DELVACCA PRESENTS: Issues Surrounding Indemnity Clauses in Merger and Acquisition Agreements May 6, 2010 Marriott Philadelphia Downtown DELVACCA thanks Cozen O Connor for sponsoring this event.
Determining What is Market ABA Private Transaction Mergers and Acquisition Deal Points Study 2008 Study Transaction Value Range: $25M $500M Number of Deals 106 Kaye Scholer 2008 LBO Legal Issues Survey What s Market 2008 Study Transaction Value Range: $2.16M $4,300M (average size $973M) Number of Deals 95
Sandbagging and Anti-Sandbagging Buyer engages in substantial diligence before signing Purchase Agreement. Buyer learns of something that it does not tell Seller, but which Buyer knows will render one of the representations or warranties untrue. Buyer decides to close the deal, then makes a claim for indemnification on account of the information it possessed before closing. By laying this trap, Buyer jumps on a claim and reduces purchase price.
Sandbagging and Anti-Sandbagging To combat this sandbagging by Buyer, Seller insists on adding clause to agreement to effect that No claim for indemnity for a breach of a representation shall be made after closing if Buyer had knowledge of such breach as of the closing date. While this seems fair, because it prevents a Buyer from withholding from Seller information it has obtained for the express purpose of bringing a claim, it has the practical effect of shifting the burden on a breach from the Seller to the Buyer. When the Buyer makes a claim for indemnity, the Seller counters that the claim is barred because the Buyer had knowledge, ensuring that the Buyer must prove that it did not have knowledge. Therefore, instead of just proving the existence of the breach, the Buyer now has to prove it did not know of the breach in the first place.
Sandbagging and Anti-Sandbagging To combat the anti-sandbagging argument, many Buyers are insisting on pro-sandbagging clauses: The right to indemnification shall not be affected by any investigation by Buyer or any knowledge acquired by Buyer at any time. This renders the appropriate balance in the arms length deal, requiring proper fulsome responses to representations and warranties without placing burden of proof on the Buyer.
Sandbagging and Anti-Sandbagging Studies in 2004 reflect that 56% of deals contained a prosandbagging clause and only 5% contained an antisandbagging clause, while 39% were silent. Studies in 2008 pertaining to middle market targets showed that 21% contained pro-sandbagging clauses while 14% contained anti-sandbagging clauses. 65% remained silent
Sandbagging and Anti-Sandbagging Considerations: If faced with anti-sandbagging clauses and no leverage to remove them, consider defining knowledge as actual or limited to specified persons. Inoculates Buyer from threat of one member of the diligence team having knowledge, or from using a reasonable person standard for defining knowledge. Easier to prove lack of knowledge in court. If faced with pro-sandbagging clauses with little leverage to remove them, either seek the right to supplement the reps and warranties given at closing, or at least disclose facts of which the Seller becomes aware prior to closing even it not entitled to formally bring down.
Sandbagging and Anti-Sandbagging Case Law: New York CBS v. Ziff Davis (1990): New York state court holds that knowing that the warranty was breached even before closing did not preclude buyer from making claim. Reliance is not an element to the claim. BUT, 4 cases since Ziff made the distinction of when the seller makes the disclosure before closing, and the buyer closes in any event, it waives right to indemnity in that claim. In Gusmao v. GMT Group Inc. (2008), Southern District Court of NY held that a buyer may enforce an express warranty even if it had reason to know that the warranted facts were untrue, but if the buyer closes with full knowledge of facts actually disclosed by the seller prior to closing, it cannot bring a claim for breach after closing based upon those facts. If seller is the source of the knowledge, the claim is barred, if it s common knowledge or learned from other than seller, buyer may prevail in the claim after closing.
Sandbagging and Anti-Sandbagging Case Law: Pennsylvania: Giuffrida v. American Family Brands (1998): The United States District Court for the Eastern District of Pennsylvania ruled that a buyer need not prove reliance to maintain a breach of warranty claim. Buyer alleged a breach of no material adverse change representation. Seller argued that it had provided interim financial data to buyer and that buyer had knowledge of the issues before closing. The court concluded that even having the information in advance did not preclude the buyer from making the claim. The Court held that the agreement itself allocates and apportions the risk among the parties as negotiated, and reliance arguments would just serve to introduce uncertainty. The purchase agreement had a survival period and a no-waiver provision.
Sandbagging and Anti-Sandbagging Case Law: Delaware Interim Heathcare v. Spherion Corporation (2005): Buyer alleged that seller withheld relevant information. Seller argued that the information could have been uncovered in normal diligence. Court acknowledged that buyer became aware of the issues before signing, but it was irrelevant in the breach of contract claim. The court stated that the buyer was not required to prove reliance on the representations and warranties as an element to claim indemnification damages. The court noted, however, that the buyer's knowledge may impact on its claim for expectancy damages.
