Материал: Amy C Kläsener

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Drafting M&A Contracts to Minimise the Risk of Disputes

Post-closing indemnification for breaches of representations and warranties

In certain M&A transactions – for example, the purchase of an asset or division of a company, or the private acquisition of a company from a single owner or small group of owners – the agreement is likely to provide for post-closing indemnification of the buyer by the seller if the buyer discovers after closing that some of the seller’s representations and warranties were untrue. In such cases, a claim for money damages can arise. In some sense, these cases are standard breach-of-contract claims. Did the party breach the representation or warranty or not? But the M&A draftsperson can limit ongoing exposure through tools such as survival periods and limitations on the amount, or source, of any indemnification. Access to books and records post-closing may prove an obstacle in some instances.

A survival clause is often viewed as evincing a clear intent to bar any claims for breach of representation and warranty after the end of the negotiated period, notwithstanding a longer statute of limitations under state law.23 A typical survival provision might read:

The representations, warranties, covenants and agreements of Buyer and Seller contained in or made pursuant to this Agreement or in any certificate furnished pursuant to this Agreement shall survive in full force and effect until the date that is 12 months after the Closing Date, at which time they shall terminate and after which time no claims for indemnification shall be made.

Of course, the purchase agreement could also provide that the representations and warranties do not survive closing at all, thereby eliminating any post-closing claim for damages stemming from a breach.A very simple non-survival provision might read:

None of the representations, warranties, covenants or agreements set forth in this Agreement, including any rights arising out of any breach of such representations, warranties, covenants or agreements, shall survive the Closing (and there shall be no liability for monetary damages after the Closing in respect thereof).

In either case, the parties are able to minimise uncertainty surrounding the period when representations and warranties made in the acquisition can be challenged.

Another common method of minimising post-closing disputes regarding representations and warranties is by including limits on liability.A typical limitation of liability provision for post-closing indemnification might read:

23See, e.g., GRT, Inc. v. Marathon GTF Tech., Ltd., 2011 WL 2682898, at *15 (Del. Ch. July 11, 2011) (‘A survival clause . . . is a tool utilized by contracting parties to avoid the uncertainty that learned commentary suggests exists where the contract is silent on the issue of survival.’) (applying Delaware law).The parties should, as always, carefully consider the law of the jurisdiction that they have chosen to govern their contract. For example, under Californian law, a survival clause can only shorten the time that a party has to sue if its intent to override California’s statute of limitations is made explicit. See W. Filter Corp. v.Argan, Inc., 540 F.3d 947, 952-54 (9th Cir. 2008) (noting California’s public policy against derogation of the statute of limitations). Post-closing indemnification disputes can lead to very significant claims. See, e.g., Hewlett Packard spin-off leads to hefty award, Global Arbitration Review, 20 August 2019 (reporting arbitration award of approximately $650 million for indemnity claim).

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Drafting M&A Contracts to Minimise the Risk of Disputes

Notwithstanding anything contained in this Agreement to the contrary, in no event shall the Seller: (i) be liable for indemnification unless and until the aggregate amount of all Losses that are imposed on or incurred by the Buyer exceed the Deductible Amount, in which case the Buyer Indemnified Parties shall be entitled to indemnification for all Losses in excess of the Deductible Amount; and (ii) be required to make payments for indemnification in an aggregate amount in excess of the Maximum Indemnification Amount.

The use of a minimum deductible amount can reduce disputes over relatively trivial items, while the total cap on liability provides certainty to the seller regarding its maximum exposure. As discussed above, the contracting parties may also wish to fund post-closing indemnification obligations through an escrow account, assuring the availability of the funds to the buyer and allowing the seller to proceed without fear of future costs. Finally, the parties may also agree that claims for indemnification are the exclusive remedy for breaches of representations and warranties, and that arbitration is the exclusive forum in which to bring any such claim.

Care must be taken in drafting the terms of a representation or warranty to reduce the risk the seller be accused of fraud or misrepresentation. In certain jurisdictions, parties can limit their exposure to claims of extra-contractual fraud, or fraud in the inducement. For example, in Delaware and New York, if parties to a contract include a provision disclaiming any reliance on representations outside the four corners of the agreement, the law will bar claims for fraudulent inducement based on extra-contractual statements.24 In other jurisdictions, the law is less clear-cut, and the parties should take care to understand their potential liability in advance of entering into contract.25 And in many jurisdictions, findings of fraudulent conduct, such as providing intentionally false representations or warranties, can result in any liability caps or other limitations on relief being vitiated as a matter of law.26 (See Part II of this Guide.)

24See Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032, 1056 (Del. Ch. 2006) (‘We have honored clauses in which contracted parties have disclaimed reliance on extra-contractual representations, which prohibits the promising party from reneging on its promise by premising a fraudulent inducement claim on

statements of fact it had previously said were neither made to it nor had an effect on it.’); Aetna Cas. & Sur. Co. v.Aniero Concrete Co., 404 F.3d 566, 576 (2d Cir. 2005) (observing that, under NewYork law,‘[w]hen . . . the contracting party disclaims the existence of or reliance on specified representations, it will not be allowed to claim it entered the contract in reliance thereon.’) (internal quotation marks omitted).

