What are the typical methods and constructs of how risk is allocated between a buyer and seller?
With locked box mechanisms being very frequent, the business risk between the last account date and closing is usually borne by the purchaser, who will have limited protection by way of ordinary course of business and no-leakage warranties and covenants.
Representations and warranties are usually qualified by matters that have been disclosed (in a certain manner) or are deemed disclosed by operation of the provisions of the acquisition agreement or the disclosure letter (e.g. information which can be obtained from publicly accessible registers). The seller will always push for general disclosure (i.e. everything disclosed to the purchaser and its advisors at whatever occasion qualifies all warranties) while the purchaser will push for specific disclosure (i.e. separate disclosure for each warranty) and try to introduce a disclosure threshold requiring that a matter must be “fully and fairly” disclosed. This is usually heavily negotiated. Disclosure letters are relatively rare.
Purchasers who have identified a risk as part of their due diligence which would be excluded due to the disclosure need to negotiate an exclusion or indemnity to have protection. Indemnities are generally not qualified by disclosure or knowledge. The tax indemnity is usually only subject to a specific tax conduct provision, a direct loss limitation and the overall cap. Other limitations are a matter of negotiation. If other indemnities (e.g. for contamination and environmental compliance or specific due diligence findings) are accepted, limitations are usually heavily negotiated.
Common limitations on warranties include:
Time limitation for bringing claims:
- title and capacity warranties usually survive 10 years at the minimum;
- business warranties between 12 and 24 months;
- tax warranties typically around seven years; and
- environmental warranties five to 10 years.
Financial limits, including:
- a cap on the total liability (where there are multiple sellers, each may seek to limit its liability pro rata);
- a minimum aggregate claims threshold (“basket”); and
- an exclusion of de minimis claims.
Limitation to direct loss (as opposed to indirect and consequential loss).
Exclusion of claims to the extent caused by:
- agreed matters;
- acts of the purchaser (outside of the ordinary course of business);
- change of law or interpretation of law; or
- change of tax or accounting policies.
No liability for contingent liabilities.
No liability if the purchaser knew or could have known.
No liability for mere timing differences (e.g. if tax authorities request longer tax depreciation periods).
Obligation to mitigate loss.
No double recovery under warranties, indemnities and insurance policies.
A conduct of claims provision.
MAC clauses are sometimes agreed, usually after heavy negotiations. Private equity sellers tend to avoid MAC clauses in order to have transaction security.
Bring-down due diligence is relatively rare.
The risk of regulatory approvals, such as merger clearance, is usually borne by both parties. While it is common for purchasers to agree on covenants with regard to prompt filings and reporting to and consulting with the seller, purchasers very rarely accept hell or high water clauses. In transactions which appear to be difficult from a merger clearance point of view, break fees are sometimes discussed, but only rarely agreed.
The typical methods of risk allocation between the buyer and the seller in transactions in which the targets are Japanese companies do not differ from the general practices elsewhere, which include provisions relating to representations and warranties, pre and post-closing covenants, closing conditions, indemnification, and closing adjustment of the purchase price.
Even when a financial sponsor is a seller of a target company, representations and warranties provided by the seller would usually include some representations and warranties about the target although the scope of such representations and warranties would be more limited compared to the scope a trade seller would provide.
With respect to closing conditions, the absence of material adverse effect and a financing condition would usually be among the most heavily negotiated between the seller and buyer.
Post-closing indemnification by the seller in favor of the buyer (for breaches by the seller of its representations and warranties and other covenants and agreements as set forth in the transaction documents) is a common means of risk allocation between the seller and the buyer. In going private transactions in which there are multiple shareholders of the target company, such indemnification is often provided by the sellers who are controlling shareholders of the target company under tender agreements executed between such controlling shareholders and the tender offeror.
The transaction will often be through a leveraged buy-out using the assets of the target company as collateral to acquire the assets of the company. The buyer will also often want the seller to retain some degree of interest in the company either by having the seller stay at the level of the management of the company or through some form of partnership to ensure the smooth implementation of the buyer’s strategy for the growth of the company.
