Embed Size (px)
Citation preview
ACQUISITION AGREEMENTS
I. BERL NADLER PARTNER
DAVIES WARD PHILLIPS & VINEBERG LLP
February 25, 2010
ACQUISITION AGREEMENTS
TABLE OF CONTENTS
I. Introduction......................................................................................................................... 1
II. Form of the Transaction: Assets vs. Shares; Amalgamations............................................ 1
A. Share/Ownership Interest Acquisition ................................................................................ 2 B. Asset Acquisition................................................................................................................. 2 C. Amalgamation ..................................................................................................................... 4
III. Consideration ...................................................................................................................... 5
A. Securities vs. Cash .............................................................................................................. 5 B. Earn-Outs............................................................................................................................ 5 C. Holdbacks to Cover Contingencies..................................................................................... 6
IV. Legal and Regulatory Issues ............................................................................................... 6
A. Competition Act (Canada) .................................................................................................. 6 B. Investment Canada Act (Canada)....................................................................................... 8
V. Acquisition Agreements...................................................................................................... 9
A. Introduction......................................................................................................................... 9 B. Subject Matter................................................................................................................... 10 C. Purchase Price.................................................................................................................. 12 D. Representations and Warranties....................................................................................... 16 E. Covenants.......................................................................................................................... 24 F. Closing Conditions ........................................................................................................... 25 G. Indemnities........................................................................................................................ 26
VI. Conclusion ........................................................................................................................ 32
I. Introduction
In this paper, I will review key legal and practical issues that arise when
negotiating and drafting acquisition agreements. The paper will focus on privately negotiated
acquisition agreements involving assets or shares and will not address the securities law issues
raised by the negotiation of agreements related to the acquisition of the shares of publicly traded
corporations. However, many of the legal and business issues that arise in negotiated
acquisitions of the shares of privately held corporations, wholly-owned subsidiaries of publicly
held corporations or of assets are of equal relevance to the negotiation and drafting of acquisition
agreements for the shares of publicly traded corporations.
II. Form of the Transaction: Assets vs. Shares; Amalgamations
A business can be acquired through the acquisition of the assets used in the
conduct of the business or, indirectly, through the acquisition of shares or other ownership
interests of the legal entity that conducts the business. The latter type of acquisition can be
effected through a direct acquisition of such shares or ownership interests or through a
reorganization, such as an amalgamation of the acquiror or an affiliate of the acquiror, with the
corporation that conducts the acquired business.
Generally speaking, the choice of the form of the acquisition – as between
shares/ownership interests or assets – will be driven primarily by income tax considerations as
the pure business objective of acquiring control of the business itself can be attained using either
form of acquisition.
- 2 -
A. Share/Ownership Interest Acquisition
As a general matter, sellers prefer to sell shares because gains realized on the sale
of shares are treated as capital gains and taxed at the reduced rates applicable to capital gains.
On the other hand, for reasons that will be discussed in greater detail below, the sale of assets
may trigger to the seller income inclusion taxed at ordinary rates. However, if the acquired
business has accumulated losses which may still be carried forward against the income of the
business in future years, a purchaser (if otherwise taxable) may prefer to acquire the shares and
apply the losses against future years' income. In these circumstances, careful attention must be
paid to the ability of the acquired business to use losses after a change of control of the acquired
company under applicable income tax rules.
B. Asset Acquisition
(i) Purchaser Preference
Purchasers may often prefer to buy the assets of acquired businesses because this
provides an opportunity – depending on the relationship between the purchase price for specific
classes of assets and their then current book value – to "bump" the costs of such assets to their
fair market value at the effective date of the transaction. This "bump" in turn gives rise to greater
capital cost allowances and future depreciation available to the purchaser than would otherwise
be the case on an acquisition of shares where the historic book values of the underlying assets of
the business – which would generally be lower than their fair market value at the date of
acquisition – would be assumed by the purchaser acquiring the shares of the corporate owner of
the assets.
- 3 -
Moreover, an asset acquisition affords to the purchaser the ability to avoid the
acquisition of any undesired liabilities of the business (generally speaking, all pre-closing
liabilities) and to "cherry pick" only those contractual obligations and other liabilities of the
acquired business that the purchaser views to be essential to the conduct of the business going
forward. Of course, the matter of liability assumption is generally a negotiating point of great
consequence to both parties and the end result will usually reflect the negotiating leverage of the
parties as much as their original intentions. An asset acquisition will also often afford the
purchaser the ability to obtain more significant and precise disclosure as to assumed liabilities.
In a share acquisition, absent negotiating specific agreements to the contrary, all
employees of the corporation and related employment and pension liabilities are assumed by the
purchaser of the shares. An asset acquisition affords the purchaser the opportunity to enter into
new contractual relationships with only those employees or other creditors, suppliers, etc. that
the purchaser deems to be necessary to the continued operation of the business. Often, a
purchaser may be in a business similar or identical to the one being acquired and a significant
portion of the staff, and other third parties having contracts with the acquired business may be
redundant given the efficiencies to be achieved by combining the two businesses. If the
purchaser does not take all or substantially all of the employees of the acquired business, a
negotiation will inevitably ensue as to the allocation of liability for severance costs associated
with the acquisition and for the impact of that allocation on the purchase price.
(ii) Seller's Perspective
From the seller's perspective, any profits made by the selling corporate entity on
the sale of inventory to a seller would be taxable as income and the sale of depreciable property
- 4 -
at prices in excess of their depreciated book value would trigger a recapture of capital cost
allowances, taxable as income. Moreover, a sale of assets by the corporate entity conducting the
business will not see the proceeds of sale falling into the hands of the corporation's owners
without a further distribution from the corporation itself, which triggers an additional layer of tax
on the proceeds of disposition, albeit at the reduced rates applicable to dividends.
