Know Your Terminology: Nuances of Cross-Border M&A, United States

GENERAL LEGAL PRINCIPLES

Many jurisdictions around the globe have implied duties of good faith. In the United States, implied covenants of good faith and fair dealing are very limited in comprehensively negotiated deals among sophisticated parties.

The transaction documentation will usually address some of the risk allocation between parties by way of negotiation, but the starting position is that the onus is on the buyer to carry out adequate due diligence to inform themselves of the risks they will inherit on the closing of a transaction.

DOCUMENTATION

In the United States, the structure of an M&A transaction can take many forms, including but not limited to stock purchase, equity interests purchase (e.g., purchase of LLC membership interests), asset purchase and merger (including different types of mergers such as forward mergers, reverse triangular mergers, etc.). The form of documentation used will vary based on the structure of the transaction.

SALE PROCESS

In the United States, a competitive auction process is very common, and negotiations typically are based upon a non-binding letter of intent, which does not impose liability for its non-binding provisions.

Where the sale process will be marketed in a competitive auction process, it is not uncommon for a seller to carry out significant upfront preparation. This preparation often is done to help increase the pool of potential bidders and accelerate the sale process. In the United States, it is uncommon for sellers to provide a comprehensive sell-side (or vendor) diligence report. Instead, a buyer will engage its own legal counsel and specialized third-party advisors (insurance, IT, tax, financial, environmental, etc.) to conduct a thorough diligence review and prepare buyer-side due diligence reports. The buyer-side due diligence reports are then shared on a non-reliance basis with third parties such as lenders and representation and warranty insurance providers.

In contrast to the UK, for example, it is uncommon for sellers to obtain a sell-side or stapled representation and warranty insurance (RWI) policy in advance of a transaction. Instead, bidders are responsible for determining if they want to procure RWI, the implications of RWI (or absence of it) on the terms of their offers, and the allocation of costs. Buyers are also typically responsible for completing the RWI underwriting process. RWI policies in US transactions are discussed in more depth later in this article. In a competitive auction process, a potential buyer often will be required to submit a non-binding indication of interest on the basis of an initial diligence review; the seller will then select a smaller group of potential bidders to invite to management meetings and will conduct more fulsome diligence on the basis of those initial indications. While it is not uncommon for a buyer to obtain exclusivity on the basis of a term sheet, competitive processes often request that bidders complete diligence and submit a proposed purchase agreement before considering exclusivity. In very competitive processes, a seller might not grant exclusivity until the fully negotiated purchase agreement is signed (and then only on the basis of limited, negotiated closing conditions).

Where the sale process involves management that are looking to continue with the business following the transaction, it is prudent to consider management terms of rollover and management incentive packages as part of the process.

PRICING MECHANISMS

Locked box

While a locked-box price mechanism is routinely adopted in European markets (such as the UK market), in the US, the locked-box mechanism is used only in a small minority of deals and usually only where a European buyer is involved.

Purchase-price adjustment

In the United States, a purchase-price adjustment mechanism is far more common practice. A typical US M&A transaction is structured with an agreed purchase price on a cash-free, debt-free basis, a baseline or “target” working capital level (which is a negotiated amount that typically is based on “normalized” working capital requirements) and a post-closing adjustment mechanism. Unlike the locked-box mechanism, when using a typical purchase-price adjustment mechanism, the seller retains economic risk for the period between signing and closing, and the purchase price is adjusted downward for any debt at closing, upward for any cash, and upward or downward for any excess or shortfall in working capital levels from the negotiated target level.

The adjustment process itself typically provides a buyer the opportunity to prepare its own financial statements within a short period after closing, reflecting the buyer’s determination of the applicable levels of debt, cash and working capital at closing. Disputes between sellers and buyers (that they cannot first resolve among themselves) as to the calculations of these items typically are referred to mutually agreed upon accounting firms for resolution.

A buyer will also typically place a portion of the overall purchase price in an escrow account at closing to provide security for any downward adjustments to the purchase price.

DEAL CERTAINTY

In a US transaction that is structured to have a bifurcated signing and closing, closing conditions (commonly referenced as “conditions precedent” in other jurisdictions) are quite common, and a US transaction will typically include the following types of closing conditions: (i) receipt of required regulatory approvals (e.g., antitrust, CFIUS) or the expiration of applicable waiting periods, (ii) the transaction is not then enjoined or prohibited by law, (iii) the representations and warranties are accurate (as of the closing date) to a negotiated standard, (iv) the parties have performed applicable covenants in all material respects, (v) there has not been a material adverse effect and (vi) the transaction closes before a specified end date.