Private M&A transactions in the Norwegian market are customarily structured as a sale and purchase of shares in the target company, except in circumstances where the parties find it more beneficial to structure the deal as an asset transaction.
The share purchase agreement or the assets purchase agreement, as the case may be, sets out the terms and conditions of the transaction amongst the parties. Such agreements customarily contains all the typical provisions on risk allocation as you would find in Nordic and European transactions, such as purchase price mechanism, pre-closing covenants, closing conditions, representations and warranties and specific indemnities.
It could be noted that general disclosure against the warranties of the dataroom is the market norm, but the warranties customarily also include sweeping provisions on the accuracy and completeness of the dataroom. The representations and warranties are normally given both at signing and closing, without disclosures after signing being permitted except in insured transactions. On the other hand, it is increasingly uncommon to permit the buyer to withdraw from the agreement on basis of material adverse changes between signing and closing.
The risk allocation in the individual case depends on the market conditions, nature of the transaction and the parties bargaining power. The recent years it has however generally been a fairly seller friendly environment in Norway, which also impacts the terms of the transaction agreements favorably to the seller.
The typical methods and constructs for the risk allocations are representations and warranties for general (unidentified) risks as well as indemnities for specific risks identified during due diligence (such as a pending litigation). In the current sellers' market, we see a shift from indemnities to so called "quasi indemnities", i.e. representations and warranties which are excluded from disclosure but which are still subject to the other limitations such as the notification obligation, de minimis, threshold/deductible, damage definition etc. In addition, risks can be allocated through the purchase price mechanism as well as certain covenants.
In the Netherlands, risk is most commonly allocated between a buyer and a seller through warranties and specific indemnities. In addition, parties sometimes allocate the risk of changes in circumstances between signing and closing by including a MAC clause.
For Dutch acquisition agreements it is common practice for the seller to give warranties relating to the business that is being sold. Several factors influence the scope of the warranties and the scope and outcome of the due diligence investigation is often an important factor in this regard. The seller will seek limitations to the scope of the given warranties. This is often done by qualifying the warranties against disclosures made during the due diligence process. It is common practice for the seller to seek to disclose the entire contents of the data room. Other customary ways in which a seller tries to reduce the scope of warranties are limiting the scope to matters which qualify as ‘material’ to the business or matters within the (actual or constructive) knowledge of the sellers.
It is common to specify a maximum amount for which the seller can be held liable in the event of a warranty breach We often see ranges between 10% and 30% of the purchase price. The amount of the cap as a proportion of the purchase price tends to be inversely proportional to the deal value of the transaction.The general tendency seems to be towards shrinking caps. This cap will typically not apply to claims in respect of: (i) certain fundamental warranties (e.g., those relating to title); (ii) tax, and (iii) fraud, willful misconduct, or intentional recklessness on the part of the seller. In addition, limitations of the amount of the seller’s liability usually include both a de minimis threshold for individual claims as well as an aggregate de minimis threshold (“basket”) for all damage claims taken together. As a very general rule of thumb, the market usually refers to a basket of 1% of the purchase price and a de minimis of 0.1%. These thresholds do not typically operate as deductible amounts, and thus claims exceeding the thresholds are usually eligible for recovery of the entire amount of the claim
The seller’s obligation under the warranties is, moreover, typically made subject to both limitations in time. A general limitation in time of the seller’s obligation for claims under the warranties is included in almost all acquisition agreements. Dutch acquisition agreements often provide for a time limit tied to a full audit cycle to give the buyer the opportunity to discover any problems with its acquisition (i.e. 18 months following completion). Time limits will generally be longer for claims for breach of certain fundamental or specific warranties: (i) for title warranties, the time limit is often tied to the applicable statute of limitations, (ii) for claims for breach of environmental warranties, the buyer will typically be able to bring a claim within five to seven years of completion and (iii) for tax warranties, this will typically be within a short period after the last day on which a tax authority can claim the underlying tax from the target.
