Canada: The Latest On Canadian Private M&A Deal Points

The Market Trends Subcommittee of the Mergers and Acquisitions Committee (the ABA Subcommittee) of the Business Law Section of the American Bar Association released in late December 2014 its latest edition of the Canadian Private Target M&A Deal Points Study (the Canadian Study) based on deals signed in 2012 and 2013. As with prior editions, the Canadian Study provides valuable insight on the use of several deal points in Canadian private M&A transactions and how they compare with those reported by the most recent US Private Target M&A Deal Points Study prepared by ABA Subcommittee which analyzed transactions completed in the US in 2012 (the US Study) as well as the prior edition of the Canadian Study (the Prior Canadian Study) which analyzed transactions completed in 2010 and 2011. This article highlights some of the findings reported by the Canadian Study. The authors were intimately involved with the Canadian Study (and previous Canadian and US studies): Kevin Kyte is Co-Chair of the Canadian Study and Tania Djerrahian1 assisted him on all aspects.

Overview

The Canadian Study shows that M&A practice in Canada is similar to US practice in terms of deal concepts: caps, baskets, survival periods, materiality scrapes, etc. The differences tend to be only as to the degree to which some of these concepts are used. In particular, indemnification concepts continue to show noticeable differences in Canada: indemnification caps tend to be higher (mean of 49% of the purchase price in Canada compared to 16.6% in the US) and survival periods tend to be longer (35% of deals in the Study had survival periods of greater than 18 months compared to only 12% of deals in the US Study). But the authors have noticed a marked convergence of data points in Canada over several years with US data points, no doubt as a result of the number of cross-border deals involving US buyers and the prevalence of these studies.

There is a high degree of quality control on these studies, including the Study. Each initial review is cross-checked by a volunteer from a different firm or organization. The results are then verified by the applicable issue group leader. The Chairs then review spreadsheets of the results, with any unusual results re-verified. Any suspicious data is disqualified. Finally, a member of the leadership of the ABA Subcommittee reviews the proposed final study.

Despite this rigorous approach, there are limitations with any such study, and any general conclusions must be qualified by an organic and dynamic market. Agreements posted on SEDAR (see below) may not represent general practice: certainly, having only 60 agreements qualify for a two year period makes for a very small sample (putting in context data points on agreements that are a subset of those 60 agreements).

The authors also maintain that referring to deal point studies is not a substitute for reasoned negotiations. Nevertheless, the Canadian Study reveals trends that are generally consistent with what we see in our practices.

The Study Sample

The Canadian Study analyzes publicly available acquisition agreements for transactions signed in 2012 and 2013 that involved Canadian private targets being acquired or sold by Canadian reporting issuers and that met the criteria for inclusion in the Study.2 Sixty agreements qualified, which is less than half the number of agreements reviewed in the US Study.3 As with prior years, a large percentage of Canadian deals are in the resources and oil sectors (25%), with the industrial goods and services sector (15%) and the financial sector (13%) close behind. Canadian deals are still typically smaller than deals in the US Study. There is, however, a notable change: the Canadian Study shows an increase in the proportion of transactions with values over C$100M.

 

US Study4

Prior Canadian Study

Canadian Study

Range of Transaction Values

US $17.2M to US$4.7B

C$5M to C$2.25B

C$5.6M to C$5.8B

Transactions Over $100M

63%

11%

31%

 

Financial Provisions

Post-Closing Purchase Price Adjustments

The percentage of transactions using post-closing purchase price adjustments in Canadian deals remains high and consistent with that reported in the Prior Canadian Study and the US Study. There are, however, some changes relating to the adjustment metrics. Notably, there is a marked rise in the use of post-closing purchase price adjustments based on more than one metric (e.g. working capital and indebtedness), making Canadian practice comparable to that reported in the US Study. Also, for the first time, the Canadian Study reports on whether purchase price adjustment provisions require the adjustment amount to exceed a threshold before it is paid – with most deals not including such a requirement, there appears to be little difference between US and Canadian practice on this deal point.5 Finally, one of the more significant differences with the US Study is that Canadian deals are far less likely to have a purchase price adjustment provision that includes a preliminary adjustment of the purchase price on the closing date or that excludes tax-related items from the working capital calculation.