In a competitive process where a buyer otherwise desires to provide additional certainty as to closing, a purchase agreement may include the following additional types of provisions: (i) a “hell or high water” obligation to obtain necessary regulatory approvals (including agreeing in advance to accept structural remedies, including divestiture obligations), (ii) an “MAE bringdown standard,” where the buyer agrees to close unless a breach of the representations and warranties would reasonably be expected to result in a material adverse effect, and (iii) reverse termination fees and expense reimbursement obligations.

In a US transaction that is structured to have a bifurcated signing and closing, a buyer would have the benefit of a full suite of interim operating covenants (including obligations to take reasonable efforts to consummate the transactions, obtain any necessary consents and otherwise satisfy conditions to closing) and would have traditional remedies available for breaches of those covenants (including the ability to seek specific performance).

Financing

Financing in a customary private equity transaction comprises debt and equity components, with assurance as to the adequacy of funds to be delivered to the seller at closing (and associated recourse for non-delivery of funds) structured with the following documents required to be delivered by the buyer at the signing of the purchase agreement: (i) equity commitment letter, (ii) debt commitment letter and (iii) limited guaranty. Private equity transactions are then typically structured such that if all closing conditions are satisfied and the debt financing is available, a seller has the right to force a buyer to close and obligate the private equity sponsor to draw down on its debt financing commitment; if the debt financing is not available, however, the seller receives a reverse termination fee as its exclusive remedy.

REPRESENTATIONS AND WARRANTIES; DISCLOSURE

Representations and warranties generally

Regardless of transaction type (share purchase, equity interest purchase, asset purchase, merger, etc.), in a US transaction, the definitive purchase agreement will contain comprehensive representations and warranties (terms that are used interchangeably in US transactions) regarding the target business and the seller, which serve a basis for overall risk allocation. These representations and warranties are then typically divided into two categories (with differing survival periods and risk allocation, as discussed in more detail later in this article): (i) fundamental representations (e.g., those representations regarding title to shares/equity, authorization, corporate status and capitalization) and (ii) general representations (e.g., those regarding financials, employment matters, material contracts and insurance).

It is increasingly common in US transactions for a purchase agreement to contain express exclusions of any representations or warranties not specifically included in the purchase agreement itself (including in any financial projections or any information provided in data rooms) and to limit a buyer’s recourse for so-called extracontractual remedies.

The negotiated representations and warranties, as qualified by the disclosure schedules, are often the subject of RWI. The RWI market in the United States is very well developed, and insurers will cover fairly extensive representations and warranties.  With RWI insurance products, the buyer has recourse against an insurer for breaches of representations and warranties (either in addition to, or substitution of, recourse against the seller). Where RWI is utilized, it is not uncommon for a buyer to have zero or limited recourse against the seller (excluding fraud). Conversely, it also is not uncommon for a buyer to have recourse against a seller for items not covered by the RWI policy, for a portion of the deductible and/or for other “special” indemnities. It is worth noting that RWI products have customary exclusions and do not extend to purchase-price adjustments. The share of the insurance premium and overall risk allocation is the subject of negotiation and both macro and transaction-specific market dynamics.

In transactions with a bifurcated signing and closing, it is common to “bring down” (or make again as of the closing date) the representations and warranties at closing and to the negotiated standard (as discussed in the Deal Certainty section above).

Disclosure

The representations and warranties provided in the purchase agreement for a US transaction will be qualified by disclosures made by the seller in the disclosure schedules (which is a separate document prepared by the seller, negotiated by the parties and delivered at signing). Qualifications and exceptions to representations and warranties are either included in the representations and warranties themselves (e.g., materiality or knowledge qualifications) or the disclosure schedules. General data room disclosures are exceedingly rare.

In the United States, it is common for a disclosure (listed in the disclosure schedules) to be agreed to qualify all representations and warranties and not just the specific disclosure that it is made against, provided that the relevance of a particular disclosure to another representation is apparent from such disclosure.

Sandbagging/Knowledge

“Sandbagging” refers to the right of a buyer to obtain indemnification coverage for breaches of representations that the buyer knows about before the signing of the purchase agreement, and often is the subject of a specifically negotiated provision in a US transaction. Pro-sandbagging provisions (i.e., granting a buyer the express right to pursue recourse for breaches or inaccuracies of representations known to the buyer prior to closing) are not uncommon in US transactions, but the majority of transactions are silent on the topic of sandbagging. In the absence of a specific provision to address the matter, US courts will permit varying degrees of sandbagging.

