The confidentiality agreement was signed long ago, the letter of intent is a distant memory and the due diligence is over. Both parties should now be sufficiently informed to negotiate a definite acquisition agreement. In Common Law jurisdictions these agreements are fairly lengthy. The lawyers point out that they have to deal with the many eventualities which reflect the due diligence and evaluations which have proceeded it.
The party which draws up the first draft is normally at a negotiating advantage as the first draft sets the tone, style and structure of the agreement. Furthermore, there is a good chance that the other side will confine itself to criticising what is written rather than introducing new ideas. It is best to be even-handed rather than annoy the other side with a blatantly one-sided first draft. However, there is nothing wrong with introducing the odd clause you know will be deleted so that the other side can be lulled into thinking it has scored when you reluctantly concede a few points.
The shares in a company can be transferred from one person to another with a single-page stock transfer form bought from any legal stationer. Why go to the bother of preparing a share sale and purchase agreement of anything up to 200 pages? The answer is that when a company is purchased through a share sale, it comes together with all its assets and liabilities irrespective of whether the buyer actually wants them. In a company with a long history or a company which has traded extensively this may involve a buyer picking up historical, unknown and unquantified liabilities. A share sale and purchase agreement therefore introduces certainty for both sides by enabling a buyer to know that it is buying exactly what it thinks it is buying and enabling a seller to sell exactly what it wants to sell. It also gives the buyer some legal protection should the business not be in the state that it thought.
In the Anglo-Saxon jurisdictions, the acquisition of shares is governed by the law of contract. Neither party is obliged to disclose facts to the other. This explains why purchasers make extensive enquiries about the company and put a provision in the contract to say that it has relied on the vendors’ answers. The acquirer should find out everything it needs to know about an acquisition target before completing the transaction. But what if the seller does not tell the acquirer the truth or does not tell the acquirer the whole story in response to questions? Or what if there are some questions to which it is impossible to have a definite answer before the transaction completes? The contract will contain negotiated provisions, known as warranties and indemnities, to deal with both these eventualities. In addition, there are two legal reasons why the acquirer needs to consider specific legal protection when buying a company:
Under English law, the acquirer buys a company on a ‘goods as seen’ basis and trying to get a refund is no fun! In Latin this is the caveat emptor or ‘buyer beware’ principle
Acquirers cannot rely on the audited accounts of the target company. If those accounts have been negligently audited, an acquirer can only hope to sue the auditors in the most exceptional circumstances
In contrast, with an asset sale the buyer only purchases those assets it wants and leaves behind anything it does not want.
Basically, the acquisition agreement should set out:
The principal financial terms of the transaction, and
The structure of the transaction
The acquisition agreement will also include:
The legal rights and obligations of the parties
The remedies for breaches of these obligations
The actions that the parties must take prior to completion of the transaction
The agreement should form a comprehensive record of the entire agreement between the parties on all aspects of the transaction. This reduces the possibility of future arguments. To do this, it needs to set out clearly who is buying what, when they are buying it, for how much and on what terms. It also needs to state that it represents the entire agreement between the parties.
The agreement should set out the immediate changes which need making to the target company. These will include matters such as the resignation and appointment of directors, the resignation and appointment of auditors, the repayment of bank debt and changes to the constitution of the company.
The traditional order of the agreement’s sections are:
The commencement section has two main points:
In some European countries, but by no means all, special conditions must be met before an agreement can come into force. Under German law, for example, agreements must be notarised to be enforceable. This means all documents that form the transaction must be notarised. In Holland only the transfer of shares needs notarisation.
Clearly the agreement should list the parties, but sometimes it is not that obvious who they are. Only the shareholders on either side can make the agreement work but there may be complications. If there are trustees, the trustees must be involved from the beginning and the powers of the vendor director/vendor shareholder must be checked very carefully. Very often, for example, the terms of the trust will prevent trustees from giving warranties. This will knock a hole in the timetable if the warranties given by a vendor director/shareholder are assumed to have been given on behalf of all shareholders.
