Risk Allocation Mechanisms in Mergers and Acquisitions: Part 2 — LIMITING LIABILITY
By Ara Babaian, Esq. and Durdana Karim, Esq.
This is the second article in a series addressing some of the mechanisms used to allocate risks inherent in M&A deals.
In our last article, we discussed the purchase price considerations typically involved in mergers and acquisitions (M&A). You can find the article HERE. In this article, we will focus on provisions that protect the buyer or seller against current or contingent liability, including performing due diligence, and drafting representations and warranties, indemnification provisions, and limitation on liability provisions, as well as limiting liability through disclosures made in a disclosure schedule. These provisions provide a mechanism to analyze and mitigate risk for both the buyer and seller in an M&A transaction.
Due diligence is a procedure by which the parties to an M&A transaction are given a period of time to review and confirm material information about each other. By gathering this information, the buyer can make an informed decision about whether to engage in the M&A deal with the seller, what purchase price to pay and when to pay it. Generally, parties engage in due diligence both before and during the M&A negotiation process. The parties also sign a confidentiality agreement prior to investigating the target business and its operations, assets and liabilities. Ordinarily, as part of its due diligence, a buyer will review the target company’s inventory, tax records and financial statements, its charter, contracts, sales records, warranties, leases, debts and liabilities, lawsuits, and lists of employees, compensation and benefits. Though not as critical, the seller should conduct a due diligence review of the buyer to ensure that the buyer will be able to continue to operate the seller’s business without exposing the seller to future liability and also to increase the seller’s chances of receiving the full amount of earnout payments, if those are negotiated (as discussed in our prior article).
The due diligence process itself can take anywhere from a few weeks to several months and often starts after a letter of intent is executed between the parties. It is wise to use a due diligence checklist to guide the parties in this process. The buyer and seller should engage legal counsel, tax experts and other professionals to help collect and analyze the information obtained during the due diligence process. Parties negotiating an M&A transaction may need to adjust the timeline for closing the deal and their expectations according to changes in the target company’s industry. Particularly given the current pandemic and potential for adverse long-term effects, buyers should consider additional due diligence when entering into negotiations in a high-risk industry by reviewing business continuity plans and crisis management procedures, supply chain availability with vendors, any increase in costs associated with using alternative suppliers and vendors, decrease of clients or customers, and the effect that remote working has on the seller’s business operations, as well as any action the target company can take to excuse or terminate third-party contracts which may be necessary to continue the business viably post-closing (i.e., force majeure provisions).
Representations and Warranties
Representations and warranties are fundamental devices found in M&A agreements. They are used to safeguard the parties against identified business-related risks. A representation is a statement of fact related to matters prior to or at the time of contracting by the buyer, seller or affiliate. A warranty conditions the buyer and seller that certain facts related to the subject matter of the agreement will continue to be true and helps to protect the seller and buyer if the statements are later found to be untrue.
A seller’s representations and warranties will be more extensive as they are used to protect the buyer regarding statements of facts related to the purchased assets or the target company. On the other hand, a seller’s goal is to limit the representations and warranties or provide “as-is” or “where-is” language.
A party that breaches a representation or warranty may be liable for a claim of fraudulent misrepresentation. As a result, representations and warranties provide assurances to the buyer and seller that the material information relied upon by the parties are accurate and will continue to be valid.
Some of the standard representations and warranties found in M&A agreements include the good standing of the parties involved, the authority of the parties to enter into the agreement and other ancillary agreements, clear title and ownership to the tangible and intangible assets being purchased, compliance with applicable laws and regulations, and the disclosure of conflicts or litigation. More detailed representations and warranties will include language specific to the assets to be acquired, goods or services to be provided and/or the applicable industry.
An indemnity provision requires one party to compensate, defend and/or hold harmless the other party for claims and liabilities by third parties that arise out of the actions of the first party, but which are claimed against the second party. Indemnifications shift the burden of loss between the parties and their affiliates in a commercial agreement. Further, the indemnification provision in an M&A agreement often includes forward-looking protections for future liabilities, including gross negligence and willful misconduct, failure to comply with laws and regulations, and breach of contractual terms. Other indemnification provisions incorporate liabilities that arise in cases of intellectual property infringement and data breaches.
