Basics done well: execution risk in M&A
They say a bird in the hand is worth two in the bush. But in mergers and acquisitions, even when a target is ‘in hand’ (with a signed sale and purchase agreement), completion is not necessarily a fait accompli. When economic conditions deteriorate, valuations soften, buyers become flighty, and transactions can lose their lustre.
This article examines how sellers (primarily) can take steps to mitigate deal execution risk before signing the contract for sale.
Minimise or shape conditions
Broadly speaking, a condition is a term which (unless strictly complied with) triggers a right to terminate the contract. From a seller’s perspective, it is important that any condition is not arbitrary and is not used by a buyer to get out of a contract cheaply. On that basis, finance, due diligence and other conditions that are largely within the buyer’s discretion or control, should be avoided. Conditions should be limited to those genuinely required to consummate the transaction (such as a necessary regulatory approval) or which are of operational significance to the target business. In uncertain times, a minimally conditional bid is a safer bet than a more attractive offer which is subject to a raft of conditions.
Beware pre-completion covenants
Pre-completion covenants are an important tool for ensuring that a seller continues to conduct a target business in the usual and ordinary course so that, on completion, the buyer is sure to get what it has bargained for. These restrictions can be quite granular, setting out specific actions or imposing financial thresholds which require the buyer’s consent. For guidance on how the High Court recently interpreted a pre-completion covenant in a commercial property transaction, refer to our recent note on the Quarrymans Hotel case.
Depending on the drafting and the deal context, pre-completion covenants can either be expressed as essential terms (ie conditions), or they are classified as warranties or intermediate terms.
If the covenant is expressed to be essential (or compliance with pre-completion covenants is expressly included in the agreement as a condition precedent), then failure to comply with or satisfy the condition will entitle the buyer to terminate the agreement.
Whether a covenant is a warranty or an intermediate term is circumstantial and depends largely on the consequences of non-compliance. For instance, if a specific covenant requires the seller to ensure that the target maintains all permits and licences during the pre-completion period, and a non-essential licence or accreditation lapses and is not renewed, then that fact by itself is very unlikely to entitle the buyer to terminate the agreement (as opposed to recover licence reinstatement costs from the seller as damages). On the other hand, if the licence is integral to the target’s operations (eg an Australian financial services licence), then the severity of consequences suggests that the covenant is an intermediate term and termination and damages are on the cards if the covenant is breached.
Sellers keen to minimise execution risk should think about negotiating clauses expressly limiting the buyer’s recourse for a breach of these terms to damages. This limitation should not be buried in the boilerplate but should clearly attach to the provisions that impose the greatest risk.
Attack the MAC
Material adverse change clauses offer buyers protection against unforeseeable events that have or are expected to have a material adverse effect on the target. Their use in Australia is common and widespread where the buyer is from the US (where such provisions are prevalent in M&A).
MAC clauses are commonly (but probably incorrectly) viewed as a ‘get out of jail free card’ for buyers. The truth is that to terminate an agreement when an unforeseen, detrimental event or circumstance impacts the target company, the buyer needs to be on solid ground with both the drafting and the nature and impact of the relevant occurrence or circumstance. There are very few Australian cases on point, but US authorities suggest that the trigger and the measure of impact on the target should be well defined and relevant to the transaction. The common thread in US authorities is that a material event must be consequential and should have the potential to impact the target over years, not months. ‘A short hiccup in earnings would not suffice’.[1]
Sellers can look after themselves by ensuring any MAC clause is limited to matters occurring between signing and completion, rather than between the last accounts date and completion. This narrows the period during which the triggering circumstance must occur. The triggering factor should also be something that only affects the target business (or, if the relevant occurrence is sector or economy-wide, it should disproportionately affect the target).
While it would be tempting to say that a vague MAC clause is better for the seller because the onus is on the buyer to prove its case, the reality is that imprecise wording and concepts operate against both parties’ interests. Therefore, it is advisable, from the seller’s perspective, that any MAC clause narrows the period during which the relevant fact, matter or circumstance (ie the trigger) needs to arise; includes customary carve-outs and exclusions such as an exclusion of general deterioration in economic conditions which should not be the seller’s risk after the sale is agreed; and only triggers if there is a clear and measurable (and materially adverse) impact on the target’s business (such as a defined percentage fall in earnings). There is also a balancing act between a short-term softening in financial performance and a longer-term impact on the business. Buyers should be required to demonstrate an actual impact on the business as a result of the relevant occurrence or circumstances, as well as a reasonably likely longer-term impact. Qualitative measures of materiality in the Accounting Standards – particularly AASB 1031 – can be useful yardsticks for inclusion in MAC clauses.
The warranty trap
Further to our discussion above (under ‘Beware pre-completion covenants’), warranties (often referred to as representations and warranties) are factual promises enforceable under contract. Absent any express provision to the contrary, if a warranty is found to be untrue or misleading, the buyer may be entitled to claim damages from the seller, subject to limitations and qualifications, but will generally not be entitled to terminate the agreement.
The position is more complex overseas, for example in the UK where a misrepresentation has induced a party to enter a contract. The aggrieved party in this scenario will typically seek the equitable remedy of rescission (ie for the contract to be rescinded and the parties returned to the position they were in prior to the contract). Rescission is generally only recognised in Australia in limited circumstances, such as where there has been a fraudulent misrepresentation which induces the parties into the contract.[2]
In light of this, buyers will often try to include a condition that, as at completion, there has been no breach of any warranty, and the seller will be asked to provide a confirmatory certificate. This approach effectively provides the buyer with a right to terminate the agreement, and consequently not proceed with the transaction, in the event that any of the warranties are breached by the seller during the pre-closing period.
In any event, sellers should be wary of including a compliance with warranties condition (even with a ‘materiality’ qualifier). It should be incumbent on the buyer to identify fundamental warranties which, if breached, would cause a significant adverse effect on the business – and similar to MAC, define what the effect of a breach of those warranties is, and isolate any condition to such circumstances.
Remedies
Generally speaking, a jilted seller will be able to sue a fugitive erstwhile buyer for specific performance of the contract and/or for damages for loss of bargain.
Specific performance is a remedy to compel completion of a contract. It is a remedy designed to compel the buyer to honour the contract and meet its obligations to effect completion (and is pursued when damages are inadequate). While this may be the ideal remedy for the seller, it may not always be the most practical solution, particularly where the buyer is simply unable to complete the transaction (perhaps due to financing no longer being available).
Conclusion
No matter the economic conditions, execution risk is always a factor in commercial transactions. However, a well drafted agreement with precisely and unambiguously drafted provisions, will appropriately allocate that risk and give each of the buyer and seller certainty as to their rights and remedies.
[1] Re Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del. Ch. 2008); Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018).[2] Alati v Kruger (1955) 94 CLR 216; [1955] ALR 1047; (1955) 29 ALJR 512; [1956] St R Qd 306; BC5500350.