8.00% 6.00% 4.00% 2.00% Escrow as percentage of purchase price* *Source: 2011 Houlihan Lokey Study ** Source: 2011 SRS Study 0.00%

31 Negotiating Indemnification Provisions Closing Deals Without Credit Important to understand how indemnification provisions are affected by new terms and structures used to get deals done in tight credit markets Some currently used terms and structures include: Post-Closing purchase price payments; Earnouts; Simultaneous Acquisitions; Seller Financing; Equity Rollover; Payments in Kind

32 Negotiating Indemnification Provisions Closing Deals Without Credit (cont d d.) Post-Closing Purchase Price Payments How does the delay affect the survival clause? Earnouts Increased risk of litigation or arbitration In the 2010 SRS Study, 25% of deals had earnouts (1/3 of which extended beyond 5 years), and the Buyer was entitled to offset indemnity payments in 59% In the 2011 Houlihan Lokey Study, 21% of deals in 2010 had earnouts, the same as 2009 and higher than the 16% in 2008 Simultaneous Acquisitions Structure t cap and baskets as first-come, first-serve or pro-rata based on purchase price?

33 Negotiating Indemnification Provisions Closing Deals Without Credit (cont d d.) Equity Rollover Used in 25% of deals in 2010, up from 18% in 2009 and 2008* Seller Financing Used in only 2% of deals in 2010, down from 6% in 2009 and 2008* Payments in Kind Two-party indemnification for swapped assets or stock * 2011 Houlihan Lokey Study 33

34 MAC Clauses and Indemnification Provisions in M&A Deals Reassessing Provisions Regarded as Seller-Friendly 34

35 Reassessing Common Provisions Consequential Damages Boilerplate provisions commonly exclude more than consequential damages Often exclude: Consequential, Incidental, Indirect, Special, Punitive Damages, Loss of Revenue/Income/Profits

36 Reassessing Common Provisions Consequential Damages (cont'd d.) Consequential damages: Compensate the buyer for real losses resulting from seller s breach of a representation or warranty Incidental damages: Include expenses incurred by non-breaching party to avoid other losses caused by the breach

37 Reassessing Common Provisions Consequential Damages (cont'd d.) Incidental damages likely include out-ofpocket expenses incurred by buyers to remedy problems resulting from seller s breach Thus, buyers should seek to exclude incidental damages from waiver provisions, although they are commonly excluded in boilerplate provisions

38 Reassessing Common Provisions Fraud Exclusion Contractual survival periods of representations and warranties generally apply only to contractual rights Fraud & Misrepresentation claims are based in tort law thus often not subject to survival period

39 Reassessing Common Provisions Fraud Exclusion (cont'd d.) Not all states allow parties to limit their liability for tort-based claims such as fraud and misrepresentation (CERAbio LLC v. Wright Med. Tech Inc. (7th Cir. 2005)) If gross negligence indicates intentional wrongdoing, a provision limiting liability may be ineffective (Food Holdings Ltd. v. Bank of America Corp. (S.D.N.Y. 2010)) Certain types of tort claims may not be excluded (DynCorp v. GTE Corp. (S.D.N.Y. 2002); Solutia Inc. v. FMC Corp. (S.D.N.Y. 2006)) When a seller has peculiar knowledge that could not be discovered by buyer When a seller denies existence of information requested by buyer However, when a sophisticated party knows that it is not receiving full information, it may be barred from relying on the peculiar knowledge of its counterparty

40 MAC Clauses and Indemnification Provisions in M&A Deals The Role of the CPA in Proving Material Adverse Change and Benefit of the Bargain Claims 40

41 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause Purchase and Sale Agreements typically include a Material Adverse Change ( MAC ) clause containing i language similar to the following: Definition Material Adverse Change any event, development, circumstance, change or effect that is or would reasonably be expected to be materially adverse to the business, financial condition or results of the operations of the Acquired Company. Representation of Seller Since date XX, there has not been any Material Adverse Change in the business, operations, properties, prospects, assets, or condition of any Acquired Company, and no event has occurred or circumstance exits that may result in such Material Adverse Change. 41