These are the paragraphs which describe (i.e. recite) the reasons for the agreement or the background against which the agreement should be read. Confusingly, these paragraphs begin with the word ‘whereas’.
The initial section of the acquisition agreement traditionally contains the deal points. The deal points typically explain the precise mechanics for transferring the shares and any underlying companies to the buyer and when and how the purchase price is to be calculated and paid.
Although there are many variations, there are three basic ways in which the buyer can meet the purchase price:
This is largely self-explanatory. Cash is normally acceptable to sellers subject to tax considerations.
Shares can take many forms including ordinary shares, preference shares, convertible shares and redeemable shares.[1] Sellers taking shares as payment will consider very carefully all of the rights attaching to the shares and whether the value is, or will be, enough to meet the price. For instance:
How and when are dividends payable?
Is a fixed dividend payable and what happens if dividends are not paid?
Is there a market for the shares if the seller wishes to sell them and will that be permitted under the articles of association of the company?
Are there effective controls against transactions draining value out of the buying company whilst the seller holds shares in it?
What protections are there against the buyer diluting shareholdings?
The main issues the seller will consider are:
Rate of interest – fixed or variable?
Does the rate of interest reflect the risk that is being taken by the seller in accepting debt?
What is the creditworthiness of the issuer and should a guarantee be obtained from a parent company or bank?
What are the events of default which will make the debt repayable in full?
Is the debt transferable?
As far as the seller is concerned, the buyer should guarantee payment of the agreed price when the agreement is signed, unless some sort of deferred consideration has been agreed. Usually the seller is not satisfied with the simple signature of the agreement by the buyer, and asks for a ‘guarantee of the guarantee’. In this case, the most common form of guarantee is the commitment of a financial institution to pay the amount due by the buyer if the latter does not.
The consideration could be for a fixed amount payable at completion, or for an initial element with additional tranches payable subsequently depending on, say, performance or the absence of warranty claims or following satisfactory completion accounts. The concept of consideration being dependent on future performance can raise difficulties because post-completion performance will be to some extent dependent on the new owners. Consideration related to post-completion performance is, therefore, best kept to short-term events such as making it dependent on the state of the company at completion.
A retention is when the buyer holds back part of the consideration. Retentions are used primarily where the buyer is concerned about the future creditworthiness of the seller to give comfort that warranty and indemnity claims will be met. The buyer holds back some of the purchase consideration which can then be set off against claims under the warranties or indemnities. They are also used when the seller undertakes to deliver something after the deal, such as the consent of a major supplier to a change of control or hitting a particular profit figure.
The main issues to address with retentions are:
Why is the retention being used? It is important that the reason is clear in the agreement
Who will hold the retention? Who is responsible for releasing it? Where will it be held and what type of account will be used?
What happens to the retention monies and any interest earned on them? The usual terms are that the party to whom payment is made also gets the interest
The circumstances under which the retention will be released
The use of a retention avoids the buyer taking a risk on the seller’s creditworthiness if there is a claim. In order to avoid the seller taking on the risk that the buyer will not pay over any retentions in the future if they are not used, money is usually paid into an escrow account. An escrow account is nothing more than a bank account opened in the joint names of the solicitors representing the buyer and the seller. The money is only released when the agreed requirements are met. If they are not, the money is repaid to the buyer.