In addition to warranties, a purchaser will want to include indemnities to cover specific risks identified during due diligence (e.g. tax, pending litigation or environmental pollution) of which it is difficult to identify the exact extent and thus the associated costs. Specific indemnities are not qualified by disclosure and are not (entirely) subject to the agreed limitations of liability (e.g. time limitation, de minimis and basket). Indemnities are mostly given on a euro for euro basis. Although, in most cases indemnity claims will be subject to a separate cap (often the liability will be limited to an amount equal to the purchase price).
The current market for sale terms is very seller friendly.
The most important risk allocation method is the locked-box itself which passes all economic risks and rewards following the effective date to the buyer.
The effective date will be based on a historic balance sheet date which has been diligenced by the purchaser. The Seller is usually expected to provide fundamental warranties following such date and for the period between signing and closing a customary set of purchaser consent rights in respect of material business issues.
All operating issues are either not covered in the share purchase agreement at all or have primary recourse as against a W&I insurance policy.
In the most competitive auction processes where there is a compressed timetable, we have seen instances of buyers signing share purchase agreements with no protection (outside of vendor due diligence and some buyer due diligence) and obtained W&I insurance coverage between signing and closing following a comprehensive confirmatory due diligence exercise.
We do not see any closing conditions except for mandatory regulatory approvals (i.e. no bring-down, no MAC) in which case most transaction documents contain either a strict hell or high water clause for the merger clearance or a corresponding contractual penalty/break fee.
In Belgium, risk is most commonly allocated between a buyer and a seller through warranties and specific indemnities. In addition, parties sometimes allocate the risk of changes in circumstances between signing and closing by including a MAC clause.
In Belgium, the inclusion of warranties in the acquisition agreement is the most common method of allocating risk between a buyer and a seller in a M&A context. Practically all acquisition agreements contain warranties by the seller. In most cases, these contractual warranties are essentially based on a standard list. Typical standard warranties include a warranty with respect to the target company’s accounts, the target company’s compliance with laws, and the seller’s full and accurate disclosure.
The seller’s liability under the warranties is usually made subject to an exception to the effect that the seller shall not be liable for damages on the basis of facts that had been disclosed to the buyer. In Belgium, full data room disclosures are fairly common. Alternatively, disclosures are restricted to specific disclosure schedules or letters. However, based on the requirement to carry out an agreement in good faith, the Court of Appeal of Liège (2 April 2015, see also a similar decision by the Court of Appeal of Ghent dated 18 February 2013) has decided that a buyer cannot invoke the indemnification obligation of the seller in relation to facts that it was aware of (or should reasonably have been aware of) even if such facts have not been explicitly referred to as ‘disclosed’ in the agreement. Consequently, it cannot be excluded that a Belgian judge would consider the data room disclosed even if the agreement does not explicitly provide for a data room disclosure. Taking this into account, purchasers should push for a reduction of the purchase price or a specific indemnity to cover risks that are known to it (see further below).
The seller’s indemnification obligation under the warranties is, moreover, typically made subject to both limitations in time and of the amount of the indemnification obligation. A general limitation in time of the seller’s indemnification obligation for claims under the warranties is included in almost all acquisition agreements. Belgian acquisition agreements often provide for a time limit tied to a full audit cycle to give the buyer the opportunity to discover any problems with its acquisition (i.e. 18 months following completion). Time limits will generally be longer for claims for breach of certain fundamental or specific warranties: (i) for title warranties, the time limit is often tied to the applicable statute of limitations, and (iii) for tax warranties, this will typically be within a short period after the last day on which a tax authority can claim the underlying tax from the target.
Limitations of the amount of the seller’s indemnification obligation usually include both a de minimis threshold for individual claims as well as an aggregate de minimis threshold (“basket”) for all damage claims taken together. As a very general rule of thumb, the market usually refers to a basket of 1% of the purchase price and a de minimis of 0.1%. These thresholds do not typically operate as deductible amounts, and thus claims exceeding the thresholds are usually eligible for indemnification for the entire amount of the claim. As regards maximum liability, the seller’s liability is almost always capped. We often see ranges between 10% and 30% of the purchase price. The amount of the cap as a proportion of the purchase price tends to be inversely proportional to the deal value of the transaction.