42 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) IBP, Inc. v. Tyson Foods, Inc. Based on VC Strine s ruling in this case, a MAC may have been sustained if: Dramatic downturn in earnings from the date of the signing of the SPA and before the closing. There is a downturn in the business that is disproportionate to the industry, The downturn is durationally-significant (or over a commercially reasonable period), meaning years and not months (is the downturn a blip or a trend?), and The change in the business in unknown to the Buyer. 42

43 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Another point of contention, assuming a MAC has occurred is whether it was known to the Buyer prior to signing the Agreement? An assessment of the Buyer s valuation process will often reveal the facts contemplated by the Buyer at the time and whether or not the causes of the MAC were known. As a related issue in assessing if damages have occurred, did the Buyer receive the benefit of its bargain or did the Seller materially mislead the Buyer as to the quality of its earnings? 43

44 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Valassis and ADVO are in the direct mail advertising business. Each company had sales in excess of $1B. The combined entity will exceed $2.65B in sales. Late in 2005 Valassis commenced merger discussions with ADVO. On July 7, 2006, Valassis and ADVO signed the SPA, whereby, Valassis would pay $37/share in cash. 44

45 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Prior to the signing of the SPA, ADVO represented: Forecasted operating income for FY2006 of $68 million; The integration of their SDR computer system was progressing as planned; That the April & May 2006 financial statements were materially correct; The SPA is signed on July 5,

46 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) AFTER the signing g of the SPA: ADVO disclosed that April and May s 2006 financial statements were misstated by $2.6M; August 10, 2006, ADVO adjusted its $68 million forecasted operating income to $54.8 million, nearly identical to an internal April 2006 forecast of $ million; Actual FY results ending 9/30/06 were $37.9 million, some $30 million below expectations. Negotiations stalemated. On October 31, 2006 Valassis filed suit to rescind the merger. 46

47 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Investigate the following allegations: Were ADVO s financial statements and financial forecasts misleading? Was ADVO s new computer system operating as represented? Financially speaking, did ADVO s business suffer a financial downturn? More specifically: Did ADVO suffer a MAC? Was ADVO performing disproportionately below its peers in the industry? Was ADVO s downturn durationally significant? Did Valassis significantly overpay for ADVO? Critique opposing expert report 47

48 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 48

49 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 49

50 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 50

51 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) The forecasted cash flows and discount rate were adjusted to reflect the downturn in the business. Valassis revised the revenue assumptions downward d which translated into a revised cash flow analysis. A control premium was added to the DCF valuation. 51

52 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 52

53 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 53

54 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) A MAC is very difficult to prove, therefore, the buyer should consider incorporating economic teeth into the MAC clause, for example: Downturn defined, in duration and monetary terms Projected vs. actual results threshold defined Loss of customer base defined The combination of these issues would trigger a purchase price adjustment 54

55 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) For example: If sales decline more than 15% from the previous quarters financial statements If EBITDA (as defined in the Agreement) declines more that $5 million from the previous months EBITDA If a customer comprising 10% or more of total sales for the previous twelve months is lost 55

56 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) The benefit of the bargain measure awards the plaintiff the difference between the gain had the misrepresentations been true and what the plaintiff actually received. 1 1 Litigation Services Handbook, Fourth Edition,

57 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Did the buyer receive the value represented by the seller? Were misstatements of the financial statement known to the buyer? If the seller misstated the financial statements, the buyer may not have received the benefit of its bargain. 57

58 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) ADVO was valued based on the financial performance as represented by Valassis in July 2006 (prior to signing) and in August 2006 (after signing). Valassis utilized both the Market and Income approaches in valuing ADVO. Valassis paid a significant control premium in its acquisition iti of ADVO. 58

59 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) A multiple of EBITDA was utilized based on the comparable companies. Valassis initially priced ADVO: Bargained for - 11 times EBITDA As received - 9 times EBITDA The multiple l of EBITDA approach included a control premium. 59

60 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Purchase Price Overpayment Calculation In Millions (except multiples) l 9.0x Multiple Pre-Signing Forecasted Fiscal '06 Op. Income - Misrepresentation $68.0 Less: Pre-Signing Forecasted Fiscal '06 Op. Income Realistic (54.5) Operating Income Misrepresentation $13.5 % of Misrepresented Operating Income 19.9% ADVO '06 EBITDA (Valassis/Bear Stearns Projection) $119.0 Less: Misrepresentation (13.5) Corrected ADVO '06 EBITDA $105.8 EV/EBITDA Purchase Price Multiple 9.0x Adjusted Enterprise Value $950 Less: Actual Enterprise Value Purchase Price 1,291.3 Purchase Price Overpayment $(341.8) % of Actual Purchase Price 26.5% 60