Table 8.1 sets out how the main M&A risks can be addressed using escrow accounts:[2]
Table 8.1. M&A risks and escrow solutions
Risks | Escrow solutions |
|---|---|
For the buyer | Buyer protection |
The representations and warranties made by the seller are untrue. | A proportion of the purchase price is put in an escrow account for a specified time. If in that time the representations and warranties do turn out to be untrue the escrow funds can be turned over to the buyer. |
Covenants (see below) agreed by the seller are not honoured. | As above. |
There are key employees in the business who may leave. | Cash or shares are placed in escrow to be released over time if the employee remains. |
A seller cannot or will not pay advisers’ fees. | Advisers’ fees are paid into escrow and released when the advisers’ work is complete. |
For the seller | Seller protection |
The buyer does not pay up on earn-outs. | Earn-out premiums are placed in escrow and paid over to the seller once performance benchmarks are reached. |
For both parties | Protection |
Approvals, e.g. from government, are not forthcoming. | Both the consideration and the shares are placed in escrow and only passed over once approval is forthcoming. |
As a matter of practice it is important that the escrow instructions (which may need to be carried out some time after the agreement is signed) are clear on all of the above matters and in particular give precise instructions about when the money can be released and to whom.
Earn-outs are another mechanism for protecting buyers. Often the existing management will continue to work in the business with a deferred consideration payable on performance. Earn-out provisions need to be tailored to the particular situation and should cover:
The relationship between the seller and the buyer especially when it comes to decision-making
The length of the earn-out period
The formula for calculating the earn-out consideration
Limitations on actions by the buyer to actively depress the profits (or which-ever criteria are used to calculate the earn-out)
Earn-outs have a number of advantages for the buyer and a similar number of disadvantages for the seller.
Advantages for the buyer:
The purchase price reflects performance. Sellers routinely overestimate potential. This is a way of only paying for performance above a certain level
As the final price is based on future profits an earn-out should ensure the continued commitment of the sellers for at least the earn-out period. This may be particularly important if the target company is dependent on existing management or a single executive
Unless money is paid into an escrow account, earn-outs enable the buyer to delay payment of a portion of the purchase price
Disadvantages for the seller:
Although the sellers may be involved in the business after the deal, they will not be in charge of it. The buyer will be able to take all major decisions and the future profitability of the target company may be dependent on matters solely within the buyers control e.g. the provision of finance. The seller therefore only has limited control over profits in the earn-out period and it may receive less under the earn-out than it would expect. This may also create bad relations between the continuing management and buyer
Payment of part of the purchase price is delayed
It is easy for sellers to be transfixed by a high maximum purchase price under the earn-out which is based on criteria which in practice will be unachievable given the involvement of the buyer
Disadvantages for the buyer:
The management team may focus solely on delivering the required numbers to an earn-out target as opposed to taking more of a long-term view
The business may struggle to adapt to significant market events or opportunities as the structure and agreed expenditure limits reduce its flexibility
Earn-outs are less popular now than they were, mainly due to the drawbacks just outlined. In addition, there is always a difficulty (which can be common with retentions) of establishing whether the relevant criteria have been met. Although the share sale and purchase agreement may contain relatively detailed provisions setting out the accounting policies to be applied and the process for agreeing a set of accounts, it is not uncommon for accountants on both sides to disagree about the precise figures.
If you are going to use an earn-out structure, keep the earn-out period short: one or two years. Also be clear and realistic about commitments and restraints. But remember that about half of acquisitions with an earn-out agreement end in tears.
The agreement should provide representations and warranties to the buyer about the company’s state and history, including any liabilities, together with indemnities where appropriate. The buyer will also provide representations in the agreement concerning the financial and legal condition of its business. Warranties, and the indemnities that go with them, are such an important part of the contract negotiations that they are dealt with in more detail in the next section. Suffice it to say for now that there are two primary functions of the representations and warranties:
First, as mentioned in Chapter 5 (Investigating the target), they are an integral part of the buyer’s due diligence investigation. Exceptions to warranties are disclosed. The disclosures give the buyer information on the state of the business
Second, they aid in the allocation of risk between the parties. Generally speaking, the aim is to make the seller liable for liabilities incurred prior to completion and the buyer liable for liabilities incurred after completion
If the representations of a party to the agreement prove to be false before the deal the other party may be able to walk away without incurring liability or, if they turn out not to be true afterwards, the buyer may be able to sue for misrepresentation.