Separate indemnification mechanisms are also usually included in acquisition agreements, although they are slightly less common in small transactions. The use of specific indemnities has increased during the last decade. These indemnities relate most commonly to tax liabilities, but can also cover ongoing litigation, environmental pollution as well as other risks identified during due diligence. Specific indemnities are usually governed by a separate liability regime, and are often not made subject to the general limitations concerning claims under the warranties. In most cases, however, indemnity claims are made subject to a separate maximum liability cap.
It should also be noted that in transactions with a deferred closing, “Material Adverse Change” (“MAC”) clauses are sometimes used to allocate risks related to changes of circumstances in the period between the signing of the acquisition agreement and the closing of the transaction. Under a MAC clause, the buyer may terminate the acquisition agreement if there is a material negative change of circumstances during such period. MAC clauses are usually included as a condition precedent to closing, but sometimes also take the form of a “backdoor MAC”, i.e. a warranty by the seller regarding the absence of a material adverse change between signing and closing in combination with a termination right of the purchaser for breach of warranty. In Belgium, MACs are mostly used to protect against risks that are specific to the target company. General risks affecting e.g. the economy or the political climate in general are usually excluded.
The full range of methods and constructs typically seen are available.
For a buyer these would include:
a. a negotiation on the concept of and level of disclosure;
b. escrow arrangements;
c. purchase price reductions;
d. representations and warranties are typical devices in SPAs;
e. indemnities, in particular relating to tax, litigation and environmental risks. They are also being increasingly requested in relation to data protection;
f. for transactions governed by Polish law, contractual penalties and submissions to enforcements (a form of pre-agreed judgment) are also available.
For the seller the protections available would include:
a. quantum and timing limitations of liability;
b. caps, de minimis and basket clauses;
c. specifically negotiated disclosure and exclusions;
d. procedural clauses dealing with third party claims.
The main methods in M&A transactions in Portugal to allocate risk in a transaction agreement between buyer and seller are through: (i) representations and warranties; (ii) specific indemnities; (iii) remedial actions and covenants.
Representations and warranties are the most commonly used method to allocate contractual risk in Portuguese M&A transactions. Representations and warranties usually cover a wide array of legal, financial and operational issues (when given by the sell-side) or are limited to existence, legal capacity and financial capacity (when given by the buy-side) and are generally subject to limitations on indemnification (caps, time limitations, baskets and deductibles are usually used), unless when referring to fundamental issues such as the ownership of shares by seller.
Representations and warranties are also usually limited by disclosures, either against information set out in a data room (“disclosed information”) or against exceptions identified in a schedule included in the transaction agreement to that effect (commonly known as “disclosure letter” or “schedule of exceptions”).
When material contingencies arise following the outcome of a due diligence exercise to the target company (which, depending on the activities performed, may be of a legal, financial, tax, market and technical nature) buyers sometimes are able to negotiate the inclusion of specific indemnities, allocating the risk of damages arising out of a known contingency to the seller, generally without financial or time limitations associated to the respective indemnification obligation. When dealing with private equity buyers, tax and compliance risks are tendentially retained by the sell-side through more general indemnities.
Finally, when contingencies which are less material are identified during due diligence, sellers will occasionally be obliged to execute, pre and post-closing, actions to remediate or annul such contingencies and will be responsible
It varies, but it is more common that warranties are given both at signing and completion so that the risk actually remains with the seller until completion. Swedish law and market practice puts a lot of responsibility on the buyer to perform proper due diligence and everything that is fairly disclosed in the data room will be considered disclosed against all warranties (normally) and any specific diligence findings will need to be negotiated as specific indemnities.