Indemnification provisions in M&A transactions typically include the use of caps and baskets. A “cap” is the upper dollar limit of the seller’s indemnification obligations to the buyer. However, limitation set by caps do not include breaches of certain liabilities such as seller’s tax liabilities and fraud committed by the seller. Generally, the size of the cap often correlates to the transaction size and can range from 1% to 100% of the transaction value, with the median cap being 10%, though larger transactions usually have caps below 10%.
A “basket”, or “deductible,” is a threshold amount of losses and damages that a buyer must incur before it is entitled to any indemnification from the seller. Generally, a basket ranges from 0.5% to 1.0% of the transaction value with a median value of 0.5%. Under a typical basket, a buyer is able to recover total losses after it has incurred losses equal to or above the basket threshold (but no more than the cap). Under a “true deductible,” a buyer is entitled to recover only the amount above the deductible. For example, if the parties negotiate a basket amount of $100,000, the buyer is not entitled to any recovery from the seller if the buyer only suffers $100,000 in losses. However, the buyer would be entitled to recovery from the seller if the buyer incurred $150,000 in losses, but only for the amount above the deductible, or $50,000. True deductible indemnifications are customarily favorable to sellers. On the other hand, a “partial deductible” allows the buyer to recover some but not all of the losses. Under this scenario, the parties may set a basket amount for $100,000 with only $50,000 in recovery. The buyer would be able to get indemnified by the seller only if the buyer suffers at least $100,000 in losses and will be entitled to recover only losses in excess of $50,000.
The key benefit of an indemnification provision is that it helps to shift the burden of cost for defending against third-party claims. During M&A negotiations, a party will benefit from limiting its indemnification obligations while increasing the indemnification obligations of the other party.
Limitation of Liability
Waivers and limitation of liability clauses are used to limit unpredictable and excessive claims of damages. Limitation of liability provisions carve out consequential damage liabilities and cap the actual damages. Although case law and statutory authority have established that an agreement cannot limit a party’s willful and intentional misconduct, limitation on liability provisions for ordinary negligence that are not against public interest have been found to be valid and they are effective risk allocation provisions. Further, these provisions often limit the other party’s ability from having a double recovery, where a seller or buyer is able to recovery from insurance stipulated in an M&A agreement or directly from a third-party
In addition, case law has established that damages in a contract breach case are limited to foreseeable injury at the time of contracting. Therefore, M&A agreements often specify what is foreseeable between the parties and eliminate the ability to collect on indirect, consequential and punitive damages.
Limitation of liability clauses provides a safety net encouraging both the buyer and seller to enter into M&A transactions without the risk of being liable for all foreseeable damages. It is also important to note that the enforceability of limitation on liability is state-specific. Most states will enforce limitation of liability clauses so long as the clauses do not limit liability for intentional wrongdoing or willful misconduct and are not against public policy.
A disclosure schedule is a key component in an M&A agreement. It allows for the seller to disclose any known liabilities, liens, permits, and consents required, provide list of intellectual property owned by the seller, and contracts assignable to the buyer. Disclosure schedules will include affirmative and negative disclosures. An affirmative disclosure allows the seller to disclose or provide a schedule or list of material contract, permits, employee and benefit plans, as well as known litigation. Conversely, negative disclosures allow the seller to list out exceptions to certain representation and warranties.
With so many businesses obtaining Paycheck Protection Program (PPP) loans either through the first disbursement or through the new second disbursement, parties to an M&A deal should take into consideration the timelines, consents and procedures required, if any, from the Small Business Administration (SBA) or the PPP lender when a seller is choosing to sell a business with an outstanding PPP loan, especially as such procedures and consents may delay the closing of the M&A deal. Generally, consents are not required to be obtained by the SBA and the PPP lender if the seller establishes an interest-bearing escrow account and funds it with amounts equal to the outstanding balance of the PPP loan. Once the seller has gone through the forgiveness process (including any appeal of the SBA’s decision) and such loan forgiveness is completed, the escrow funds must be disbursed first to repay any remaining PPP loan balance plus interest (if the PPP loan is not fully forgiven) and then to the seller.
As a result, parties to an M&A transaction should bear in mind the time involved in making sure the seller has fully transferred any permits, assigned necessary contracts and obtained required consents to consummate the closing.
To discuss the above topic, please contact Ara Babaian at firstname.lastname@example.org or email@example.com or any other Encore Law attorney.
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