 

US Study

Prior Canadian Study

Canadian Study

Deals with Post-Closing Purchase Price Adjustments

85%

70%

73%

Deals Using More than One Adjustment Metric

59.5%

22.5%

55%

Includes Preliminary Adjustment on Closing Date6

88%

41%

48%

Working Capital Excludes Tax Related Items7

39%

16%

10%

Earnouts

Earnouts allow the parties to an M&A transaction to bridge a valuation gap relating to the future performance of the target by providing for additional payments upon the attainment of certain performance milestones by the target during a specified post-closing period. The percentage of transactions using earnouts in Canadian deals remains consistent with those reported in the Prior Canadian Study and the US Study. For the first time, the Canadian Study reports on three additional earnout-related deal points: (i) whether the earnout accelerates upon a change of control of the target: similar to US practice, acceleration is not market in Canada, (ii) whether buyer can offset indemnity payments owed to it by seller against an earnout payment it owes to seller: unlike US practice, Canadian agreements are equally likely to either expressly permit offsets or be silent on the point, and (iii) whether there is an express disclaimer of a fiduciary relationship by buyer: similar to US practice, an express disclaimer of fiduciary relationship is not market.

 

US Study

Canadian Study

Deals with Earnouts

25%

25%

Earnout Accelerates on Change of Control8

21%

7%

Buyer can Offset Indemnity Payments Against Earnout Payments9

68%

40%

Silence as to whether Buyer can Offset Indemnity Payments Against Earnout Payments10

27%

40%

Express Disclaimer of Fiduciary Relationship Not Included11

79%

80%

Pervasive Qualifiers

Pervasive qualifiers, such as knowledge and material adverse effect (MAE), serve as a risk allocation tool. The use of MAE in Canadian deals remains fairly comparable with that reported in the Prior Canadian Study and the US Study. Some of the key differences between Canadian and US practice are (i) the inclusion of prospects in the definition of MAE, which is considerably higher in Canadian deals, and (ii) the application of MAE to the target's subsidiaries, which is considerably higher in US deals. The Canadian Study shows an increase in the use of carveouts to what constitutes MAE in general, making practice on this deal point more like that reported in the US Study. Finally, the Canadian and US studies show that US and Canadian practice regarding knowledge is fairly similar: knowledge in most deals is defined as constructive knowledge requiring express investigation and imputing the knowledge of identified persons to the target.

 

US Study

Prior Canadian Study

Canadian Study

MAE Included but not Defined

4%

14%

2%

MAE Included and Defined

96%

83%

88%

If MAE Defined, MAE Includes Prospects

17%

35%

40%

If MAE Defined, there are Carveouts

91%

70%

83%

If MAE Defined, MAE Expressly Applies to Target and/or Subsidiaries

88%

50%

61%

Knowledge Not Defined

2%

17%

10%

Knowledge Defined as Actual Knowledge

18%

14%

18%

Knowledge Defined as Constructive Knowledge

80%

69%

72%

If Knowledge Defined as Constructive Knowledge, Express Investigation

71%

87%

91%

Knowledge of Identified Persons Imputed to Target

96%

78%

82%

Target's Representations and Warranties

The target's representations and warranties are important as they serve the basis upon which buyer can obtain disclosure, terminate the transaction, or obtain an indemnity. The Canadian and US studies indicate that, similar to US deals, most Canadian deals include (i) a "fair presentation" representation on the target's financial statements, (ii) a representation regarding no undisclosed liabilities that is not qualified by knowledge and applies to all liabilities (as opposed to only GAAP liabilities), and (iii) a representation on compliance with laws that is not qualified by knowledge. According to the Canadian and US studies, there are still a number of differences between Canadian and US practice in terms of the target's representations and warranties including that a representation on compliance with laws in a Canadian deal is more likely to cover present and past compliance, but less likely to include a notice of violation.