25For example, California law is notably less clear than Delaware or NewYork law on this issue. It is against California public policy for parties to be able to exempt themselves by contract from negligent fraud, and anti-reliance clauses will be ignored. See Manderville v. PCG & S. Grp., Inc., 146 Cal.App. 4th 1486, 1501-02 (2007) (citing Cal. Civ. Code § 1668). Courts applying California law may, however, take such clauses into effect in determining whether a party’s reliance on the extra-contractual representation was reasonable. See Hinesley v. Oakshade Town Ctr., 135 Cal.App. 4th 289, 302 (2005).

26See, e.g., Abry, 891 A.2d at 1064 (Delaware public policy prohibits limitations on liability for intentional fraud); Turkish v. Kasenetz, 27 F.3d 23, 27-28 (2d Cir. 1994) (noting that, under NewYork law,‘[i]t is well settled

that parties cannot use contractual limitation of liability clauses to shield themselves from liability for their own fraudulent conduct.’).This principle also applies in civil law countries. See, e.g., Code civil art. 1231-3 (France); Código Civil Federal art. 2106 (Mexico).

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Drafting M&A Contracts to Minimise the Risk of Disputes

Representation and warranty insurance is becoming increasingly common in M&A transactions. (See Chapter 5 on special issues in connection with indemnity and warranty insurance.) The aim of such insurance is to insure one party (almost always the buyer) against the risk that the other party has breached its representations and warranties. In some cases, the acquirer who has bought insurance may be willing to forgo any post-closing survival period for the representations and warranties. Such insurance is usually carefully negotiated, but can provide an attractive alternative or complement to standard representations and warranties and can limit a potential point of dispute between the parties, although it may result in disagreements with insurers.

True-ups

Post-closing true-ups of working capital or other balance sheet items are another increasingly common source of M&A disputes and are frequently resolved in proceedings outside court. The idea behind these provisions is simple. The parties agree to a target working capital at the same time as setting the overall deal consideration, and the seller agrees to compensate the buyer for any working capital shortfall at closing, while the buyer agrees to refund any working capital excess at closing. Between signing and closing, the target company must continue to operate and during that time its working capital may increase or decrease.A simple working capital true-up provision reads as follows:

The Closing Adjustment shall be set forth in writing by the Seller three days prior to closing and shall be equal to the amount of estimated working capital at closing less theTarget Amount. If the Closing Adjustment is a positive amount, then the Purchase Price paid by the Acquirer at Closing shall be increased by the Closing Adjustment. If the Closing Adjustment is a negative amount, then the Purchase Price paid by the Acquirer at Closing shall be decreased by the Closing Adjustment.

If the parties are unable to agree on the true-up, they may contractually agree to spend a certain period (such as 30 days) resolving the issue before seeking the help of a third party to resolve the question. Because the true-up is an extremely narrow issue, the parties may choose to have the issue resolved by an ‘expert’, whose authority is precisely limited to the determination of this factual question, rather than an ‘arbitrator’, who is usually considered to have a wider scope of authority and can draw legal conclusions.27 (See Chapter 3 on conflicts between expert determination and arbitration clauses, and Chapter 7 on managing expert determinations.) The parties may choose to bargain for their own standard of

27See, e.g., Chi. Bridge & Iron Co. N.V. v.Westinghouse Elec. Co. LLC, 166 A.3d 912, 931 (Del. 2017) (noting that the language ‘acting as an expert and not as an arbitrator’‘narrow[s] the scope of the expert’s domain’); New York City Bar, Report by the Committee on International Commercial Disputes, Purchase Price Adjustment Clauses and Expert Determinations: Legal Issues, Practical Problems and Suggested Improvements 27 (June 2013) [‘Purchase Price Adjustment Report’] (noting that an ‘expert determination cannot decide the ultimate liability of a party’).

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Drafting M&A Contracts to Minimise the Risk of Disputes

judicial review of the expert’s award, although in the United States a court may also choose to apply the Federal Arbitration Act, which provides for a very deferential standard of judicial review.28 A very simple expert determination clause might read as follows:

In the event of a dispute between the parties over the proper calculation of the Closing Adjustment, the parties shall submit any items in dispute for resolution by an Independent Auditor, who shall be functioning solely as an expert and not as an arbitrator.

There are many traps for the unwary in these provisions. Parties need to have a clear, mutual understanding of how ‘working capital’ is to be defined and calculated, and the definition must match the target company’s customary operating accounting. If not carefully considered, this adjustment mechanism may be susceptible to manipulation, such as by challenges to line items or accounting methods not used by the seller, creating a potential mismatch in the post-closing true-up.The working capital dispute mechanism may also lead to attempts to avoid limitations on remedies that the parties agreed for a breach of the representations and warranties by providing another avenue to seek relief not tied to those breaches.29

Earn-out clauses

An earn-out is a provision in an agreement allowing the seller to obtain an increase in the purchase consideration based on the performance of the business post-closing. Earn-out provisions very frequently lead to post-closing disputes: as the Delaware Court of Chancery has observed,‘an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.’30 These disputes are again frequently resolved in expert or arbitral proceedings, and the parties may minimise the risk of dispute by negotiating the provision carefully in advance. Earn-out disputes, like working capital true-ups, are often relegated to the jurisdiction of independent auditors. A very simple earn-out provision might provide as follows:

‘Earn-Out Payment Amount’ for any Fiscal Year in the Earn-Out Period means the positive amount, if any, equal to the product of (x) the Net Profit for that Fiscal Year minus the Overhead Amount and (y) the Earn-Out Multiplier.