61 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 61

62 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont d.) 62

63 CPA s Role in Proving MAC and Benefit of the Bargain Claims Standard d Material Adverse Change Clause (cont d.) Case settled, as it should have, at about a $150 to $200 million discount Material Adverse Change: Difficult to rescind a merger The duration of ADVO s downturn was a significant debate Durationally-significant is difficult to prove when a new customer could be obtained immediately or take years Fraud claims were compelling: Alleged non-disclosure of Budget Alleged misrepresentation of success of sales promotion Alleged misrepresentation of the status of the computer system 63

64 MAC Clauses and Indemnification Provisions in M&A Deals Merger and Acquisition Issues From Dispute to Resolution 64

65 M&A Issues From Dispute to Resolution 65

66 M&A Issues From Dispute to Resolution The Deal Earn Outs Amerisource Case: This case falls in the archetype pattern of doomed d corporate romances.after some time, the initial romance fades, the relationship consequently sours, and both parties find themselves before the court loudly disputing what the merger agreement really meant back in the halcyon days. 66

67 M&A Issues From Dispute to Resolution 67

68 M&A Issues From Dispute to Resolution Intersection of Indemnification and Closing Date Adjustments Background: An Interest Purchase Agreement ( IPA ) provides for a working capital adjustment and indemnification of third party claims Indemnification provisions for financial statements and undisclosed liabilities apply A third party claim for pre-closing unpaid rent is made Indemnification notice and defense provisions of the IPA actuated First issue is legal: who defends and does seller have a conflict Second issue is legal and financial: can there be both a PPD and an indemnification claim for the same issue and if so, how derived?

69 M&A Issues From Dispute to Resolution Intersection of Indemnification and Closing Date Adjustments Illustration: Indemnification claim is settled for $750k The purchase price equates to approx. 6X EBITDA from warranted F/S Buyer contentions: Buyer gets BOTH its $750K as a PPD and $4.5m of indemnification The rent expense error will result in recurring additional expense Buyer primarily based its consideration on an EBITDA multiple Seller contentions: Buyer does not get indemnification for amounts not paid to third parties Buyers claim is Plus One and therefore duplicative; Buyer will pass on additional costs to its customers; Should be Minus One if anything Seller is not responsible for how Buyer derived its offering price 69

70 M&A Issues From Dispute to Resolution Intersection of Indemnification and Closing Date Adjustments Illustration cont d.: What if contentions: If issue was unrecorded revenue does Buyer owe 6X? If Seller paid the claim out of own funds what happens? If Seller paid the claim out of the funds of the acquired business what happens?

71 M&A Issues From Dispute to Resolution The Dispute What to discuss with the potential arbitrator Details about the process: from dispute to resolution 71

72 M&A Issues From Dispute to Resolution The Dispute What issues routinely arise in a purchase price dispute? Discovery issues Dates through which information is relevant GAAP vs. consistency Errors in the benchmark Materiality Due diligence Additional disputed items Overlap of PPD issues and Indemnification

73 M&A Issues From Dispute to Resolution The Dispute Accounting issues common to purchase price disputes General Areas Specific Issues

74 M&A Issues From Dispute to Resolution The Dispute How to improve your chances of success in a PPD Expect disagreement over closing balances Engage legal and financial resources Enroll support from key employees Retain/obtain documents Be thorough in picking the neutral No underestimating the opposing position Avoid overreaching Provide support and proof beyond argument Develop an expected value and min/max probabilistic outcomes Respond fully to all arbitrator questions Don t compromise on strong positions

75 M&A Issues From Dispute to Resolution How to limit the likelihood of PPDs Set baskets Define the closing date adjustment narrowly Avoid late changes to the SPA Double check formulaic adjustments for selected amounts Set closing date at month end Set or limit changes to contra asset accounts and reserves Take physical inventories i Agree on fixed asset existence verification Shorten time from benchmark to closing Perform buy and sell side diligence Document the dispute resolution process specifically 75

76 Todd B. Pfister Presenter Contacts Kevin Kreb Jeff Litvak