We explore how to structure earnouts for buyers and sellers in M&A and the use of performance metrics, earnout milestones & protection clauses in SPA.
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Due diligence and representations and warranties (“reps and warranties”) play an important and inter-related role in mergers and acquisitions (“M&A”). At one extreme, a purchaser may seek to rely exclusively on reps and warranties to provide comfort as to a business acquisition, foregoing any due diligence on the business to be acquired. At the other extreme, the seller may push the purchaser to rely exclusively on due diligence so that no reps and warranties are given as to the M&A target. In this article, we provide an overview of due diligence and describe its interplay with reps and warranties. Other articles in this multi-part series on M&A look at the provision of financial assistance in the purchase of shares, letters of intent (“LOI”), and purchase and sale agreements. If you would like specific information about due diligence or reps and warranties, please contact one of our M&A lawyers.
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In any business acquisition, the purchaser will wish to ensure that it is confident in the commercial case for the transaction, and the seller will wish to ensure that the purchaser will be able to complete the transaction. These objectives may be achieved through a combination of due diligence, deal structure and reps and warranties.
For the seller, a core concern is whether the purchaser can and will successfully complete the transaction. Often, this is a simple question of whether the purchaser can satisfy the contractual covenant to pay the purchase price. However, the question may turn in other cases on the ability of the purchaser to meet regulatory or third party approvals necessary for completion of the transaction.
In some cases, the seller may rely upon a sizeable deposit on the purchase price to allay this concern. If the purchaser fails to pay the purchase price to complete the transaction, the seller will simply pocket the deposit and walk away from the transaction.
In other cases, the seller may wish to carefully vet the credit-worthiness of the purchaser to confirm the value of the purchaser’s completion covenants so that if the purchaser fails to complete the business acquisition, the seller can obtain a remedy against the purchaser in damages.
For the purchaser, a core concern in any business acquisition is whether the business and affairs of the M&A target are consistent with the purchaser’s expectations. As a starting point, the law affords the purchaser limited recourse in the event that assumptions underlying the purchaser’s commercial case prove false. Consequently, a prudent purchaser will wish to (i) satisfy itself that it understands what it is buying before it completes a business acquisition, and (ii) negotiate contractual provisions, including reps and warranties, to provide recourse against the seller in the event that the target’s true state of affairs differs from its understanding.
Due diligence is the process where the purchaser requests the disclosure of information so as to confirm its commercial case for buying the target.
Due diligence may help the purchaser in:
valuing the target;
identifying and understanding the potential risks of the deal and determining how to manage them; and
determining whether to proceed with the deal at a given purchase price.
A prudent purchaser will use due diligence to consider whether to adjust the purchase price and to negotiate reps and warranties to provide recourse against the seller in the event that the target turns out to be different from what the purchaser has agreed to buy.
Specific areas of focus for due diligence and reps and warranties are set out below.
Due diligence and reps and warranties relating to the subject matter of the deal aim to ensure that whatever is being bought in fact exists and that the seller has good and marketable title to it.
Financial due diligence and reps and warranties aim to provide assurances as to the financial performance of the target and to identify transactions which would or may affect the financial position of the target, including, for example, distributions, the incursion of material long term commitments, the assumption of guarantees, indemnities or other contingent liabilities, or the possibility of key customers or suppliers walking away from the target.
Due diligence and reps and warranties relating to the litigation history of the target aim to ensure that the target being bought is not subject to litigation in which it is being sued or, is suing another person but may, if unsuccessful, be subject to a significant adverse cost order.
Due diligence and reps and warranties relating to compliance matters aim to preclude the possibility that the target being bought is the subject of a government or regulatory investigation or enquiry which can result in criminal sanctions, regulatory sanctions or other negative administrative consequences (e.g. loss of license, registration or authorization required to conduct its business).
Regulatory due diligence and reps and warranties may seek to confirm that the target has the requisite licenses, registrations and authorizations to conduct its activities and is conducting its business in accordance with applicable laws and regulations.
Due diligence and reps and warranties relating to property ownership may seek not only to verify ownership of real estate or the right to use particular real estate but also to verify the absence of significant liabilities attached to real estate.
Due diligence and reps and warranties relating to title to assets and material contracts aim to confirm the extent to which the target in fact owns and has access to the assets which are important to its business, including intellectual property and contracts which may grant key rights which benefit the target.
Due diligence and reps and warranties relating to employment matters may seek to ensure compliance with employment laws and to define employment liabilities, including in respect of salaries, bonuses, retirement, and medical and dental benefits, and to define the risk that employees may resign.