Bringing Down Reps and Warranties Buyers expect that the seller s reps and warranties will be true and correct when given and at closing as if given again at closing. This ensures that the information at signing upon which pricing was determined does not change before closing without giving the buyer a chance to walk or renegotiate the price. Sellers prefer to give reps and warranties at signing and to certify that they were true and correct when given, leaving the buyer with the right to walk only if there is a MAC out. Buyers do not like to rely on MAC out because materiality as a part of the overall deal is hard to define, and it requires the buyer to exercise the nuclear option to blow up the deal as the buyer s sole recourse even if only a minor breach of a rep.
Bringing Down Reps and Warranties Sellers seek the right to supplement or bring down the reps and warranties as a negotiated compromise to this issue. The reps and warranties are true and correct at closing. The reps and warranties are true and correct at signing and, subject to supplement, are true and correct at closing.
Bringing Down Reps and Warranties Buyers beware: It s tough to sign a deal and price it if you cannot rely on the reps and warranties at signing. How do you make sure your agreement protects against known issues. Carving certain points (litigation, environmental, IP issues) out of indemnity baskets or caps. It places the due diligence burden solely on the Buyer.
Bringing Down Reps and Warranties Compromises: Bring down only for events post signing. No bring downs if caused by breach of operating covenants. Add a dollar amount threshold to walk from the deal if less than a MAC out.
Bringing Down Reps and Warranties In a 2009 study, 69% of the deals in the middle market space required an express duty to update, of which 93% made no distinction if the information was pre signing or post signing. 81% of those instances in which there was an express duty to update did not limit the buyer s rights to indemnity for updated matters (unless the closing condition was waived or MAC right to terminate not exercised). In that same study, 66% of the middle market deals required that representations be true and correct when made, and 100% required bring downs at closing.
Materiality Scrape In the private M&A context, buyers are becoming increasingly successful in obtaining a so-called materiality scrape clause, providing that the words materiality or material adverse effect in the seller s reps and warranties are disregarded for purposes of indemnification claims. In determining whether any breach of any representation or warranty made by the Seller in this Agreement has occurred, the terms material, materiality and Material Adverse Effect and other similar terms shall be disregarded and given no effect. In the Kaye Scholer 2008 LBO Market Study, 20% of the 95 deals reviewed from 2002-2007 had a materiality scrape provision, and in the 2009 ABA Target M&A Deal Study 84 deals had some form of materiality scrape.
The Buyer s view: Materiality Scrape The indemnification provisions already contain a basket, which is basically the definition of materiality. If Seller also gets the benefit of materiality, the seller gets double materiality. Also, the word material is inherently subjective and will lead to disputes in indemnity claims.
Materiality Scrape The Seller s view: Does the basket really reflect materiality? While scrape provisions are increasing, the amount of the basket as a percentage of transaction value is actually decreasing in the buyer friendly market. At a minimum, the presence of the scrape should dictate that the basket be a deductible rather than a tipping basket. If there is a diminimis threshold per claim, the argument for scrape is more persuasive. If the Seller agrees to a materiality scrape, should all materiality be disregarded? Need to consider carve outs. 10b-5 representations. a list of material items on a schedule. No MAE rep? Reps that are carved out of the basket (capitalization, environmental, taxes, etc.).
Materiality Scrape Other Compromises: Consider disregarding materiality for purposes of calculating damages but only if there is a breach giving effect to the use of materiality. Negotiating on a rep by rep basis when materiality should be disregarded.
Consequential Damage Waivers Waivers should only include items that should not be recoverable as losses. Act as a waiver of recovery even though a party has experienced a loss. Similar to limitations on losses: covered by insurance that could have been avoided or mitigated with a corresponding tax benefit that are recoverable from third parties. Waivers and loss limitations should never apply to damages recovered by third parties.
Consequential Damage Waivers Typical consequential damages limitation or waiver provision: Notwithstanding anything to the contrary contained in this Agreement or provided for under any applicable Law, no party hereto shall be liable to any other Person, either in contact or in tort, for any consequential, incidental, indirect, special or punitive damages of such other Person, [including] [or any] loss of future revenue, [or] income or profits [, or any diminution of value or multiples of earnings damages] relating to the breach of alleged breach hereof, whether or not the possibility of damages has been disclose to the other party in advance or could have been reasonably foreseen by such other party.
What are Consequential Damages? Contract damages not based upon fault but upon performance and are meant to approximate the agreed upon performance. General Rule: must be natural, probable and reasonably foreseeable, or within the contemplation of the parties, consequence of the breach. Hadley Rule: default rule: recoverable contract damages always include those losses that arise: normally and naturally as the result of a breach of a similar contact; and from the special circumstances of the non breaching party that were within the contemplation of the parties at the time the contract was entered into.
Consequential Damages: Transaction Context Do indemnification provisions override the default (Hadley) rule? Yes: for specific indemnities claims that do not arise out of a breach of representations and warranties. Unclear: for claims that arise out of breaches of the representations and warranties.
Consequential Damage Waivers: Practical Considerations Buyers: avoid the kitchen sink approach to waivers, carefully review the types of damages excluded so as to no limit ability to collect actual damages. Never excluded incidental damages. Buyers: consider replacing the term consequential damages with remove or speculative damages Sellers: consider limiting damages to market measure damages, the difference between the value of what the buyer received (with breach) and what the buyer would have received without a breach.