Asset sales also often attract provincial sales tax, land transfer tax and federal
goods and services tax which would generally not be applicable in a share purchase. Also these
taxes are generally paid by the purchaser, they increase the all-in cost of the acquisition and can
thereby depress the purchase price.
C. Amalgamation
An amalgamation may often be the most desirable way for a corporate entity to
acquire another given the tax-free "rollover" that may be available on the amalgamation of
taxable Canadian corporations. In the event that a business acquisition is effected as an
amalgamation, two amalgamating corporations would combine under applicable corporate law
and continue as one corporate entity. Generally speaking, the shareholders of the acquired
corporation would receive cash on the completion of the amalgamation through the issuance on
the amalgamation of redeemable preferred shares of the newly amalgamated corporation. Such
shares would immediately be redeemed for cash following implementation of the amalgamation.
In planning an acquisition, careful consideration should be given to the income tax consequences
of an amalgamation structure when compared to the share or asset purchase alternatives.
- 5 -
III. Consideration
A. Securities vs. Cash
The simplest form of consideration is cash paid in full at closing. That approach
is, for reasons which do not require elaboration, the most desired by sellers and the least desired
by purchasers. Purchasers may often want to offer as consideration shares or other securities
either of the purchaser itself, of a subsidiary or other affiliate of the purchaser or of an investee
corporation of the purchaser. In the event that the purchaser or other issuer of the consideration
securities is a public company, the issuance will attract securities law regulation which, as I
indicated at the outset, is beyond the scope of this paper. However, even if the issuer of the
consideration securities is not a publicly held corporation, given the effective elimination of the
old "private company" exemption under newly introduced securities commission policies on
private placements, care must be taken to ensure that prospectus and registration exemptions are
available under applicable securities law in respect of the issuance or trading of the shares to the
seller.
B. Earn-Outs
It is not uncommon to see acquisition transactions structured with an "earn-out"
provision pursuant to which the payment by the purchaser of a portion of the purchase price is
contingent on the earnings of the acquired business during a specified period of time after
closing. The consideration for the "earn-out" can be paid either in cash or shares or other
securities at specified dates after closing. There are particular income tax issues relevant to
- 6 -
"earn-outs" that should be considered if this option is pursued and are well beyond the scope of
this paper.
C. Holdbacks to Cover Contingencies
In addition, payment of a portion of the purchase price may be held back for a
specified period and held in a trust account from which the purchaser may draw in order to cover
successful claims made by it under the indemnity provisions of the purchase agreement. If the
purchase price is not paid in full at the time of closing, the seller may often require security for
the unpaid balance. Note that where the purchase price is deferred or held back, the seller may
be required in certain circumstances to recognize the gain immediately for tax purposes on
proceeds not received.
IV. Legal and Regulatory Issues
A. Competition Act (Canada)
Where a transaction is subject to notification under the Competition Act (Canada),
the parties will commonly incorporate clauses in the purchase agreement to deal with the
Competition Act review process. For example, there will usually be a covenant requiring the
parties to use their best or commercially reasonable efforts to file their notifications in an
expeditious fashion following execution of the agreement (sometimes a specific deadline is
established). It is also customary to include a covenant obliging the parties to cooperate with
each other in obtaining clearances from the authorities, e.g., in the preparation of the written
brief to the Competition Bureau explaining why the transaction does not raise substantive issues.
Since this cooperation will usually involve exchanges of information between the parties, it will
- 7 -
be important to make it clear in the agreement that any exchange of information must be
conducted pursuant to appropriate confidentiality restrictions. This is necessary to avoid
allegations that the parties have used the merger negotiation process improperly to provide each
other with competitively sensitive information. Other matters that can be covered by the
"cooperation" covenant include allocating the liability for paying the notification fee (in Canada,
the purchaser is usually responsible although this is not a statutory requirement) and the extent, if
any, to which the seller will be an active participant in the review process (e.g., by vetting drafts
of submissions and being notified in advance of and participating in representations to or
meetings with the Bureau). As a general matter, the purchaser will take the lead in dealing with
the Competition Bureau, but sellers will sometimes insist on having a more pronounced role
depending on the nature of the transaction and the circumstances.
Purchase agreements will also typically include Competition Act-related closing
conditions. The most common form of closing condition will confirm that the transaction cannot
be consummated unless: (i) the statutory waiting period triggered by the filing of the notification
has expired or been earlier terminated by the Bureau and the Bureau has confirmed to the
purchaser that it does not intend to challenge the transaction; or (ii) the purchaser has received a
special type of clearance, known as an "Advance Ruling Certificate" ("ARC"), which also has
the effect of taking the transaction outside of the notification and statutory waiting period
requirements.
In the event that the purchaser is willing to bear a greater share of the risk that the
Competition Bureau may object to the transaction, the Competition Act closing condition can be
limited to the expiry of the applicable waiting period without any requirement that the Bureau
provide the purchaser with positive clearance in the form of an ARC or otherwise. The parties
- 8 -
may agree to covenants describing the specific steps that the purchaser must take in order to
obtain the Bureau's approval, including the divestiture of specific assets. Given the obvious
sensitivities, parties will sometimes use a side-letter to deal with this type of covenant rather than
include it in the purchase agreement itself.
Other closing conditions that may be incorporated in the agreement include: a
deadline within which Competition Act approval must be obtained; a "break up" fee that the
purchaser must pay to the seller if the transaction cannot proceed for Competition Act reasons;
and in a transaction involving multi-jurisdictional approvals, a list of the jurisdictions other than
Canada whose approval is a condition of closing.