Tax due diligence and reps and warranties may seek to preclude the possibility of tax liabilities which have not yet been recognized or the possibility of non-compliance with tax laws which may result in penalties.
Each purchaser will need to determine the extent of due diligence which it requires to get comfortable with each deal. The decision as to the extent of due diligence to undertake will often turn on the extent to which the purchaser may rely on reps and warranties which provide contractually binding assurances as to the state of the target’s business and affairs. This, in turn, will depend on a number of factors.
There may be practical constraints on what due diligence the purchaser can conduct or on what due diligence the seller is able to give. For example, time or cost constraints may limit the amount of due diligence which a purchaser is able to conduct. Equally, for example, where the seller is selling the target through an auction process, it may not be feasible to allow each potential purchaser to conduct its own customized due diligence exercise.
It may be difficult for the purchaser to enforce reps and warranties in the purchase and sale agreement following completion of the deal. For example, the legal costs of enforcement may be commercially prohibitive. Equally, for example, the seller may be of suspect credit-worthiness. In these types of cases, the purchaser may place little value on reps and warranties given by the seller and may instead, rely more heavily on due diligence.
The seller may limit the scope of reps and warranties it is willing to give in the purchase and sale agreement. For example, if the seller is the liquidator of the target, the seller’s knowledge of the target business may be limited and thus, the seller may only be in a position to provide limited reps and warranties for the business acquisition. In these types of cases, the purchaser may have no choice but to place greater emphasis on due diligence.
The seller may limit claims on breaches of reps and warranties in time and amount in the purchase and sale agreement. Common limitations include a limit on total liability (e.g. no claims in excess of total consideration paid), a de minimis limit which precludes claims unless they exceed a specified threshold, and a limit in time beyond which claims for breaches can no longer be advanced (e.g. no claims following 2 audited financial years after the deal completes).
In the context of due diligence, a purchaser will often require access to personal data. For example, a purchaser may require information about specific key employees or clients. A concern which arises in this regard is whether a target is permitted under personal data privacy laws to provide the purchaser access to such personal data.
Though Hong Kong generally restricts the use of an individual’s personal data to circumstances where the individual has consented to such use, this restriction is relaxed in the context of a due diligence exercise where the objective is to assess whether or not to proceed with a proposed transfer of a business or property or a transfer of the shares in a business holding personal data.
A purchaser may wish to rely upon the audited financial statements of the target as part of its due diligence exercise. The extent to which a purchaser may prudently do so is unsettled where the financial statements are not specifically prepared for the purchaser in the context of a business acquisition.
Hong Kong law generally precludes the purchaser from any recourse under the law of negligence against the target’s auditor in the event that the audited financial statements prove to be wrong. As a result, whilst the fact that the target’s financial statements are audited may comfort the purchaser because an independent audit firm has reviewed the financial statements, it may be that a purchaser has no recourse against the target’s auditors if these audited financial statements turn out to have been negligently prepared.
However, despite this general position, there is authority for the position that the target’s auditor may be liable where they have knowledge of or consent to the purchaser’s reliance on the audited accounts. In light of the foregoing, a purchaser should consider appointing accountants specifically to report on the financial condition of the target generally or to validate specific and critical financial assumptions underlying the business acquisition where the audited financials form a vital part of the decision to proceed with the deal.
To minimize liability under reps and warranties, the seller will normally disclose information formally to the purchaser through a disclosure letter, disclosure schedule or disclosure bundle to qualify reps and warranties made in the purchase and sale agreement. As disclosures may limit the scope of contractual reps and warranties, a purchaser should treat them as seriously as the reps and warranties in the purchase and sale agreement themselves and seek early production of a draft of the disclosure letter to allow for sufficient time to review them. Conversely, as statements made in a disclosure letter may themselves constitute legally actionable representations, a seller should treat them seriously as the purchaser may rely upon them potentially to rescind the transaction (meaning the purchaser may refuse to complete and instead, bring the transaction to an end).
Disclosure letters typically include both general disclosures and specific disclosures.
General disclosures may deem the purchaser to have knowledge of general matters such as those set out below, whether or not the purchaser in fact has knowledge of such matters:
matters of public record (e.g. information filed in the Companies Registry) relating to the target company;
the target company’s memorandum and articles of association or equivalent constitutional documents in the jurisdiction of the target’s incorporation;
all information contained in the agreement between the purchaser and the seller and any documents or transactions referred to therein;
the contents, matters and information in the target’s accounts;
information relating to the target which is public knowledge; and
information disclosed to the purchaser as part of its due diligence.
