Risk Apportionment in the Purchase and Sale Transaction

Risk Apportionment in the Purchase and Sale Transaction

Presented by: Leanne C. Krawchuk, Partner

Dentons Canada LLP

Dentons Canada LLP Presentation to the CBA’s Alberta Law Conference 2013

http://www.dentons.com/leanne-krawchuk

Outline – Risk Apportionment

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1. Representations and Warranties

2. Indemnity Clauses and Limitations

3. Purchase Price Adjustments and Holdbacks/Escrow

4. Maximize the Value Proposition

5. Due Diligence

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Representations and Warranties

300 Month 2013 Dentons Canada LLP Document reference #


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• What is a representation?• it is a statement of fact, past or existing (it does not speak to the future)

• What is a warranty?• it is a promise that a fact is or will be true

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• They become meaningful when tied to the indemnity provisions in the definitive agreement

• The purchaser is seeking assurances from the vendor(s) that certain facts are true, and will be true, relating to the purchased assets or purchased entity; if they prove not to be true, the purchaser is to be compensated for its losses

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Who should be giving them and regarding what?

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• Share Sale• The shareholders are the vendors• Target corporation is not a party

unless providing collateral covenants• Joint and several liability among

vendor shareholders or only several liability

• Regarding target corporation and its historical business

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• Asset Sale• The vendor is the corporation (only

several liability; not joint)• Sometimes the shareholders of the

vendor corporation (may then be joint and several liability)

• Regarding the purchased assets notthe vendor corporation

Who should bear the risk?

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• It is dependent on:• The purchase price• Adjustments to the purchase price• Bargaining strength of the parties• Transaction factors

• The “Closing Date” or “Effective Date” is the date that delineates the date for risk apportionment and is the date the vendor’s representations/warranties are to be true

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Liabilities

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• In a share purchase, the purchaser is buying all known and unknown liabilities

• In an asset sale, the purchaser is usually only buying assets not liabilities, but could buy certain specified liabilities (i.e. assume debt related to certain purchased assets)

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Negotiating the Risk

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• As a result, in a share sale, the purchaser is looking for exhaustive representations on all known liabilities and is hoping to extract vendor representations on unknown liabilities as well

• The vendor will be motivated to reduce its potential liability for a breach of a representation/warranty and will introduce exceptions

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Exceptions Introduced by the Vendor to Reduce Liability

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1. Knowledge qualifier

2. Materiality

3. Other Exceptions to Disclosure> the Schedules

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Knowledge Qualifier

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• The vendor will try to limit its representations and warranties to “the knowledge of the vendor”

• Vendor will want this phrase to mean only “actual knowledge” and of only certain vendors (the majority shareholders or management shareholders)

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Knowledge Qualifier

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• If the purchaser permits this qualification:• The purchaser will want “knowledge” to either:

• require the vendor to have made a reasonable inquiry into the matter; or • to be the knowledge a reasonable person should have using reasonable care or

diligence

• The purchase agreement should contain an interpretation section regarding this phrase

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Materiality Exception

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• The vendor will want to add a level of materiality to representations/warranties so that “non-material breaches” will not result in a breach of the purchase agreement giving rise to indemnity obligations

• Can be defined in relation to having a certain minimum aggregate dollar value per year or as a % of the purchase price

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Materiality Exception

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• “The vendor shareholder represents and warrants that, as at the Closing Date, the target corporation is not a party to any material contract except as disclosed on Schedule A”.

• “material” means, in relation to any contract, having an aggregate minimum value of at least $100,000 on an annual basis”

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Other Exceptions to Disclosure

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• The vendor will attempt to qualify the purchaser’s broadly worded representations with specific exceptions to disclosure which are set out in Schedules; often the result of due diligence

• “The vendor shareholder represents and warrants that except as set forth in Schedule B, the target corporation has never received notice of non-compliance with the Occupational Health and Safety Act (Alberta).”