Depending on the circumstances, a purchaser may also insist that the seller
provide representations and warranties that (i) it is not involved in any conduct that contravenes
or is reasonably likely to contravene the Competition Act; and (ii) it is not being investigated or
is the subject of other proceedings (e.g., civil suits) involving conduct of this nature. For
example, the purchaser may want this type of representation where it is not familiar with the
industry in which the seller is active or, alternatively, when the purchaser knows that the seller's
industry has been the subject of Bureau scrutiny in the past.
B. Investment Canada Act (Canada)
Finally, in cases where the transaction is subject to review under the Investment
Canada Act, the purchase agreement should include a representation and warranty that all
necessary approvals under that Act have been obtained or, alternatively, that the prescribed time
period provided for review under that statute has expired and the transaction has been deemed to
have been approved in accordance with the provisions of that Act.
- 9 -
V. Acquisition Agreements
A. Introduction
Another session of this conference dealt with the pre-acquisition agreements that
are entered into by parties, namely, confidentiality agreements and letters of intent or
memoranda of understanding ("MOUs"), the latter of which are generally non-binding. Letters
of Intent or MOUs, as a general matter, are designed to reflect the principal business terms of the
acquisition transaction and, unlike purchase agreements, are not intended to function as
comprehensive legal codes that govern all aspects of the transaction. Accordingly, they should,
as a general matter, expressly disclaim their binding nature except for certain provisions, e.g.,
confidentiality, term, exclusivity, non-competition or solicitation, that are expressly agreed to be
binding on both parties.
The purchase agreement should expressly provide that it alone governs the
transaction and that it supersedes and overrides all prior agreements, understandings, regulations
and discussions, whether written or oral, in connection with the subject matter thereof, including
the MOU/Letter of Intent.
It is the formal acquisition agreement that is designed to be the sole
comprehensive legal code that governs the transaction. Generally speaking, acquisition
agreements follow a very well defined and highly precedented format that is accepted world-
wide. These agreements almost always are formatted to address all of the following subjects:
(i) subject matter of the agreement (assets or shares);
(ii) purchase price (cash or securities; paid in full or deferred; adjustments);
- 10 -
(iii) representations and warranties;
(iv) covenants;
(v) closing conditions;
(vi) indemnities; and
(vii) general provisions, e.g. governing law, notice, etc.
In the remainder of this paper, I will discuss the salient features of acquisition
agreements and some of the key issues that recur in the course of their negotiation.
B. Subject Matter
(i) Detailed Description of Purchased or Underlying Assets
Generally speaking, the provisions of a purchase agreement that deal with the
subject matter of the acquisition will refer either to the assets, most of which will be listed and
described in detail in schedules to the agreement, particularly but not necessarily exclusively in
the case of an asset purchase, or the relevant shares or other securities that are subject to the sale.
Typically, in an asset purchase agreement, the itemized list of acquired assets will
refer to correspondingly numbered schedules to the agreement that will list and describe in detail
the assets included in the purchase. Corresponding comparable schedules will be appended to
share purchase agreements generally in connection with the representations and warranties as to
the underlying assets and liabilities of the corporation being acquired as more particularly
discussed under "Representations and Warranties" below. It is critical that the list of purchased
assets in the case of an asset purchase, and the schedules of purchased or underlying assets, in
either type of transaction, be prepared after a detailed due diligence review of the purchased or
- 11 -
underlying assets so that the purchaser acquires all assets (either directly or indirectly) that will
be necessary to conduct the business after closing.
(ii) Shares or Other Securities
In the case of a purchase of shares or other securities, it is always critical to
review carefully the description of the shares or other securities to ensure that the relevant
provisions of the agreement accurately reflect such description as it appears in the articles or
other documents pursuant to which the shares or other securities are created (e.g., a note
indenture in the case of debt instruments). Counsel for the purchaser must review any
restrictions on the transferability of the shares or other securities in such constating documents
and should conduct due diligence reviews of any other contracts, statutes, common law or other
regulatory or contractual sources that may contain or give rise to restrictions on or conditions to
the transferability of the shares or other securities or that otherwise encumber the ability of the
seller to transfer the shares or securities. In addition, the provisions governing the shares or other
securities found in the articles, partnership agreements or other constating documents which
create the acquired securities should be reviewed carefully so that the nature of the securities and
the rights of holders are clearly understood and explained to the purchaser. In addition, as
described above, any tax implications of the securities themselves must be clearly understood by
the purchaser.
- 12 -
(iii) Assets
In the case of an asset purchase transaction, the applicable law may require that
particular types of assets be defined or described in a specific manner. For example, if
intellectual property licences are included among the acquired assets or assumed liabilities in an
asset purchase transaction, it is important for counsel to review the description of the intellectual
property licences contained in the acquisition agreement against the actual terms of the licences
to be acquired to ensure its accuracy as well as its conformity to any regulatory regimes that
govern such assets, and, in particular, the transferability thereof.
C. Purchase Price
(i) Manner of Payment
As noted above, the purchase price can be paid in cash, securities or other
property or a combination thereof. It can also be paid upfront or deferred in whole or in part
based on conditions. Some of those conditions can relate to the completion of parts of the
transaction that cannot be completed on the initial closing or the provision of an earnout to the
seller which ties the payment of a portion of the purchase price to the satisfaction of certain
financial performance conditions post-closing. All of this will be subject to commercial
negotiation. The lawyer's primary task is to ensure that, whatever the results of the negotiation,
the drafting of the agreement is clear, unambiguous and enforceable. This paper will address
some issues that arise in every transaction in connection with the negotiation and articulation of
the purchase price provision although they are certainly not the subject of universal resolution.