A claim for misrepresentation can arise from statements made in pre-contractual negotiations, during due diligence, in the acquisition agreement itself or in the documents disclosed with the disclosure letter. The seller will be particularly concerned to avoid liability for statements made by employees during due diligence as this is an area over which it has little control. The seller will seek to do this by including an ‘entire agreement clause’ and/or exclusion clause.
An entire agreement clause provides in effect that the buyer has not relied on any representation or undertaking whether oral or in writing save as expressly incorporated in the agreement. By excluding reliance, one of the essential elements of a misrepresentation claim is removed. In the past, however, such claims have not been sufficient in all cases to exclude liability.
If a seller wishes to exclude the possibility of a claim for misrepresentation, the clause must:
Specifically exclude liability for statements other than those contained in the agreement and the buyer must acknowledge this to be the case
Distinguish between liability for negligent or innocent misrepresentation, the exclusion of which may be fair and reasonable, and liability for fraudulent misrepresentation, the exclusion of which is unlikely to be either fair or reasonable (according to the Unfair Contract Terms Act 1977)
Following acquisition of the target, the buyer will not want the goodwill it has just bought to be eroded. It will therefore wish to prevent the seller competing against it in the same market. Restrictive covenants are normally inserted in share sale agreements to prevent this. Covenants are agreements by the parties either to do something, or refrain from doing something, for a specified period of time. They impose restrictions on how the parties conduct their businesses prior to closing, describe actions that must be taken to consummate the transaction and prescribe how the parties must respond to third parties, such as other would-be buyers.
Most covenants, especially those of the buyer, expire at closing. Other covenants, such as an agreement by the seller not to compete or not to tempt away the target’s employees or customers, usually continue well beyond closing. This is an extremely complex area of law. An outline of the principles involved is set out below.
Legally speaking, covenants in contracts which restrict a seller’s or an employee’s activities are considered unenforceable as being contrary to public policy. Two conditions must be fulfilled for them to be valid:
The restraint must be reasonable and in the interests of the contracting parties, and
It must be reasonable and in the interests of the public
A restrictive covenant will therefore be unreasonable and void if it extends beyond protecting the legitimate interests of the parties concerned. It is therefore essential to spend time working out exactly what the buyer needs to protect. It is far better to have an enforceable but limited restrictive covenant than a widely-drafted but unenforceable one. Questions to consider include:
Will the seller have a continuing interest in the same area of business following the deal and if so, where, geographically, will the business continue to operate?
What is the nature and location of the target’s business? Is there likely to be any change in the nature of the business?
Are there any senior employees of the target who will cease to be employed as a result of the sale who have had contact with valuable customers, potential customers and suppliers? Have they had access to trade secrets/confidential information?
Having set out the basics, both sides are in a position to decide what restrictions will be necessary. One or more of the five main types of restrictive covenant discussed below might be needed.
Non-competition. This seeks to prevent the seller from competing in the same business as the target. It will be unenforceable unless it applies only to the existing business and the geographical areas in which the target operates
Non-solicitation of customers. This type of restrictive covenant seeks to prevent the seller from soliciting the custom of the target’s customers after completion. The smaller and more clearly defined the group of prohibited clients in the agreement the better
Non-dealing with customers. This type of covenant is broader than the above as it seeks to prevent not just solicitation but dealing with existing customers. Again the more precise the drafting the better the chances of enforcing it
Non-solicitation of employees. This seeks to stop the seller trying to recruit employees of the target after completion. Such covenants are probably enforceable if they only apply to senior employees
Confidentiality clause. This seeks to protect the target’s confidential information. The law is more willing to protect secret processes which are vital to the business (i.e. trade secrets) than it is other types of confidential information
Therefore, restrictive covenants must protect a legitimate business interest and must be reasonable in scope, geography and time. They are included in share purchase agreements to protect the goodwill that the buyer is purchasing and are therefore perfectly legitimate at the time the agreement is signed. They must also be reasonable when they are enforced (if they ever are) and be ‘wholly’ reasonable. For example, if a court considers that a one-year restriction is enforceable but the contract contains a three-year restriction then the whole restriction would be void. The court would not enforce the one-year restriction. It is important that they are drafted specifically for the deal and not just cooked up in a standard form. For this to happen the lawyers drafting them must understand:
The business
Why the seller is selling the business (and any problems associated with it)
Why the buyer is buying the business and where it perceives the business’s particular value to be
The definitions section defines the terms used throughout the document (where definitions are used in one section only, they are usually found in that section). The most important are the key concepts which actually define how the agreement works. Definitions are usually fairly easy to recognise because they usually start with a capital letter.