In the Chinese M&A market, the parties’ identity, level of sophistication and relative negotiating leverage are more likely to drive the approach to risk allocation than any particular market term. For example, with respect to the scope of representations, disclosure and conditionality, depending on the circumstances, the parties may follow either a U.S. construct (with extensive representations and warranties backstopped by an indemnity and qualified only by the disclosure schedules and negotiated closing conditions, including absence of a material adverse change) or a European construct (where representations are qualified by the content of the data room and the buyer has more limited conditionality than merely obtaining relevant regulatory approval). In competitive auctions and/or large transactions by financial sponsors, sellers are increasingly able to obtain very favorable terms, including no recourse against the seller following closing (other than for limited exceptions such as breach of fundamental warranties). In the case of investments in a Chinese company where the Chinese founder remains involved in operation of the business, it is more common for buyers to insist on broad representations and warranties back-stopped by an indemnity, although for attractive assets sellers have in recent years been able to negotiate limitations (e.g. in terms of cap and survival period) to their exposure.
In addition to tailored purchase price mechanisms (earn-outs etc.) designed to share risk regarding future performance or events, warranties and indemnities in purchase agreements are the main contractual means of risk allocation. The seller’s liability for unknown risks are covered by warranties, which are commonly subject to e.g. time and monetary limitations as well as the buyer’s knowledge based on the disclosure material in the data room. Financial sponsors typically endeavour to achieve a ‘clean exit’ with only limited fundamental warranties given by the seller, and operative warranties being covered by a W&I insurance policy paid for by the buyer.
Risks related to known but contingent liabilities, such as pending litigations or environmental risks, are commonly dealt with by means of specific indemnities negotiated on a case-by-case basis depending on the bargaining power of the parties.
In addition, post-closing covenants, such as confidentiality obligations, non-compete and non-solicitation and, in case of separate signing and closing, pre-closing covenants concerning e.g. seeking regulatory approvals or ordinary course of business, are generally agreed upon.
Under a customarily structured share purchase agreement, the risks attached to the business of the target company are mainly dealt with through interim covenants and leakages protection. Purchase price mechanism, closing conditions, representations and warranties and specific indemnities are also used to reduce the risks attached to the transaction.
For the past couple of years, due to the influence of private equity transactions, the French market has been more and more seller friendly. This is particularly tangible when it comes to warranties, anti-sandbagging clauses being the standard.
It should however be noted that recent evolutions in the French civil code impose to sellers a duty to provide to the purchaser all key information relating to the object of the sale. However, professional purchasers such as private equity sponsors are supposed to perform reasonable due diligence in the context of a transaction.
The current market for sale terms is very seller friendly.
The most important risk allocation method is the locked-box itself which passes all economic risks and rewards following the effective date to the buyer. The effective date will be based on a historic balance sheet date which has been diligenced by the purchaser. The Seller is usually expected to provide fundamental warranties following such date. All operating issues are either not covered in the share purchase agreement at all or have primary recourse as against a W&I insurance policy. In the most competitive auction processes where there is a compressed timetable, we have seen instances of buyers signing share purchase agreements with no protection (outside of vendor due diligence and some buyer due diligence) and obtained W&I insurance coverage between signing and closing following a comprehensive confirmatory due diligence exercise. We do not see any closing conditions except for regulatory approvals (i.e. no bring-down, no MAC) in which case most transaction documents contain either a strict hell or high water clause for the merger clearance or a corresponding contractual penalty/break fee.
Risk allocation is a key factor in various aspects of an M&A transaction. Some of these and the way they are addressed are:
(a) Deal certainty and MAC: Clear conditions precedent are included. Any adverse changes between signing and closing are dealt through MAC clauses; the more quantifiable and linked to specific results these are (i.e. amount of loss, EBITDA hit etc), the less controversial their interpretation will be. The Seller may ask for guarantee or equity commitment letter in case the Buyer is an SPV
(b) Closing and price adjustment: a clear definition of cash, cash equivalent, debt and debt like items is included for the purposes of price adjustment in case a closing account mechanism is used. In case the parties find this too complicated and resort to a locked box mechanism, a clear definition of ‘leakage’ and ‘permitted leakage’ is required.