The purchase price, in both asset and share transactions, will be reflective of the
underlying values of the assets of the business which will not necessarily be the values reflected
- 13 -
on the financial statements of the acquired business. For example, the fair value of certain assets
may be significantly different than the book values reflected on the financial statements. Care
should be taken to ensure that the parties reach precise agreement on the basis for valuing the
business and its underlying assets and that the description in the agreement accurately reflects
such agreement. If such values are reflective of the GAAP presentation on financial statements,
they should obviously be recorded in that manner. If not, variations from GAAP or financial
statement presentation should also be accurately recorded and described.
(ii) Payment Mechanisms
Counsel should ensure that payment mechanisms are precisely agreed and
accurately described. If the purchase price is payable in cash, whether in full at closing or in
instalments, and payments are to be effected by wire transfers of funds, the accounts to which
funds must be wired and the timing of the wire transfers should be accurately described. Any
interest to be accrued on delayed payments should also be accurately described. Similarly, the
terms of any deposit against the purchase price, and in particularly conditions of its release, must
be carefully considered and precisely drafted.
If securities are to be used to satisfy all or part of the purchase price, the
consideration securities must be accurately described and the relevant securities laws that govern
the issue and transfer of the consideration securities must be reviewed to ensure that the
appropriate filings are made or exemptions available for both the issuance and transfer of the
consideration securities. The purchaser in particular will be concerned to ensure that the
securities are freely tradeable immediately upon closing under applicable securities law and
should receive representations from the seller to such effect. If, under applicable securities law
or stock exchange regulations, there are restrictions on the tradeability of the consideration
- 14 -
securities, such restrictions should be accurately understood and clearly described in the
purchase agreement and should be addressed in a legal opinion from seller's counsel addressed to
purchaser.
(iii) Assumption of Liabilities
To the extent that the price or economic cost of the transaction involves the
assumption by the purchaser of obligations of the purchased business (in the case of asset
acquisition – such assumption is a necessarily implicit aspect of a share purchase unless
specifically excluded) the assumed liabilities must be clearly described. If the liabilities are
creatures of law, care should be taken to understand the legal regime, whether statutory or under
licences or permits, under which they arise. Liabilities or tax liabilities that are either subject to,
or the creatures of, statutes and the statutory basis for such liability must be investigated and
understood by counsel to the purchaser. The provisions of the agreement under which those
liabilities are described and assumed must be informed by a knowledge of the aspects of the
relevant law which governs such liabilities.
(iv) Determination and Adjustment of the Purchase Price
Every purchase agreement will provide a mechanism for adjusting variable
portions of the purchase price to reflect adjustments in the values or quantities of certain types of
purchased assets – or the assets underlying the purchased shares – on which the purchase price is
determined which will inevitably vary between the date on which the initial determination is
made and the date of closing. The most obvious examples of these variables are accounts
receivable and inventory.
- 15 -
The adjustment mechanism will contemplate delivery by the seller to the
purchaser of an estimated balance sheet prepared by the seller shortly prior to closing which will
form the basis on which the purchase price will be paid at closing. This estimated closing
balance sheet will be subject to adjustment by a balance sheet prepared at or shortly after closing
and which is designed to reflect the value of the purchased assets – or the value of the underlying
assets of the corporation whose shares are being purchased – as at the closing date. The closing
balance sheet will generally be delivered by the purchaser and will, in turn, be subject to further
verification by the seller and its accountant once delivered, generally shortly after closing.
In the event of any dispute between the parties as to the closing date balance
sheet, the agreement should provide for a mediation and/or arbitration mechanism by an agreed
third party, often a partner in a recognized accounting firm that is independent of seller and
purchaser. It is preferable to identify the third party either by name or by title (e.g. a senior
partner of a major accounting firm to be designated by that firm) so that the identity of the
arbitrator does not itself become an unnecessary additional matter that can be subject to dispute
and itself requires third party resolution.
This adjustment will not be necessary where the parties agree to fix the purchase
price as at a date which precedes the closing date and are able to agree on an effective date
balance sheet that reflects the final agreed values of the acquired or underlying assets prior to
closing. This circumstance is atypical but certainly possible. A purchaser, by agreeing to that
mechanism for determining the purchase price, effectively accepts the risk of the acquired
business from a date prior to closing and its acquisition of physical possession of and control
over the business. In that circumstance, the covenants that govern the behaviour of the parties
between signing and closing should severely restrict the seller's ability to, in effect, conduct the
- 16 -
business on the purchaser's account, between those two dates. Restrictions could include a
limitation on the ability of the seller to enter into, amend or terminate material contracts or
material transactions; to purchase or dispose of material assets (other than assets sold in the
ordinary course of business); or to engage, dismiss or alter the terms of employment of the
employees of the business.
(v) Allocation of the Purchase Price
In asset acquisitions, the parties will want to negotiate and agree to an allocation
of the price between the various assets primarily from a tax perspective. The parties will often
have opposing interests in how the purchase price is to be allocated to the various assets and
negotiation will be required to resolve those differences to the mutual satisfaction of the parties.
The allocation, once settled, should be set out explicitly in the purchase agreement.
D. Representations and Warranties
(i) Introduction
The bulk of most purchase agreements is dedicated to the representations and
warranties of the parties. While both sellers and purchasers provide each other with
representations and warranties, the representations and warranties of the seller are most
significant. Many precedents for asset and share purchase agreements are readily available and
the scope and subject matter of representations and warranties can easily be understood by
reviewing these precedents.
The nature of representations and warranties essentially can be categorized as (a)
legal and status representations and warranties; (b) title representations and warranties; and (c)
factual representations and warranties as to the status of the business including its assets and
- 17 -
liabilities (contractual, statutory, actual and contingent). Purchasers may attempt to introduce
securities-like representations as to the completeness of the representations and warranties
themselves with varying degrees of success.