Certain conditions will need to be satisfied prior to the closing of the transaction. Examples of common conditions include the receipt of regulatory approvals and third-party consents. In most cases, the acquisition agreement provides that if one party fails to satisfy its conditions prior to closing, the other party can walk away.
As a general rule, conditions should be avoided unless they are required by law or are commercially necessary for one or both parties. They fall into two categories, subjective or objective, and can include some or all of those set out in Table 8.2. Subjective conditions are fine if you are the party in control of the condition but they should be avoided at all costs if you are subject to the whim of the other party.
Table 8.2. Examples of conditions to closing
Objective | Subjective | |
|---|---|---|
Description | These normally depend on third-party actions and can be seen to have occurred e.g. the clearing of a proposed merger by the Competition Commission | These rely on the satisfaction of either the buyer or the seller e.g.the buyer being satisfied about the due diligence it has carried out |
Examples |
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There are a number of consequences which flow from having conditions:
Conduct of the business between exchange and completion. There will be a period after signature of the sale and purchase agreement before the conditions are satisfied. In this period the seller will be keen to carry on its business without interference by the buyer while the buyer will want to make sure that the business carries on as normal. The usual mechanism is to provide that the buyer will be kept fully informed of all material matters and of any material matters arising which are outside the ordinary course of business. The buyer may also have a veto, or at least a right to be consulted, over any action that is to be taken over such matters
Warranties. Warranties (see below) are given at the time of signing of the sale and purchase agreement. A buyer will normally also want them to be repeated at completion so it is protected against any changes in the target between signature and completion. A seller will usually strongly resist the repetition of warranties. It will argue that risk in the business should pass to the buyer at the time of signing the contract and that as a buyer will get the benefit of any events occurring between signing and completion it should also be prepared to accept any liabilities or losses which occur over the same period
Disclosure. There will be a similar discussion over whether the seller should be permitted to update its disclosure letter at completion. If it is permitted to do so and discloses matters which were not disclosed in the previous disclosure letter the buyer will want a right to rescind the contract
Fulfilment of conditions. The agreement should contain an appropriate long-stop date if conditions are not fulfilled and should also explain what is to occur, when. In particular, the following matters need to be considered:
Will both parties bear their own costs?
Confidentiality – it is important that all confidential information is returned
Poaching of staff and customers. The seller can help prevent this if its employment contracts contain suitably drafted restrictive covenants
The indemnification section is the principal mechanism for the monetary risk allocation in the agreement. It defines the rights of the buyer and seller to be compensated for breaches by the other of the representations, warranties, covenants and other obligations contained in the agreement.
Although the indemnification provisions most often run in favour of the buyer, the seller may also be an indemnified party. For example, in a deal where the purchase price is paid in the common stock of the buyer, the seller often seeks indemnification for false representations regarding the buyer’s business and other matters that could impact the value of the buyer’s stock.
Warranties and indemnities are covered in the next section.
The last section of the contract contains what is often called ‘boilerplate’. Boilerplate is a technical legal term describing the clauses towards the end of an agreement which deal with what might be termed the administrative matters. This section will contain clauses on the applicable law, who pays the legal fees for the agreement, how notices under the agreement should be served and when they take effect and the parties’ ability to terminate the agreement and the effect of termination.