Specific disclosures provide information qualifying specific reps and warranties but commonly, the seller will wish to provide that such disclosures be regarded as disclosures against all of the reps and warranties in the purchase and sale agreement. Thus, for example, where a seller discloses a pending litigation in respect of a specific representation and warranty as to the absence of litigation, the seller will also wish this disclosure to qualify a representation and warranty as to the absence of any material change even though no specific reference is made in the disclosure to the latter representation and warranty.
The disclosure letter is normally given at the same time as the purchase and sale agreement is signed. However, as circumstances may change between the time the purchase and sale agreement is signed and the closing of the deal, the seller may wish to reserve the right to update the disclosure letter, thus qualifying reps and warranties with matters not known to the purchaser at the time the purchaser committed to the deal through the purchase and sale agreement.
The purchaser, however, is likely to resist any right for the seller to update the disclosure letter without the option to terminate his commitment based on new disclosures. Understandably, the purchaser may feel that his commercial case for the deal may be significantly and adversely affected by disclosures made after he signed the purchase and sale agreement.
As a result, the sale and purchase agreement may specify whether the seller has the right to make disclosures after the signing of the purchase and sale agreement and if so, what type of disclosures may be made.
Under Hong Kong law, the extent to which disclosures will qualify reps and warranties in the purchase and sale agreement will depend upon the specific language of the M&A documentation.
Where, as is commonly the case, reps and warranties are merely expressed to be subject to the disclosures (e.g. “save as disclosed in the disclosure letter”), it has been held that a disclosure will only qualify a representation and warranty to the extent that the effect of the disclosure on the representation and warranty is clear.
Thus, for example, one court held on such language that disclosure by a seller of illness of a key target employee without commentary on the specific financial consequences of the illness may not qualify a representation and warranty as to the financial condition of the target company.
Similarly, another court held on such language that a disclosure referencing sources of information from which a purchaser may find relevant information may not qualify a representation and warranty even if a diligent review of the information referenced could identify facts relevant to such a representation and warranty.
A breach of reps and warranties normally results in damages reflecting the diminution in the market value of the target as a result of the breach, though rescission is also possible. Damages may be unsatisfactory if, for example, the diminution in the value of the business as a result of a breach may be less than the cost for the purchaser to remedy the representation and warranty. At the same time, a purchaser will have a duty at law to mitigate the loss in the event of a breach, thus reducing the total amount of damages which can be claimed.
Consequently, it is common for purchase and sale agreements to include indemnities which give the purchaser the right to claim from, and be reimbursed by, the seller for the amount of any expenses, loss or damage it may incur as a result of the seller’s breach of reps and warranties on a dollar for dollar basis.
Sellers will often wish to include in the purchase and sale agreement an entire agreement clause. An entire agreement clause is a clause which is intended to limit the seller’s liability to only those representations, warranties and covenants specifically and expressly set out in the purchase and sale agreement. If effective, an entire agreement clause would, for example, prevent the purchaser from relying upon pre-contractual statements made to it by the seller in relation to the target if such statements do not ultimately feature explicitly in the written purchase and sale agreement.
In Hong Kong, entire agreement clauses which seek to exclude liability for misrepresentations are subject to statutory controls.
Where an entire agreement clause is in place, it is important for the purchaser to consider whether the statements forming its commercial case have been reflected in the reps and warranties in the written purchase and sale agreement and if not, whether it is prepared to proceed with the deal without recourse to those statements.
An M&A lawyer will often coordinate due diligence for each of the purchaser and the seller.
The role of the lawyers for the purchaser will be to help identify the scope of due diligence which may be prudent in the business acquisition, conduct due diligence (e.g. by conducting searches and by reviewing documents produced during the course of due diligence), and help the purchaser understand the ramifications of information found during the due diligence process (e.g. whether a charge over an asset is a significant problem for the transaction).
At the same time, lawyers acting for the purchaser will help draft and negotiate reps and warranties as well as indemnities for breaches of such reps and warranties, and review and advise on any disclosure letter provided by the seller.
For the seller, an M&A lawyer will help limit the seller’s liability for misrepresentation, whether in the purchase and sale agreement or in the disclosure letter, and will help minimize the risk of the purchaser being able to refuse to close a deal on the basis of a misrepresentation.
We explore how to structure earnouts for buyers and sellers in M&A and the use of performance metrics, earnout milestones & protection clauses in SPA.
HKCFI rules letters of no consent regime unconstitutional; Hong Kong Police & JFIU cannot issue LNCs to freeze bank accounts before STR filing
The first of a multi-part series on Hong Kong mergers & acquisitions law. This part provides an overview of M&A including letters of intent.
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