Generally, both seller and a purchaser will provide legal and status representations
while the seller alone will provide title and factual representations. The legal and status
representations are generally comprised of representations as to incorporation and capacity of the
corporate party or other legal entity to enter into the transaction; due authorization by the
corporate party or other legal entity of the transaction; the enforceability of the transaction
agreements against such party; the absence of any agreements by the seller to sell the relevant
assets or shares to others; and the transaction not being in violation of any other agreements,
laws or judgments to which the representing party is a party or by which it is bound.
Representations as to title will generally be provided by seller with respect to the
title to the purchased shares, purchased assets or corporate title of the acquired corporation or
other legal entity to the underlying assets used in the purchased business. However, where the
consideration is paid in whole or in part by consideration securities, the seller may fairly demand
from the purchaser a representation as to the purchaser's title to the consideration securities being
issued or transferred to the seller. Moreover, if the consideration securities are issued by a
corporation not subject to the disclosure requirements of securities law, the seller may
legitimately ask for factual representations concerning the underlying business of the issuer of
the consideration securities.
The factual representations will again generally be provided only by seller and
relate to all material aspects of the seller's business such as the condition of tangible property, the
- 18 -
right of the seller to its intangible property (this can also be classified as a title representation),
the list of agreements to which the purchased business is bound accompanied by a detailed
schedule setting out those agreements together with a representation as to the standing of those
agreements and the existence of any defaults thereunder; the compliance by the purchased
business with applicable law and regulation; the identification of any third party or regulatory
consents, approvals or filings required in connection with the transfer together with a detailed
schedule of such consents, approvals and filings; the quality of the books and records of the
purchased business together with a representation as to the compliance of the presentation of
financial information on those books and records with an objective standard such as GAAP; the
existence of and status of any litigation involving the purchased business together with a detailed
schedule describing any such litigation; the list of customers of the business together with a
detailed schedule; the tax status of the purchased business; a detailed representation as to
employees and employment contracts, and benefit plans, generally accompanied with a detailed
schedule; and a detailed representation as to compliance of the purchased business with
applicable environmental law including a detailed schedule of any environmental issues.
The issues that arise in connection the negotiation of representations and
warranties in a purchase agreement are themselves susceptible of an entirely distinct and
comprehensive paper and presentation. Because this paper attempts to provide an overview in
general terms of the issues involved in drafting and negotiating acquisition agreements, I will not
provide a detailed review of the representations and warranties of acquisition agreements, and
the issues that arise in their negotiation, in detail. However, I will address certain major themes
that continually arise in the negotiation of these provisions.
- 19 -
(ii) The Purpose of Representations and Warranties
The key point to be made about factual representations and warranties in
particular is that they should not be seen by the parties as a statement of the seller's knowledge of
the affairs of the business. Rather, they should be understood to reflect an agreement between
the parties as to the appropriate allocation of risk between them for the represented state of the
business that is ultimately agreed by them. While representations and warranties generally
follow a virtually universal format, the "devil is in the details" inasmuch as the scope of the
particular representations and warranties will ultimately reflect the relative negotiating power of
the parties and the ability and experience of their respective counsel.
The seller's representations and warranties are intended to provide a snapshot of
the business that the seller has agreed to sell and the purchaser has agreed to buy. To the extent
that the business or underlying assets turn out to vary adversely from the description reflected in
the representations and warranties, the purchaser will have a claim for damages against the seller
subject only to the limitation periods, the thresholds for the initiation of claims and the caps on
the aggregate amount of claims that can be asserted under the purchase agreement. All of the
latter provisions, like the representations and warranties themselves, are found universally in
acquisition agreements but will vary within certain defined parameters, based on the
circumstances of the transaction and the negotiating leverage of the parties.
(iii) Substantive Limitations on Representations and Warranties
The two drafting devices that counsel to sellers generally employ to limit the
scope of sellers' representations and warranties are qualifications as to "materiality" and
"knowledge". In a perfect world, a seller would agree to represent the state of the purchased
business or assets without qualification based on the purchaser's understanding of what it has
- 20 -
agreed to acquire. A successful and balanced negotiation will virtually never result in this
perfect state.
(a) Materiality
Legal, status and title representations should not, in my opinion, generally be
subject to materiality qualifications. A purchaser should be entitled to the absolute comfort that
it is dealing with existing parties who have title to all of the acquired assets or shares (subject to
clearly described and agreed encumbrances when applicable) and that the contracts entered into
by them in connection with the transaction are all enforceable, without qualification (other than
the typical qualification as to insolvency and equitable remedies found in legal opinions).
However, it may be appropriate to qualify factual representations in certain
circumstances. For example, if the purchaser is successful in extracting a seller's representation
as to the enforceability of the contracts of the business, the seller may, depending on the scope
and number of contracts, fairly and successfully argue that given the scope of the business, the
range of contracts involved and the immateriality of some or many of them, the representation
should be limited either to "material contracts" only or that the representation should be limited
so that it would only be breached if the unenforceability of the contracts subject to the
representation would or could reasonably expect to result in a "material adverse effect" on the
acquired business or assets. In this example, the terms "material contracts" and "material adverse
effect" would both require definition, which definitions themselves would be the subject of
negotiation. In this example, the definition of a "material contract" could be limited to contracts
involving a certain dollar value either of payments or revenues within a defined period, usually
one year, and a "material adverse effect" could be defined as an effect which would be materially
- 21 -
adverse to the business, operations, assets – and sometimes prospects – of the acquired business.