The buyer and seller usually agree that each will pay its own expenses. Additionally, the buyer will demand that the seller pays its expenses with its own resources and not use those of the company being sold. The provisions at the end of the contract should always be carefully reviewed as they can often hide one or two unexpected traps.
There is a fundamental conflict between the seller and buyer in any acquisition. The buyer wants a comeback if what it buys is not what it thought it was buying. The seller, however, likes the principle of caveat emptor very much as it means the buyer’s remedies and its own corresponding liabilities are restricted.
The function of warranties and indemnities in the acquisition agreement is to limit the operation of the principle of caveat emptor – buyer beware. They do this in different ways.
A warranty provides a guarantee that a particular state of affairs exists. Any breach of this guarantee which affects the value of the acquisition will entitle the buyer to what is effectively a retrospective price adjustment.
An indemnity, on the other hand, is a guaranteed remedy, paid pound for pound, if an event occurs regardless of whether or not the value of the target is affected.
The relevant issues are:
Each is dealt with below.
Guarantees are only as good as the person giving them. Warranties and indemnities are no exception to that general rule. If the buyer appears flaky or is about to move all its assets to the Bahamas, it would be as well to think of other forms of protection.
A good example of the creativity sometimes required in finding other remedies came in a case where the buyer and seller disagreed about the likely treatment by the tax authorities of group charges. The buyer thought that group charges would be seen as excessive and therefore give rise to an extra tax liability. It was not comfortable relying on a tax indemnity because it thought it very likely that the indemnity would be called and it was not prepared to spend the time and trouble dealing with the inevitable dispute over the validity of the claim. It also knew that the vendor was not in a strong financial position. In the end it was agreed that the target business would be hived off into a new company, leaving the sellers with a corporate shell in which the tax risk remained.
Warranties in an acquisition agreement are designed to:
Typically warranties are prefaced by a clause such as:
The Vendors/Warrantors warrant to the Purchaser that, save as set out in the Disclosure Letter, the Warranties are true and accurate in all respects.
Warranties are contractual terms. If they are breached, the purchaser can claim for damages for any loss.
A warranty that existing facts are true and accurate is absolute. Even if the warranty is qualified as being ‘to the best of the warrantor’s knowledge and belief’, it is not necessarily robbed of all effect. The courts will impose an objective test of knowledge. The warrantor will be taken to have knowledge of all the information which could reasonably be expected to be available to him. This is even true where a warranty is given for a future state of affairs. The courts have decided that such a warranty should be a guarantee that the forecast of the future has been honestly made and is based on reasonable assumptions.
After completion, if the buyer decides that it has not got what it bargained for, it will have to establish that:
The complaint constitutes a breach of a specific warranty or warranties which is not excluded by the disclosure letter, and
The breach has resulted in the business being worth less than the price paid or, in some limited circumstances, that the buyer has suffered an actual loss
This last point is key. It is not enough for the buyer to demonstrate that a warranty has been breached. It must also prove and quantify the loss. In effect this means that the buyer must show that the company is worth less than it paid for it. This is not always easy by any stretch of the imagination as a host of other factors could have had an influence on value by the time the breach is discovered. This is covered in more detail below.
It is the disclosure letter which limits the scope of the warranties and so it is through the disclosure letter as well as the terms of the agreement that the seller will seek to reallocate risk to the buyer.
Warranties are statements of fact made by the seller. They are the basis for the buyer claiming damages where it has relied on inaccurate information and ended up out of pocket. For now, however, we want to concentrate on the disclosures made against warranties.
Warranties will be worded along the lines of ‘there is no outstanding litigation except for...’ For example the warranty might be ‘the target company is not involved in any litigation’. If the seller is asked for such statements, but cannot give them, because, for example, there is litigation, it does not amend the warranty but instead discloses the real facts – which are the details of the actual litigation. This is done in a separate letter, called the disclosure letter. By making accurate disclosures to exceptions to the warranties, the seller avoids any liability under the warranties. It all seems a bit roundabout but it works.