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Survival Periods

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• Purchase agreement must contain a survival clause so that the representations/warranties do not merge on closing

• How long should they last?-typical range is 1 to 3 years; some are indefinite or extend until the expiry of any assessment period

• Acts as a time limit on ability to claim for indemnity

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Indemnity Clauses and Limitations


Indemnity Clauses

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• An obligation on the first party to indemnify a second party for a loss incurred by the second party

• Serves to protect the purchaser for a breach of representation/warranty of the vendor that occurs during the survival period (and vice versa)

• Should be drafted to include both direct losses/claims and to include third party claims

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Mobil Oil Canada Ltd. v. Beta Well Service Ltd. (1974), 43 DLR (3d) 745 (Alta Sup Ct App Div)

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• Indemnification By Contractor:“10. Contractor [Beta] shall be liable for and shall indemnify and save harmless Mobil Oil of and from all manner of actions, causes of action, proceedings, claims, demands, loss, costs, damages and expenses whatsoever which may be brought or made against Mobil Oil, or which it may sustain, pay, or incur as a result of or in connection with the performance, purported performance or non-performance of this agreement or other work hereunder by Contractor or his sub-contractors and whether the same results from or in connection with the use by Contractor or his sub-contractors of any machinery, tools or equipment belonging to Mobil Oil, or from or in connection with the negligence or wilful acts or omissions of Mobil Oil, its servants, agents, employees or its other contractors, while acting under the direction or control of Contractor or his sub-contractors, and Contractor shall further indemnify and save harmless Mobil Oil from all claims, suits, and demands for infringement of any patent or similar right growing out of or incident to Contractor’s performance of said work or the use of material or equipment furnished by Contractor.”

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Mobil Oil Canada Ltd. v. Beta Well Service Ltd. (1974), 43 DLR (3d) 745 (Alta Sup Ct App Div)

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• Held: The clause only required the Defendant (Beta) to indemnify the Plaintiff (Mobil Oil) against claims brought by third parties, and did not apply to direct loss caused by the operations of the Defendant to the Plaintiff.

• Reasons: “[T]he “liability” provision and the “indemnification provisions” are linked together by the conjunction “and” … The clause may therefore be interpreted as providing for the acceptance by the contractor (Beta) of liability for, and an undertaking to indemnify Mobil Oil against, claims of third parties, rather than direct claims of Mobil Oil against the contractor for loss or damage it might sustain… It must be borne in mind that this is Mobil's contract. The rule or principle of contra proferentem requires the words of written documents to be construed more forcibly against the party using them.”

• Decision upheld at the Supreme Court of Canada (Mobil Oil Canada Ltd. v. Beta Well Service Ltd. (1974), 43 DLR (3d) 745 (SCC)).

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TransCanada Pipelines Ltd. v. Potter Station Power Limited Partnership (2003), 226 DLR (4th) 262 (ONCA)

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• “10. Potter Power shall indemnify and save harmless TransCanada from and against all liability, actions, claims, losses, costs and damages which may be brought against or suffered by TransCanada and which TransCanada may incur, sustain or pay arising out of or in connection with:(a) construction, operation and maintenance of the Facility (including the Duct System); (b) the negligence or willful misconduct of Potter Power, its directors, officers, employees, agents, servants, contractors and subcontractors arising out of or incidental to this Agreement; or (c) a breach by Potter Power of any of the terms and conditions set forth in this Agreement,except to the extent that such losses or damages, result from the negligence or willful misconduct of TransCanada.”

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• Held: The wording of the clause was not ambiguous; it was not confined to third party claims, and clearly included losses suffered directly by the Plaintiff.

• Reasons: “In particular, I adopt the motion judge’s reasoning that the words “losses, costs and damages which may be… suffered by TransCanada” introduce an obvious alternative to “all liability, actions, claims…. which may be brought against…. TransCanada” and that, when read in context, the alternative is “more appropriately associated with damage to TransCanada itself”.

• “The key difference between the two provisions [this one and the one in Mobil Oil] is the compelling alternative introduced by the words “which may be brought against or suffered by” in the Indemnity. In the Mobil Oil provision, there is no similar clear alternative.”

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• “Rather, in Mobil Oil, the potential alternative is between the words “which may be brought or made against” and the words “which it may sustain, pay, or incur”. However, while the words “which may be brought or made against” appear to be used synonymously, such that each verb applies individually to only some of the preceding nouns, it is not obvious whether the words “which it may sustain, pay, or incur” are to be interpreted synonymously and applied individually to only some of the preceding nouns or whether they are to be interpreted as introducing an alternative by applying each verb individually to all of the preceding nouns. Put another way, in Mobil Oil, the words “which it may sustain, pay, or incur”, when juxtaposed against “which may be brought or made against” and interpreted in conjunction with the rest of the clause, do not produce the same compelling alternative that exists in the Indemnity”.