All of these terms are subject to negotiation and modification in the context of any particular
transaction. The application of the "materiality" discussion to a representation on contracts is
given by way of example. This discussion can legitimately repeat itself in the context of
numerous factual representations and warranties in an acquisition agreement.
(b) Knowledge
Sellers frequently attempt to qualify factual representations based on their
"knowledge" of the relevant facts being represented. Given its common meaning – namely
actual knowledge – a representation of facts given "to the seller's knowledge" encumbers a
purchaser with the risk of the seller's inadequate or negligent management of the business.
Accordingly, if, from an objective perspective, a reasonable seller in this circumstance
reasonably ought to have known something that the seller in question actually doesn't know, and
the fact represented was qualified by the seller's "knowledge", undefined and unmodified, the
purchaser would, in effect, be assuming the risk of the seller’s negligent mismanagement of the
business without recourse. As a consequence, purchasers who agree to knowledge qualifications
in representations and warranties should attempt to negotiate an "objective" standard for
determining "knowledge". One form of objectifying the standard would be to define the seller’s
knowledge as that which "a senior manager of the seller with responsibility for the matter in
question would reasonably be expected to have in respect of the relevant matter after due
inquiry". Alternatively, the knowledge could be that which "a reasonable seller in the business
of the seller would reasonably be expected to have of the matter in question". In some contracts,
the parties will name specific officers of the seller who either actually know or reasonably ought
to know of the matter in question. The purchaser may even agree to an actual knowledge
- 22 -
standard when the knowledge is attributable to an identified officer of the seller or manager of
the purchased business in whom the purchaser has confidence as a result of its due diligence
investigations.
(iv) Procedural Limitations – Thresholds, Caps and Survival Periods
Aside from the substantive limitations on the scope of representations and
warranties described above, an additional practical limitation on the scope of the representations
and warranties will be the thresholds, caps and survival periods on the indemnities for
representations and warranties, all of which are discussed under "Indemnities" below.
(v) Bringdowns of Representations and Warranties
It is a customary condition of closing, generally for the benefit of each party, that
the representations and warranties of the other party, which speak as of the date of the signing of
the agreement, be true and correct as well on the closing of the transaction. The controversy that
arises in the "bringdown" of representations to closing relates to exactly how true and correct
such representations and warranties ought to be at closing. Is it sufficient that the representations
and warranties are true and correct "in all material respects" or should they be just as true and
correct on closing as they were on the date the agreement was signed? After all, it was only on
the basis of these representations and warranties as negotiated and settled, that the parties agreed
to enter into the transaction. Why should a party then be compelled to close based on the
carefully negotiated representations and warranties being "almost totally true" on closing. The
purchaser will inevitably argue for this position with some reason. The seller will look for a
materiality qualification in the "bringdown" closing condition.
- 23 -
Aside from the fundamental problem in principle with a materiality qualification
in this closing condition, a subsidiary problem is that many of the representations and warranties
will, as discussed above, have already been qualified by materiality. To address this particular
concern, it is not uncommon to provide in the bringdown closing condition that those
representations qualified by materiality must be true and correct on closing while those which are
not so qualified ought to be true and correct "in all material respects" on the closing date. While
the latter solution is commonly adopted, it is clearly not optimal from a purchaser's perspective
and fails to address the problem in principle.
(vi) Changes to the Underlying Representations and Warranties Between Signing and Closing
Another issue that arises as a result of the universal requirement to "bring down"
the representations and warranties to closing is who bears the risk for any changes in the state of
facts between signing and closing? If, for example, the facts change so that the bringdown
cannot be made as outlined above, should that provide a purchaser with the basis for
withdrawing from the transaction? The principled response would be "yes" but frequently
representations and warranties are given with respect to, for example, descriptions of assets in a
schedule which may reasonably change in the interim period between signing and closing. In
such circumstances, it is not atypical for the parties to agree that the seller may supplement the
schedules with amendments to reflect the state of reality at closing as long as it doesn't result in
any material or materially adverse change to the state of affairs represented as at the contract
date.
- 24 -
E. Covenants
While representations and warranties reflect the current state of the business as at
the time of execution of the acquisition agreement and again, at the time of closing, covenants
are contractual agreements of the parties that are designed to govern their behaviour between
those two dates and, occasionally, subsequent to closing. They may deal with, among other
things, the conduct of the business during the period between signing and closing, the access of
the Purchaser to the premises of the acquired business, the treatment of employees, the pursuit of
third party contractual and regulatory consents, effecting filings and registrations, environmental
matters such as the conduct of environmental investigations prior to closing, and the treatment of
employees, e.g. whether employees are to be terminated during the interim period and, in an
asset deal, the need for the purchaser to enter into employment agreements on agreed terms with
all of the specified employees of the purchased business.
The manner in which all of these issues are addressed will be heavily influenced
by the risks associated with the conduct of the business by the seller during the period in which
the economic result of such conduct may directly accrue to the purchaser. This will particularly
be the case in the circumstances discussed under "Purchase Price" above, where the effective
date of the transaction precedes the closing date on which the conveyance of assets or shares
occurs and the full risk of the business accrues to the purchaser prior to its assumption of control
and control over the business. In any event, how a business is conducted from the date on which
the representations and warranties are "frozen" – namely, the date on which the contract is signed
– until the conveyance of the business and its assets will have a significant effect on the nature of
the business being acquired. Consequently, the purchaser will have a strong business interest in
monitoring, if not controlling, the conduct of a business during the interim period. While the
- 25 -
concerns are essentially commercial, counsel to the purchaser should develop a good
understanding of the risks associated with the business and, in particular, those which are of
specific concern to the purchaser, in order to be in a position to negotiate the terms of the interim
period covenants. Once aware of the particular risks, counsel should also analyse them in the
context of the regulatory and legal risks associated with the business such as the consents,
permits, licences and approvals that must be obtained, and the filings that must be made, in order
to effect the transaction as well as any environmental or labour issues that may arise, all of which
will factor into the covenants that are ultimately drafted, negotiated and agreed as part of the
acquisition agreement.