The term ‘letter’ is something of a misnomer. The ‘letter’ can end up more like a filing cabinet. This is because entire sets of documents or reports can be part of the disclosure. It is a key negotiating tool. It usually goes through a number of drafts, and sellers will delay disclosing for as long as possible. All of this can require buyers to wade through details at the last minute if they do not insist on early and complete disclosure.
Actual, specific, facts must be disclosed. It is not enough for the seller to make the buyer aware of facts which might have enabled it to discover the problem for itself. Nor is it good enough just to disclose the consequences of those facts. In the case of Levison vs Farin, the buyers sued over specific warranties, in particular the change in net asset value since the last balance sheet date. The sellers had disclosed that the target’s fortunes were declining because of the seller’s ill-health. The court decided that this disclosure was not specific enough to constitute disclosure of what was in fact a breach of the ‘no material change in net assets’ warranty. The seller should have specifically disclosed that there was a breach of that particular warranty.
The case of Eurocopy plc vs Teesdale seems to have established that what counts with exceptions to warranties is the actual knowledge of the buyer and not just what is in the disclosure letter. In this case, the sellers had warranted that all material facts had been disclosed. The acquisition agreement also contained the standard clause to the effect that, apart from information set out in the disclosure letter, the buyer’s knowledge of the target’s business and affairs at completion was irrelevant. Nonetheless, the Court of Appeal ruled that a buyer should not be able to claim that it has suffered loss by purchasing shares at a certain price when, because of breach of a warranty, the shares were actually worth less. As the buyer knew all about the company’s problems before it agreed the price it must therefore have taken them into account before deciding how much to pay.
This is a ruling which conflicts with the fundamental principle that it is up to contracting parties to decide what goes into their agreement. It means that buyers should be wary of making claims for breach of warranty for matters about which they clearly have knowledge. Also buyers should certainly not agree that their due diligence constitutes disclosure.
First, it is best to avoid making a claim. You are unlikely to recover the damages you consider reasonable. You can end up with substantial costs and spend a lot of time on it – all of which is a diversion from running the business. The seller will impose restrictions on the buyer’s ability to choose when and how to make a claim. In particular it will insist on:
Shorter time limits than the statutory six-year period. These are enforceable and generally require any claim to be made within two or three years of completion. Beware, because short time limits can be inappropriate for some types of warranty such as environmental warranties
Formal requirements for giving notice of the claim. These are likely to be prescribed in the agreement and these must be complied with before the notice is effective. Generally, the notice will have to specify in reasonable detail what gives rise to the claim, the specific breaches that result and the amount claimed
Similarly, the seller will want to impose restrictions on the minimum and maximum size of claims as follows:
De minimus provisions, i.e. minimum amounts for the size of claims. This avoids dozens of small claims being made but can have quite expensive repercussions in areas such as employment, where individual claims may be small, but come to a lot if they are all added up. For this reason, de minimus claims should be carefully negotiated
As well as a minimum level of claim, a seller will want a maximum level of claim. The ceiling of liability is often fixed at the amount paid for the target, but it is a matter for negotiation
The quantification of the claim can often be a difficult matter. However, it is important that the buyer is able to maintain a consistent position so that the case set out in the notice will form the basis for litigation if this becomes necessary.
To obtain compensation, an acquirer has to prove that a ‘loss of bargain’ has incurred due to the seller breaching the warranty. Proving a warranty breach and quantifying the subsequent loss through the courts can be time-consuming and expensive.
The starting point is to identify the specific warranty or warranties under which the claim can be made and then to gather the necessary evidence. A complaint may constitute breach of more than one warranty and it is important that all the possible alternatives are identified at the outset.
The general principle is that the buyer is entitled to the difference between the value of the company or business as warranted and its actual market value. Although this sounds very straightforward and logical, in practice this principle is not always easy to apply.