 

US Study

Prior Canadian Study

Canadian Study

Includes Fair Presentation Representation on Financial Statements

99%

93%

96%

Includes No Undisclosed Liabilities Representation

94%

78%

90%

If Includes No Undisclosed Liabilities Representation, Qualified by Knowledge12

3%

18%

2%

If Includes No Undisclosed Liabilities Representation, Applies to all Liabilities13

78%

n/a

79%

Includes Representation on Compliance with Laws

99%

89%

95%

If Includes Representation on Compliance with Laws, Qualified by Knowledge14

5%

23%

5%

If Includes Representation on Compliance with Laws, Covers Present and Past Compliance15

33%

55%

62%

If Includes Representation on Compliance with Laws, Covers Notice of Violation16

73%

21%

36%

Target's Covenants

The parties to an M&A transaction typically negotiate covenants with respect to how the target may be operated during the period between the signing and closing of transaction and what each party will do to ensure that the transaction is completed. The Canadian and US studies report on a number of such covenants. For the first time, the Canadian Study reports on whether Canadian deals include a covenant by the target to conduct business in ordinary course. Similar, to what has been reported in the US Study, most agreements include a covenant by the target to conduct business in ordinary course and the covenant typically includes a qualification that the conduct be consistent with past practices. What differs between US and Canadian practice is that in a Canadian deal, the covenant is more likely to include an efforts standard.

 

US Study

Canadian Study

Includes Covenant of Conduct Business in the Ordinary Course17

95%

93%

If Includes Covenant to Conduct Business in the Ordinary Course, Qualified by Efforts Standard

16%

41%

If Includes Covenant to Conduct Business in the Ordinary Course, Qualified by Consistent with Past Practices

89%

78%

Conditions to Closing

A purchase agreement will include conditions to closing when the transaction does not simultaneously sign and close. If the conditions in favour of a party are not met, that party will typically have the right to refuse to close the transaction. The Canadian and US studies report on a number of closing conditions, one of which is the condition requiring the target's representations and warranties to be accurate as of the closing date of the transaction (i.e., a bring-down). The Canadian Study indicates that, similar to US deals, almost all Canadian deals include a bring-down condition. There are, however, some differences between Canadian and US practice in the elements included in a bring-down condition. One of these differences is whether double materiality will be "scraped". Double materiality occurs where some of the representations and warranties regarding the target in the purchase agreement are qualified by materiality and the corresponding condition is also qualified by materiality. Where a double materiality "scrape" is included, for the purposes of the bring-down, the materiality qualifiers included in the representations and warranties are disregarded and only the materiality qualifier in the closing condition applies. According to the Canadian and US studies, double materiality "scrapes" are typically included in bring-downs in the US, but not in Canada.

 

US Study

Canadian Study

Includes Condition on Accuracy of Representations and Warranties at Closing18

99%

99%

If Condition on Accuracy of Representations and Warranties at Closing Included, Double Materiality Scrape Included

86%

18%

Indemnification

Survival Periods

The parties risk post-closing liability for a breach of the representations and warranties or covenants in the purchase agreement to the extent that, and for the time period during which, their representations and warranties or covenants survive the closing. The Canadian Study shows that the survival period for representations and warranties in Canadian deals is getting shorter. However, US deals are still far more likely to have a shorter survival period.

 

US Study19

Prior Canadian Study

Canadian Study20

Survival with Period of 18 months or less

85%

35.8%

58%

Survival with Period of more than 18 months

12%

55.5%

35%

Survival with Silence on Period

1%

7%

4%

Express No Survival

2%

1.7%

4%

Indemnity Baskets

Indemnity baskets establish the minimum dollar amount of losses a party has to incur under the purchase agreement before the other party is obliged to indemnify. Baskets can be (i) deductible: once a party's losses exceed the amount specified in the agreement, the other party has to indemnify only for losses exceeding the specified amount or (ii) first dollar: once a party's losses exceed the specified amount, the other party has to indemnify for all losses starting from dollar one. Similar to the US, most deals in Canada have baskets. However, Canadian and US practice diverge on the type of basket used, with first dollar baskets being more common in Canada and deductible baskets being more common in the US.

 

US Study

Prior Canadian Study

Canadian Study

No Basket21

4%

20%

8%

Deductible Basket22

59%

14%

36%

First Dollar Basket23

32%

59%

50%

Combination Basket24

5%

7%

6%

Another type of basket is known as an eligible claim threshold or a mini basket. An eligible claim threshold will provide that a party is not required to indemnify the other party for an individual claim where the loss relating to the claim is less than a specified amount, the idea being that any claim below the specified amount is not a significant enough given the scope of the transaction. According to the Studies, the use of eligible claim thresholds, though still not used in the majority of transactions, is on the rise in Canada and is comparable to US deals.