F. Closing Conditions
Every acquisition agreement will set out a list of conditions that must be met for
the parties to close. Those conditions are usually divided into (i) mutual conditions that must be
satisfied for either party to be obliged to close; (ii) conditions that must be satisfied for the seller
to be obliged to close; and (iii) conditions that must be satisfied for the purchaser to be obliged to
close.
The mutual conditions would include: the absence of any action, pending or
threatened to enjoin, restrict or prohibit the consummation of the transaction; and the receipt of
all necessary approvals and the execution of all the principal agreements relating to the
transaction. In regard to the last condition, it is advisable for the parties to attempt to negotiate
and settle, before signing the purchase agreement, the substantial form and terms of all principal
agreements to be entered into on closing the transaction and to annex them as exhibits to the
purchase agreement on its execution. Finalizing collateral agreements concurrently with the
- 26 -
execution of the purchase agreement can eliminate further intensive negotiations and accelerate
the timetable between execution of the agreement and closing of the transaction. It can also
provide significantly greater certainty to the parties that closing will occur and will provide
greater comfort to parties that are public corporations in publicly disclosing the transaction on
execution of the acquisition agreement.
Examples of conditions of closing in favour of each party would include the truth
of representations and warranties in favour of such party; the performance by the other party of
the covenants required to be performed prior to closing; and the receipt of specific consents in
favour of such party. Those conditions exclusively in favour of the purchaser might include the
agreement of designated employees to continue their employment with the business; the absence
of any material damage to the purchased or underlying assets; the absence of any material
adverse change with respect to the business between signing and closing; and the delivery of the
appropriate closing documentation, conveyances and opinions in favour of the purchaser.
Conditions in favour of the seller in particular would include the receipt of payment; and where
there is a deferred payment or a payment made by way of the issuance of the securities of the
purchaser or an affiliate, the absence of any material adverse effect with respect to the purchaser
or such affiliate and the delivery of the appropriate closing documentation, conveyances and
opinions in favour of the purchaser.
G. Indemnities
While, as a matter of common law, the breach of a representation, warranty or
covenant in itself gives rise to a damages claim without the need for any specific contractual
indemnity, the general commercial practice is to include indemnities that address specifically the
- 27 -
rights of the parties to assert damage claims in respect of breaches of representations, warranties
and covenants and to specifically allocate various pre-closing and post-closing liabilities between
the parties. For example, in addition to indemnities for breaches of representations, warranties
and covenants, indemnities in asset transactions will provide for cross-indemnities relating to
pre-closing liabilities of the acquired business on the part of the seller, and post-closing liabilities
of the acquired business on the part of the purchaser. Specific indemnities are often added in
respect of employee claims made against the purchaser for pre-closing liabilities retained by the
seller and claims made against the seller in respect of post-closing liabilities assumed by the
purchaser. Finally, environmental lawyers will often want specific indemnities relating to
releases of hazardous substances and other environmental liabilities. In share purchase
transactions, the seller's additional indemnities may cover any liabilities not disclosed in the
financial statements which form the basis for the purchase price including undisclosed contingent
liabilities such as product liability claims and undisclosed litigation that arise in respect of the
conduct of the purchased business prior to the closing.
The indemnity provisions of an acquisition agreement will generally also include
a fairly detailed procedural code which will set out the procedure to be followed by an
indemnified party in asserting an indemnity claim including the provision of notice, deadlines for
various steps to be taken and the ability of the parties to take carriage of any action initiated by
third parties against an indemnified party in respect of a matter alleged to be covered by the
indemnity.
- 28 -
(i) Threshold/Baskets and Caps
(a) Application
As noted under "Representations and Warranties" above, the most substantive
aspect of the indemnity provisions of an acquisition agreement – and the one that is usually the
subject of the most intense negotiation often settled only at the very end of the negotiating
process – relates to the "basket" or "threshold" and "cap" on indemnity claims. First, it must be
understood that the "basket/threshold" and "cap" should only relate to contractual claims; that is,
claims for breaches of the contractual provisions of the acquisition agreement itself. These
restrictions should in no event apply to pre or post-closing liabilities assumed by the parties that
arise from the conduct of the business per se and that are subject to explicit cross indemnities in
the agreement. For example, if a purchaser of assets receives an invoice relating to the conduct
of the purchased business by the seller prior to closing and the seller has indemnified the
purchaser against all pre-closing liabilities of the business, the purchaser should be able to assert
this claim before the aggregate of indemnity claims has reached the threshold and after such
claims have exceeded the agreed cap. A purchaser should not be precluded from collecting on a
the third party pre-closing liability claim under the seller's express indemnity for such claims as a
result of the operation of the thresholds and caps. The same principle applies to seller's claims
for post-closing liabilities assumed by the purchaser.
(ii) Threshold or Deductible
An issue that arises in virtually all negotiations of the "basket/threshold" is
whether the threshold is a deductible or a pure procedural threshold. The purchaser, who will
generally be more interested in this matter because of the scope of representations and warranties
in its favour, will want the threshold to be that – a purely procedural threshold – which will
- 29 -
prevent the purchaser from asserting a claim until damages reach the agreed threshold amount
but once reached, would entitle the indemnified party to assert a claim in respect of all damages
resulting from a breach of the contract.