• “In addition, the commercial context of the two cases is vastly different. Mobil Oil involved an indemnity contained in a repair contract between an oil and gas well servicing company and a well owner. A clause in the repair contract required the servicing company to perform its work in a good and workmanlike manner. It therefore established a standard of performance that was inconsistent with absolute liability on the part of the contractor… In contrast… neither the specific terms of the … Agreement nor its surrounding context weigh against interpreting the Indemnity as extended to damages suffered by [the Plaintiff] … directly.”

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What Alberta Courts are Saying About Mobil Oil - Herron v. Hunting Chase Inc., 2003 ABCA 219

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• Section 9.1(a) provides that the shareholder vendors “shall indemnify and save harmless the Purchaser […] from and against all Losses which [it] may suffer, sustain, pay or incur as a consequence of a breach of a representation and warranty […] or a breach by a Vendor of any of the covenants made by it in this Agreement […]”

• Section 9.1(b) provides indemnification for losses which Hunting (the Purchaser) “may suffer, sustain, pay or incur in connection with any Claim relating to any product produced or sold, or any service provided, by or on behalf of Chase (the target company) prior to the Time of Closing.”

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What Alberta Courts are Saying About Mobil Oil - Herron v. Hunting Chase Inc., 2003 ABCA 219

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• Held: The indemnification provision would apply to non-third party losses resulting from breaches of covenants of the shareholder vendors, including losses resulting from breach of the retained earnings covenant.

• Reasons: “Subsequent Alberta decisions have not treated Mobil Oil… as authority for limiting the application of indemnification clauses to third parties… Rather than relying on Mobil Oil, the plain and ordinary meaning of each contract must be assessed in its own context with a focus on the intention of the parties…”

• “It follows that s. 9.1(a) provides indemnification for losses suffered by a party whether or not they relate to claims by third parties… This section [s. 9.1(b)] specifically indemnifies for third party claims, but in no way limits the broader indemnification in s. 9.1(a).”

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What Alberta Courts are Saying About Mobil Oil -Sinclaire v. South Trail Shell (1987), 2002 ABQB 378

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• 2.14 Indemnity

“You will indemnify us and hold us harmless against any claim against us (including costs and expenses) resulting from or connected with your business at the Site, including, without limitation, any claim for damages relating to environmental contamination; any persons entering, coming on, or leaving the Site, or using your services; and loss or damage to property.”

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What Alberta Courts are Saying About Mobil Oil -Sinclaire v. South Trail Shell (1987), 2002 ABQB 378

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• Held: “It [Clause 2.14] would require Cannon… to indemnify Products for liability for negligence of Cannon… on the Site whether Cannon’s negligence was whole or partial. The Clause would not, however, cover liability for negligence of Shell or Products on the Site whether whole or contributory.”

• Reasons: “… Mobil Oil remains, in my view, authority for the proposition that indemnity clauses should be read in the overall context of the agreement, and also should be read, where the total [is] unclear, in light of the principle of contra proferentum…

• The interpretation by Shell and Products would… seem to impose upon Cannon the duty to indemnify Shell and Products even if the loss were found to be exclusively as a result of the negligence of Products… Such an absolute shifting of responsibility should… require much clearer language than exists here.

• …Clause 2.14 is ambiguous in and of itself… apply the contra proferentumprinciple.”

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Preserve Common Law Right to Sue for Breach

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• Often, the purchaser still wishes to also preserve its common law right to sue for breach of contract in addition to right to indemnity from vendor; purchase agreement must be clear on this

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Negotiating a Cap

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• Vendor Should Negotiate Caps on Indemnity: i.e., a percentage of the purchase price or a fixed dollar amount

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Percentage of Deals Including Caps for

Transactions completed in 2007, 2008 and 2009*

* Source: American Bar Association’s Business Law Section – 2010 Canadian Private Target Mergers & Acquisitions Deal Points

Negotiate an Indemnification Basket

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• Vendor to Negotiate Indemnification Baskets: the minimum loss/damage ($$) that must be suffered by a purchaser for a breach of a vendor’s representations and warranties

• (1) deductible baskets and (2) dollar-one baskets and sometimes (3) combination baskets

