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.
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.
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.
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.
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 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.
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.
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.
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 "earn-outs" that should be considered if this option is pursued and are well beyond the scope of this paper.
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.
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 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 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.
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.
The preceding 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:
- subject matter of the agreement (assets or shares);
- purchase price (cash or securities; paid in full or deferred; adjustments);
- representations and warranties;
- closing conditions;
- indemnities; and
- 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.
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.
Generally, 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 underlying assets so that the purchaser acquires all assets (either directly or indirectly) that will be necessary to conduct the business after closing.
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.
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.
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 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.
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 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.
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.
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.
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 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.
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.
Representations and Warranties
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 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 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.
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.
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 agreed to acquire. A successful and balanced negotiation will virtually never result in this perfect state.
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 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.
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 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.
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.
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.
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.
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.
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 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.
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 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.
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 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.
Threshold/Baskets and Caps
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.
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 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.
There is no uniform practice as to the aggregate 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.
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 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.
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.
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 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.
Limitations Act, 2002 (Ontario)
On January 1, 2004, the Limitations Act, 2002 (Ontario) came into force in the Province of Ontario. This statute provides a long overdue simplification of Ontario's complex and previously inconsistent laws governing limitation periods. However, it also creates a potentially serious problem for the negotiation of survival periods in commercial agreements as it contains a provision stating that "a limitation period under this Act applies despite any agreement to vary or exclude it". This provision applies 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 shortens the previous statutory limitation period of six years for contract claims.
The question arises as to whether this precludes 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 commence on the closing date and not on the date the parties discovered or ought to have discovered the basis for the claim. It is not clear whether a court would find these traditionally agreed survival periods to be in breach of the prohibition against varying or excluding the two-year limitation period prescribed under the new Act or whether they merely provide for contractual periods during which the representation survives. At the very least, however, if a party discovers a breach within, for example, a two-year contractual survival period, the new legislation would appear to provide that party with an additional two years to initiate a warranty claim irrespective of the terms of this agreement itself with respect to the initiation of claims. The Government of Ontario has to date not been receptive to concerns raised by the commercial bar about the presumably unintended application to major commercial agreements of the statutory provision disallowing agreements that "vary or exclude" its application.
Until further clarification from the government, the alternatives available to counsel in Ontario are threefold: (a) emphasize that the specified survival periods of representations and warranties or indemnities is an inherent aspect of the contractual rights created under the agreement in order to distinguish these provisions from provisions that contract out of procedural limitation periods; (b) acknowledge that the beneficiary of a contractual provision has had a reasonably opportunity to discover a breach within the survival period stipulated in the agreement; or (c) choose a governing law other than Ontario. There can be no assurance that any of these strategies will be effective. However, a choice of a law other than Ontario will be upheld if it would otherwise be upheld by the Ontario conflicts of law rules.
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 negotiation of these agreements is a critical and demanding feature of any commercial law practice.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.