The indemnifying party, on the other hand, will generally want to provide that the
"basket/threshold" is essentially analogous to an insurance deductible and that the claims that can
be asserted start with the first dollar in excess of the threshold.
The result will vary depending on the negotiation.
(iii) Cap
There is no uniform practice as to the limit of the cap. From a purely principled
perspective, one could reasonably argue that if a party incurs damages as a result of contractual
breaches by the other party, it should be entitled to claim for the full amount of such damages.
As a matter of practice, however, this is rarely the case. A purchaser may argue that, at the very
least, it should be entitled to a return of the purchase price where damages are at least equal to
that amount. Sellers will often successfully resist that argument and parties may often agree to a
percentage of the purchase price or to a fixed amount of damages that is unrelated to the
purchase price. Once again, the practical reality of negotiating leverage will inevitably trump
moral absolutes.
(iv) Exclusive Remedy
The indemnity provision will generally provide that it is the exclusive code for
asserting claims under the agreement to the exclusion of any other common law rights and
remedies that a party may have. It is not uncommon for agreements to provide that parties
- 30 -
always retain their rights to equitable remedies such as injunction and specific performance in
circumstances where damages would not be an adequate remedy for a breach of the contract.
(v) Net Damages
It is not atypical for parties to agree that damages calculations will be net of any
proceeds of insurance or tax benefits resulting from the incurrence of the loss. Parties may
negotiate whether insurance proceeds must actually be received in order to be netted against
damages or whether there should merely be an entitlement to the proceeds in order for the
amount to be deducted from the damages claim. An agreement to factor the tax benefit into the
loss, while not uncommon, is less frequently found because of its generally subjective nature and
the period of time it could take to determine the tax impact of the loss.
(vi) Survival or Limitation Periods
To address the doctrine of merger which, if applicable, would have
representations and warranties expire at closing, purchase agreements have traditionally provided
for survival periods for representations and warranties of anywhere generally between six
months to five years after closing. As a matter of practice, purchasers may reasonably argue that
they should be entitled to have at least one audit cycle to be completed after closing to determine
whether factual representations and warranties are correct. Generally, depending on the time of
year in which closing occurs, this can be accomplished within one to two years after closing.
However, it is common to provide that basic legal, status and title representations remain in full
force and effect indefinitely, subject to applicable limitation periods and that representations and
warranties as to tax liabilities (generally only applicable in share purchase transactions) survive
until a defined period of time after the expiry of the relevant statute of limitations or, if an audit
- 31 -
or other assessment has been commenced, until a defined period of time after the conclusion of
that audit or assessment. It is also not uncommon to provide that representations and warranties
relating to environmental matters, which generally take longer to discover, will apply for an
agreed period that is longer than the period applicable to other factual representations and
warranties.
(vii) Limitations Act, 2002 (Ontario)
On January 1, 2004, the Limitations Act, 2002 (Ontario) came into force in the
Province of Ontario. This statute provided a long overdue simplification of Ontario's complex
and previously inconsistent laws governing limitation periods. However, it also created a
potentially serious problem for the negotiation of survival periods in commercial agreements as
it contained a provision stating that "a limitation period under this Act applies despite any
agreement to vary or exclude it". This provision applied to all agreements entered into on or
after January 1, 2004. The basic limitation period under the new Act is two years from the date
on which the basis for a claim is discovered, or ought to have been discovered, by a person
entitled to bring the claim. This shortened the previous statutory limitation period of six years
for contract claims. In addition to the basic limitation period, there is an ultimate limitation
period of 15 years beginning the day on which the act or omission takes place, regardless of
whether the essential elements of the claim become known to the claimant or were discoverable
during the 15-year period and whether any other limitation period has expired.
The question arose as to whether the provisions precluded parties from
contractually agreeing to the survival periods discussed in the previous paragraph which are
often shorter than the two-year limitation period prescribed under the new Act and generally
- 32 -
commence on the closing date and not on the date the parties discovered or ought to have
discovered the basis for the claim. The Act was amended in 2006 to resolve the uncertainties by
permitting parties to a business agreement entered into at any time on or after October 19, 2006
to vary or exclude the application of the two-year basic limitation period. A business agreement
is one in which neither party is a "consumer" within the meaning of the Consumer Protection Act
(Ontario) viz., "an individual acting for personal, family or household purposes".
In addition, the ultimate 15-year limitation period may be suspended or extended,
provided the claim in question has been discovered at the time the agreement to suspend or
extend the period is made. Therefore, parties to a business agreement cannot vary the ultimate
limitation period by trying to agree to an indefinite duration, or one longer than 15 years, before
a claim is known to exist. However, once a claim has been discovered, the parties could then
agree to extend the limitation period beyond 15 years.
VI. Conclusion
Privately negotiated acquisition agreements are among the most voluminous and
detailed agreements encountered in commercial practice. Because of the detailed nature of these
acquisitions, these agreements, together with their annexed Schedules and Exhibits, often exceed
the size of the phonebooks of decently sized North American cities. The preparation and
negotiation of these agreements demand extreme care and attention to detail by counsel and an
awareness by counsel who prepare and negotiate them of a number of areas of law (tax,
employment, competition, securities and environmental immediately come to mind) that will
have an impact on the transaction and the terms of the agreement. The preparation and
- 33 -
negotiation of these agreements is a critical and demanding feature of any commercial law
practice.
![Attachments [Plurilateral Agreements in General] …...Attachments [Plurilateral Agreements in General] 1. Multilateral Agreements and Plurilater al Agreements on Trade-related Issues](https://img.pdfslide.net/doc/110x75/5eb6874079a91941835bf687/attachments-plurilateral-agreements-in-general-attachments-plurilateral-agreements.jpg)