28See, e.g., Seed Holdings, Inc. v. Jiffy Int’l A.S., 5 F. Supp. 3d 565, 576-78 (S.D.N.Y. 2014) (holding that review under the Federal Arbitration Act applied to a working capital true-up performed by an accounting firm, even though the purchase agreement did not use the term ‘arbitration’). But see Purchase Price Adjustment Report at 20-23 (asserting that state law, not federal law, applies to ‘expert’ determinations and that the parties may choose to bargain for their own standard of review).

29In the Chicago Bridge & Iron case, the Delaware Supreme Court stopped an attempt by one party to use the working capital process to circumvent the intent of a transaction agreement that claims regarding financial misstatements not surviving closing. 166 A.3d at 933 (in agreement where representations and warranties did not survive closing, buyer ‘could only use the True Up to resolve disputes arising from changes in facts or circumstances of [the target company’s] business between signing and closing.’).

30Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009).

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Drafting M&A Contracts to Minimise the Risk of Disputes

Sometimes things do not work out as planned. Different legal jurisdictions will have their own approach to this issue. US law typically provides for a duty of the acquiring party to work in good faith to meet the earn-out expectations, but not to take extraordinary steps.31 As might be expected, these kinds of provisions can distort incentives post-closing. Thinking through the nature of the business and potential ways to maximise the seller’s protection of its economic expectations ahead of time is important. For example, potential protections for the seller could include specific actions that the buyer must take to maximise the seller’s revenue, or an explicit requirement that certain money be paid on a deferred timetable without regard to the economic success of the ongoing business. Of course, the exigencies of a particular deal will dictate the negotiating leverage for a selling party.32

Joint ventures and shareholder agreements

Parties in cross-border transactions commonly agree to plan to work together (or mix some assets) long term without fully merging or changing control.There are many issues to think through here depending on the nature of the deal, the parties’ position in the post-closing entity, and the parties’ long-term strategic goals: these may include control rights, rights in regard to certain operational or financial matters such as dividends, rights upon a future sale, and rights if one party changes control (leaving the other party in a relationship with a partner that it did not expect).These provisions, not surprisingly, are highly negotiated.

But one thing that is common to all joint ventures is the need to think through how disputes will be resolved in a way that minimises the negative effect on the business if it is intended to be a long-term relationship and to what extent a dispute will undermine the ongoing business. Some parties will develop elaborate dispute resolution provisions to do so. Arbitration, unsurprisingly given the overall goal of maintaining ongoing relations, is commonly used.

These shareholder agreements may themselves give rise to M&A disputes. For example, one of the parties to the shareholder agreement may claim that an M&A transaction being pursued by the other party violates its rights, and may seek to obtain an order blocking the transaction or granting money damages if the deal goes through.33 A party to a shareholder agreement that wants protection in the event that its partner enters into an unrelated

31See, e.g., Bloor v. Falstaff Brewing Corp., 601 F.2d 609, 614 (2d Cir. 1979) (holding, under NewYork law, that even in the absence of a ‘best efforts’ clause, a buyer would have been under a good faith duty to ensure that ‘substantial’ royalties were paid); Winshall v.Viacom Int’l, Inc., 76 A.3d 808, 816-17 (Del. 2013) (holding, under Delaware law, that implied covenant of good faith and fair dealing applies to earn-out provision).

32Any claim for post-closing damages will likely include a claim for interest. Parties to cross-border agreements with arbitration provisions should be aware that international arbitration tribunals may not apply the statutory rules for payment of interest of the jurisdiction whose law governs the arbitration agreement. See, e.g., New York City Bar Committee on International Commercial Disputes, Awards of Interest in International Commercial Arbitration: NewYork’s Law and Practice 2 (June 21, 2017) (‘International arbitrators have discretion to apply

or not to apply NewYork’s statutory prejudgment interest provisions to the determination of pre-award and post-award interest in an international commercial arbitration governed by NewYork substantive law and seated in NewYork . . . .’).

33For example, in the Casino v. Diniz arbitration, Casino sought an order in the arbitration barring CBD from agreeing a merger with Carrefour. See supra note 7. See also Helm LLC v. Corp Group Holding Inversiones Ltda., Verified Petition for Injunctive Relief Pending Arbitration, No. 656601/2016 (N.Y. Sup. Ct. Dec. 20, 2016) (seeking an injunction against a transaction arising out of a merger of one of claimant’s contractual partners).

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