Consequential Damage Waivers in Agreements Express exclusion of consequential damages is on the increase: 43% of deals in the ABA 2008 Study included an express exclusion of consequential damages 31% of deals in the ABA 2006 Study included an express exclusion of consequential damages
Are Punitive Damages Consequential Damages? Punitive Damages may be awarded in tort actions and Consequential Damages may be awarded in breach of contract actions. Punitive Damages are additional damages, they go beyond the actual damages caused by the wrongdoers conduct.
Waiver of Punitive Damages Express exclusion of punitive damages is on the increase 47% of deals in the ABA 2008 Study included an express exclusion 34% of deals in ABA 2006 Study included an express exclusion
Incidental Damages What are incidental damages: All costs and expenses incurred by a non breaching party to avoid other direct and consequential losses caused by a breaching party. Example: Attorneys fees expended in connection with obtaining a required permit that the seller did not have but needed (the failure to have such a license constituting a breach of a representation and warranty).
Incidental Damage Waivers Express exclusion of incidental damages is on the increase: 36% of deals in the ABA 2008 Study included an express exclusion of incidental damages 16% of deals in the ABA 2006 Study included an express exclusion of incidental damages
Other Indemnification Provisions: Overview and Trends Survival Periods Damage Limitations Baskets Caps
Indemnification Provisions: Survival Periods 38% of deals in the ABA 2008 Study provided for survival periods of 18 months. This is an increase from 2006 and 2004. 20% of deals in the ABA 2008 Study provided for survival periods of 12 months. This is a decrease from 2006 and 2004. Will this trend continue as buyer have the upper hand? Is there a relationship between the increase in survival periods and the limitation of the type of damages?
Indemnification Survival Periods Most buyers require differing survival periods for different representations Statute of limitations tax, environmental, ERISA, intellectual property No expiration capitalization, authorization and brokers and finders fees
Damage Limitations Limiting losses / damages to out of pocket damages only: In ABA Study only 4% of deals limited damages/losses this way No change between 2006 and 2008 ABA Study Expressly exclude diminution of value from losses / damages: 15% of deals in 2008 ABA Study expressly excluded diminution of value 10% of deals in 2006 ABA Study expressly excluded diminution of value
Baskets Types of Baskets: Deductible Basket: only recover to the extent damages/losses exceed an agreed upon amount. Tipping Basket: once damages /losses reach an agreed upon amount entitled to recover damages/losses from dollar one.
Baskets: Trends No basket: 5% of deals in 2008 ABA Study 3% of deals in 2006 ABA Study Deductible basket: 47% of deals in 2008 ABA Study 54% of deals in 2006 ABA Study Tipping basket: 36% of deals in 2008 and 2006 ABA Study
Indemnification Caps CAPS as % of Transaction Value: caps are becoming smaller. 4% of the deals in the ABA 2008 Study set the cap at the purchase price and 86% set the cap at an amount less that the purchase price 7% of the deals in the ABA 2006 Study set the cap at the purchase price and 88% set the cap at an amount less that the purchase price
Indemnification Caps Size of Transaction Size of Cap: from the Kay Scholer Study In 2006 and 2007 the average cap as a percentage of purchase price for deals of all sizes was around 15% In 2005 the average cap as a percentage of purchase price varied significantly based on deal size: 7.4% in deals up to $250 million 10.3% in deals between $250 million and $1 billion 25.2% in deals over $1 billion
Steven N. Haas is vice chairman of the Corporate Practice Group and a member of the Emerging Business and Venture Capital Practice Group at Cozen O Connor. He also serves as chairman of the firm's Technology Committee. Steven assists both established and emerging growth companies in acquisitions, mergers, and corporate finance transactions, as well as corporate aviation matters. He also represents domestic and international clients in the purchase, sale and financing of corporate aircraft.
Anna M. McDonough is a member of the Business Law Department of Cozen O Connor. Her practice is focused on corporate and operational matters, including negotiation, drafting of agreements, mergers and acquisitions, and debt restructurings. Prior to joining the firm, Anna was of counsel with Kleinbard Bell & Brecker LLP in Philadelphia, and also served as principal of her own law office, representing clients in all aspects of commercial purchasing, licensing and leases.
Phil Weinberg is the executive vice president/general counsel at Comcast Spectacor since the partnership was created in 1996. He is responsible for oversight of all the company s legal affairs, including litigation, financing activities, and player related matters. Phil also serves as executive vice president, Legal and Business Affairs, for Comcast Sports Management Group, which manages 10 networks serving 40 million viewers in top markets across the United States. Prior to joining Spectacor, he was in the private practice of law for seven years, mainly with the litigation firm of Sprague and Sprague.
Raphael Licht is chief operating officer of RAIT Financial Trust, following a 3 year term there as chief legal officer. He was CLO and secretary of Taberna Realty Finance Trust and has also served as CLO of Cohen & Company, and of iatm global.net, a financials services technology company. Raphael was previously an associate with the law firm of Morgan Lewis & Bockius, LLP, specializing in structured finance and securitizations.