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Baskets as Percentage of Transaction Value for Transactions completed in 2007, 2008, and 2009*


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• Buttressing the Indemnity Covenant• In an asset sale, the shareholders may be requested to provide

guarantees to back-stop the vendor (shell) corporation’s (several) indemnity obligations

• Holdbacks from the purchase price may be used by the purchaser as “security” for the indemnity obligations of the vendor and used to set-off any losses

• Joint and Several or only Several Indemnity?• Joint and several representations> generally leads to joint and

several indemnity obligations, with vendors then attempting to limit indemnity amount to their share of purchase price Joint and several = advantage purchaser Several = advantage vendor

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Purchase Price Adjustments and Holdbacks/Escrow


Purchase Price Adjustments

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• Purchase price may be dependent on future earnings of the business over a period of time after closing. As future earnings will not be known at the time of closing, a portion of the purchase price is then structured as an “Earn-Out”

• If vendor not involved in the business after closing, vendor has no control on whether earn-outs are met

• If vendor has no control in the business after closing, purchaser or target company may spin out the business or key assets resulting in targets not being achievable• Normal Earn-Out vs. Reverse Earn-Out

• Normal earn-out added to price = Advantage buyer as earn-out is taxable income

• Reverse earn-out taken from price = Advantage vendor as adjustment is all on account of capital (proceeds)

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Holdbacks/Escrows

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• Can the vendor avoid holdbacks or escrow altogether?

• Avoid agreeing to too large a portion of the purchase price being held back to secure the indemnity obligation (or other covenants) of the vendor or guarantors in the purchase agreement

• Ensure any holdback funds are placed in a solicitor’s escrow account or obtain security from the purchaser to secure the purchaser’s obligation to pay the future (potential) holdback

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Percentage of Deals Employing Escrow for Transactions*


Maximize the Value Proposition


Maximizing The Value Proposition

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A. Legal Factors That Hurt Value in Vendor Business

• Failure to appreciate the value in the Vendor or more importantly in the management that need to stay involved after the closing

• Failure to properly protect intellectual property (i.e. Copyright, Trademark, Trade Secrets, Industrial Design Issues)

• Failure to address important liabilities• Litigation, Environmental liabilities, Tax liabilities and

Employee severance cost liabilities

• Failure to appreciate the time involved in completing the transaction, include due diligence requirements

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A. Legal Factors That Hurt Value in Vendor Business Cont…

• Inappropriate or pre-mature disclosure• Without Confidentiality Agreement• Disclosing too much information too soon• Lack of control of information disclosure

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B. Understanding the Unanimous Shareholder Agreement (USA):• What is the share structure?• Does the USA drag along minority shareholders or do they

have pre-emptive rights?

C. Purchaser will typically want non-compete from key employees and/or departing shareholders

D. Key personnel and strength of management team: ensure they are going to be in place post-closing

E. Ensuring survivability of business transactions/material contracts/key suppliers/key customers

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Due Diligence


Due Diligence

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What is Due Diligence and Why Conduct it?• Investigations into target company’s business, legal and financial affairs

• Reviewing contracts, financial statements, legal public search results, environmental phase I’s or II’s, etc.

• To help ensure the intended results:• Is the vendor selling the assets it intends to sell and that the purchaser

expects to purchase?• Is the vendor giving appropriate and correct representations and warranties?

Do the Schedules contain accurate disclosure?

• Scope, depth and purpose is transaction specific

• To determine what consents/notices /rulings are required and how this affects Closing– regulatory, other third parties? (i.e. bankers, shareholders approvals, customers, Competition Act, Investment Canada Act)

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Due Diligence

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• Resource Allocation by Vendor• Which employees will be involved?

• “Presale Due Diligence”• Consider overall process in advance

• What documents and arrangements need to be disclosed• How will they be assembled, collected and disclosed

• Develop a system to collect, index and retain documents• Where is that major customer agreement kept?• Where are the share certificates that are being purchased located?• Will an electronic datasite be used and who will populate and manage it?

• Correct issues/defects with current agreements and arrangements

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Questions?

Presented by:

Leanne C. Krawchuk, PartnerEdmonton780 423 [email protected]

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http://www.dentons.com/leanne-krawchuk

The preceding presentation deals with the kinds of issues companies dealing with risk apportionment could face. If you are faced with one of these issues, please retain professional assistance as each situation is unique.

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