 

US Study

Prior Canadian Study

Canadian Study

Eligible Claim Threshold25

30%

19%

27%

Indemnity Caps

Purchase agreements may also contain a cap on indemnification obligations which sets out the maximum amount a party can recover for losses. The Canadian and US studies indicate that almost all deals in Canada and the US have a cap, but that caps are still generally much higher in Canada.

 

US Study

Canadian Study

No Cap Specified26

4%

10%

Mean Cap as % of Transaction Value27

16.6%

49%

Median Cap as % of Transaction Value28

10%

40%

Cap as % of Transaction Value:29

- Less than 10%

48%

8%

- 10%

12%

10%

- Greater than 10% to 15%

29%

5%

- Greater than 15% to 25%

4%

20%

- Greater than 25% to 50%

2%

15%

- Greater than 50% but Less than Purchase Price

0%

17%

- Purchase Price

6%

25%

Stand-Alone Indemnities

In addition to the general indemnification obligations, the parties to an M&A transaction may also negotiate stand-alone indemnities relating to specific issues. Stand-alone indemnities benefit the buyer as they are typically carved out of the general basket, cap and survival periods that otherwise apply to breaches of representations and warranties and covenants. For the first time, the Canadian Study reports on the use of stand-alone indemnities in Canadian deals. According to the Canadian and US studies, Canadian practice is similar to US practice in terms of stand-alone indemnities and is seen in the chart below.

 

US Study

Canadian Study

Employee Benefit30

3%

7%

Environmental31

5%

9%

Taxes32

40%

53%

Other33

51%

56%

None34

27%

22%

Footnotes

1 Of the Montreal office of Stikeman Elliott LLP. The views expressed by the authors do not necessarily reflect the views of other M&A practitioners at Stikeman Elliott LLP.

2 The Canadian Study sample was obtained from acquisition agreements filed on SEDAR (the System for Electronic Documents and Analysis and Retrieval) maintained by Canadian securities regulatory authorities for reporting issuers. The Canadian Study excluded acquisition agreements for transactions in which the transaction value was less than C$5M, transactions where the target was in bankruptcy, transactions involving non-arm's length parties, transactions not governed by Canadian law, and transactions otherwise deemed inappropriate for inclusion. The reviewers started with over 600 agreements for potential inclusion. Less than 10% were retained.

3 136 agreements were reviewed in the US Study.

4 The Canadian dollar and the US dollar were close to par during the study period.

5 In the US Study, 9% of transactions with a post-closing purchase price adjustment required the adjustment amount to exceed a threshold and in the Canadian Study, 5% of transactions with a post-closing purchase price adjustment required the adjustment amount to exceed a threshold.

6 Of the subsets deals with post-closing purchase price adjustments.

7 Of the subset deals with working capital post-closing purchase price adjustments.

8 Of the subset deals with earnouts.

9 Of the subset deals with earnouts.

10 Of the subset deals with earnouts.

11 Of the subsets deals with earnouts.

12 Of the subset deals with Undisclosed Liabilities Representation.

13 Of the subset deals with Undisclosed Liabilities Representation.

14 Of the subset deals with Compliance with Laws Representation.

15 Of the subset deals with Compliance with Laws Representation.

16 Of the subset deals with Compliance with Laws Representation.

17 Of the subset deals with deferred closings.

18 Of the subset deals with deferred closings.

19 Total reported by the US Study is 101% due to rounding.

20 Total reported by the Canadian Study is 101% due to rounding.

21 Of the subset deals with survival provisions.

22 Of the subset deals with survival provisions.

23 Of the subset deals with survival provisions.

24 Of the subset deals with survival provisions.

25 Of the subset deals with baskets.

26 Of the subset deals with survival provisions.

27 Of the subset deals with caps.

28 Of the subset deals with caps.

29 Of subset deals with determinable caps.

30 Of the subset deals with survival provisions.

31 Of the subset deals with survival provisions.

32 Of the subset deals with survival provisions.

33 Of the subset deals with survival provisions.

34 Of the subset deals with survival provisions.

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.

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