The purchase price is generally taken as the warranted value and one of the normal commercial methods of valuation is applied to assess the market value. However, the purchase price will not always reflect the warranted value. For example a buyer may have paid an inflated price for reasons of its own. A buyer who overpays will not be able to recover that overpayment in damages. There will also inevitably be a dispute as to the method of valuation to be applied, with each party arguing for the method which produces the most favourable valuation for it.
In some circumstances, a different measure may be adopted. An illustration of the departure from the general rule is the case of Levison vs Farin mentioned above. The buyer complained that the net assets of the company were £8,000 less than the warranted value. This did not necessarily mean that the value of the company was diminished by the same amount. The buyer argued that she required £8,000 to put the company into the position it had been warranted to be in. The court accepted the argument and awarded the full amount. In the case of TFL Prosperity the charterers of a ship recovered damages representing the loss of profit resulting from a smaller-than-warranted hold size.
Post-acquisition claims for breach of warranties or indemnities are extremely uncertain. Generally, decisions are made to settle claims at a fairly early stage not least because this, rather than litigation, is the only sensible, commercial, solution. Ironically, often a commercially-sound settlement is more likely to be reached if the matter is approached from the outset as if there will be litigation, but this means that the costs of instructing lawyers, obtaining independent reports and interviewing witnesses will probably all be incurred before settlement negotiations even begin. It may well be that when drafting acquisition agreements the parties should consider at the outset whether Alternative Dispute Resolution, rather than litigation, would be in the best interests of all concerned. An agreement to use mediation or determination by an expert to resolve disputed claims may offer the best solution.
As mentioned above, an indemnity is a guaranteed remedy against a specific liability. An indemnity allows both buyer and seller to adopt a ‘wait-and-see’ attitude. The most common indemnity is an indemnity against tax liabilities and it is a promise by the seller to meet a particular liability should it arise. Most of what has been said above about warranties also applies to indemnities. Other points to keep in mind are:
The acquisition agreement needs a provision in it to say whether claims under warranties or indemnities have precedence
In the event of a claim, consider whether any breach of warranty might also give rise to any breach of indemnity and vice versa and which would produce a more favourable result (if an option is available)
The taxation implications of money received as an indemnity payment as opposed to damages for breach of contract
Other issues which are relevant to indemnity claims are considered as part of the discussion on warranties.
It is essential that line management is made fully aware of the warranties and the correct procedure in the event of a breach and preferably somebody should be given responsibility for identifying possible warranty and indemnity claims which come to light after completion. The managers running the target post-acquisition are unlikely to have been involved in the details of the deal and as businessmen their typical reaction to a problem is to go out and solve it rather than consider whether it could be the basis for a legal claim.
The statutory limitation period for notifying warranty and indemnity claims is 6–12 years. These periods are commonly amended by negotiation in the sale agreement down to as little as two years for commercial warranties and six years for taxation warranties and indemnities.
Diarising these limitation periods is a vital part of the post-acquisition due diligence procedure. The sale agreement can contain formal notification procedures for dealing with warranty and indemnity claims as well as provisions for resolving claims through arbitration and the acquirer should comply with all relevant procedures in accordance with the sale agreement.
Apart from legal protection in the form of warranties and indemnities, other forms of protection can always be negotiated following adverse due diligence findings. These include:
Price adjustment
Retention from the purchase price
Earn-outs
Third-party guarantees
Insurance
Asset sale rather than a share sale
Exclusion of certain assets and liabilities from the acquisition
Rectification of any problems at the seller’s cost
As already mentioned in Chapter 3 (Preliminary negotiations), cross-border transactions can bring the added complication of whether or not agreements are binding. For this reason parties should determine in the agreement at which point in the negotiations they should be bound.
Negotiating the sale and purchase agreement is the scary, adrenalin-charged part of the acquisition process. Focusing on its main elements and not getting lost in the lawyerly complexities of drafting agreements is enormously helpful for success. Leave the details to the lawyers, which after all is what you are paying them for.
This chapter has summarised those main elements.