RECOURSE; INDEMNIFICATION

Remedies generally

Recourse and remedies for breaches of representations and warranties ultimately derive from contractual claim for breach of contract and equitable principles under common law. Where a buyer suffers damages in reliance on representations or warranties made in a purchase agreement (or for failure to perform a covenant), a buyer has the right to pursue the seller to recover such damages to the extent available under common law.

However, the buyer and seller in a typical US M&A transaction will negotiate contractual remedies (indemnification), specific parameters regarding any such available remedies, the procedures and deadlines for submitting claims, and individual and aggregate monetary limitations.

Remedies for breaches of representations and warranties; indemnities

Traditionally, a seller was expected to provide a contractual obligation to indemnify the buyer for a seller’s breach of its representations and warranties, breach of its covenants, and for known risks allocated to the seller in the negotiation of the transaction documents (so-called “special indemnities”), subject—in each case—to negotiated parameters discussed above and below. At least one or more of these concepts is included in the vast majority of transactions.

However, in a competitive auction or for a particularly good asset, sellers often are able to obtain a “no indemnity” or “walk-away” deal where a buyer’s recourse is limited only to available coverage under an RWI policy. In the majority of US transactions utilizing an RWI policy, however, there will still be some available recourse against the seller, including for breaches of covenants and items excluded from RWI coverage. A typical recourse allocation in these types of transactions will provide the financial thresholds as discussed below.

Materiality scrapes

Another provision typically included in a US transaction that relates to representations and warranties is the materiality “scrape.” The materiality scrape is a separate provision that disregards materiality qualifications in the representations and warranties for the purpose of indemnification or RWI coverage. These types of provisions are very common. A “single scrape” disregards materiality qualifications for the purposes of determining damages, whereas a “double scrape” disregards materiality qualifications both for the purposes of determining damages and whether a representation was breached in the first instance.

Financial limits

As noted above, representations and warranties are typically divided into two categories (with differing financial limits on the amount a buyer can recover for breaches or inaccuracies): (i) fundamental representations and (ii) general representations.

A typical recourse allocation in US transactions (assuming the use of RWI) will provide the following financial thresholds:

• Damages from “dollar one” for fundamental representations, with a cap at the RWI retention amount (typically 1% of enterprise value).
• Damages in excess of a deductible (typically 0.5% of enterprise value) for general representations, with a cap at the RWI retention amount.
• No deductible and no cap for fraud.

In the absence of RWI coverage, a typical US transaction would provide the following financial thresholds:

• Damages from “dollar one” for fundamental representations, with a cap at the purchase price.
• Damages in excess of a deductible (typically 0.5% to 1% of purchase price) for general representations, with a cap between 10% and 15% of the purchase price.
• No deductible and no cap for fraud.

It is also not uncommon for a seller to advocate for a minimum or de minimis claim threshold to limit “nuisance” claims and/or to serve as a proxy for a materiality threshold where a double scrape is used.

In addition, in all cases there will be an exclusion on any caps for claims of fraud.

Survival periods

In a typical US transaction, the purchase agreement also will set out the survival periods within which the buyer is able to make a claim for a breach of a representation and warranty.

The following are typical survival periods:

• Fundamental representations can survive indefinitely or for a negotiated period (six years or the statute of limitations are common).
• General representations typically survive for between 12 to 18 months.

In an RWI transaction that provides recourse against the seller, both the fundamental representations and general representations typically survive for 12 months.

Escrow amounts

The use of escrow amounts in US transactions is common. There are typically two types of escrows that can be used: (i) an amount deducted from the purchase price and set aside as security for indemnification obligations and (ii) an amount deducted from the purchase price and set aside for any purchase-price adjustments.

A typical indemnity escrow for a transaction involving the use of RWI is equal to 0.5% of the purchase price, and a typical indemnity escrow for a transaction without RWI is equal to 10% of the purchase price.

The amount of an adjustment escrow is more transaction-specific, often negotiated to cover reasonably anticipated fluctuations in working capital and some additional coverage for potential inaccuracies in the financial statements supporting the estimated working capital.

TAXES

In the United States, there is no transfer (or stamp) tax on transfers of shares of stock or transfers of limited liability company interests.

Subject to certain exceptions, the United States generally does not tax capital gains of non-US investors. As such, non-US sellers typically prefer stock deals from an exit perspective.

The US domestic tax law and US treaty network provide nonresidents with tax efficient financing and cash repatriation opportunities.

NON-COMPETE

Post-closing restrictions (e.g., non-compete and non-solicit) often are provided by sellers.

Under US law, unreasonable restraints of trade are void, and what is reasonable depends on the length, operational scope and geographic breadth of the relevant restriction. Unlike other jurisdictions, post-closing restrictions cannot therefore be excessive and are usually set between three to seven years.