(c) Due Diligence and disclosure: Vendor’s due diligence are getting more popular. sellers aim to include in the ‘disclosed’ definition any items included in the data room, whereas buyers want to limit such definition to any items included in a Disclosure Letter.
(d) Warranties: Warranties insurance becomes more popular. Sellers use customarily limitations of liability (cap of liability, de minimis, time limitations); ‘fundamental’ or ‘core warranties’ (i.e. good title and non-encumbrance of shares to be sold, as well as, capacity to sell) are usually not subject to the above limitations.
(e) Pre-closing period: seller’ covenants will typically be inserted so that the target continues to operate as a going concern but there is no leakage or unnecessary increase of liabilities.
(f) Seller’s guarantees for target’s performance: Purchase price deferred payment or earn-outs are used from a buyer’s side. An escrow mechanism may be asked from the seller in such cases.
It is very deal specific in Ireland with a wider range of "market practice" but the tread is moving in favour of Sellers. The old market practice of having liability for 100% of purchase price under warranties and indemnities is much less common with caps on liability of 25-30% now very common.
Common to other jurisdictions, the standard way of allocating risk between a buyer and seller in Luxembourg is through use of warranties and indemnities in the acquisition agreement.
Financial sponsors are reluctant to give anything other than the basic warranties upon sale (i.e. as noted in the response to question 2 above, it is sought to limit warranties to warranties as to title, capacity and authority).
The ultimate approach agreed to the level of warranty and indemnity protection is very much dependent on the relative bargaining power of the parties involved.
As noted below, W&I insurance has become increasingly popular where anything other than fundamental warranties are given.
The current market for sale terms is very seller friendly.
For transactions with a separate signing and closing, the obligation of the buyer to close is typically conditioned upon target’s compliance with its pre-closing covenants in all material respects, as well as the accuracy of the target’s representations and warranties as of closing. The vast majority of transactions we have worked on required the representations and warranties to be true and correct as of closing subject to a material adverse effect qualifier (scraping the reps of materiality), with the balance subject to a materiality or no qualifier.
In addition, the majority of transactions do not include a condition that buyer shall have obtained its financing. However, buyer and sellers regularly allocate financing risk by adopting either the “Private Equity Model” or “Fully Equity Backstopped Model” of financing risk allocation.
The Private Equity Model provides that if all closing conditions are satisfied, target has right to force buyer to fund and close, but only as long as debt financing is available. Otherwise, target cannot force buyer to close, but if debt financing is unavailable and closing conditions are satisfied, target is entitled to payment of a reverse termination fee (typically as its exclusive remedy). Approximately 67% of the transactions we have worked on in the last 12 months (with a separate signing and closing) used the Private Equity Model and in such instances, the median reverse termination fee was 5% of enterprise value.
The Full Equity Backstop Model provides that if all closing conditions are satisfied, target has the right to force buyer to close (regardless of whether the buyer’s debt financing is available, if sought) or to sue for damages (often capped). Approximately 33% of the transactions we have worked on in the last 12 months (with a separate signing and closing) used the Full Equity Backstop Model.
In competitive auction processes, buyers are increasingly willing to forgo post-closing indemnification from sellers. 30% of all transactions we have worked on in the last 12 months did not include any post-closing indemnification. In those transactions where the parties agreed to include post-closing indemnification there has been downward pressure on the size of the incentive equity cap due to seller leverage and increasing use of R&W Insurance, with approximately 44% of deals having a basic indemnity cap of 2% or less.
The allocation of risk between the parties to a Maltese law governed M&A transaction will very much depend on the nature of the transactions and the negotiating leverage held by each of the parties to the deal. Regular points of contention that arise tend to revolve around issues such as the attribution of risk of the significant asset/s underlying the deal, the adjustment of the negotiated price on the basis of any variances resulting from the operation in the business until completion, or the discovery of material adverse effects by the buyer in the course of the transaction.