In a previous blog entry, we offered a brief review of cybersecurity issues that can arise in the course of M&A transactions and discussed the importance of cybersecurity due diligence by the buyer. This entry will focus on contractual provisions that the buyer can request in the definitive transaction agreement to hedge against any cybersecurity risks it assumes. In particular, this blog post will focus on purchase price adjustments, representations and warranties, and indemnities.
Purchase Price Adjustments
Where the due diligence phase of the transaction has revealed risks and vulnerabilities in the target's cybersecurity systems, policies or practices, the buyer must decide how it wishes to proceed. If the risks or vulnerabilities of the target's systems are significant, or if the target's systems are compromised or outdated, the value of the target may be affected. The buyer may seek to negotiate the deal to reflect the assumption of risk or to account for the costs the buyer anticipates it will incur by implementing any changes it feels are necessary after closing. If the target is a public company, generally no post-closing price adjustments are possible, but where the target is a private company, the buyer may be able to negotiate a holdback on the purchase price to cover off any contingent liabilities relating to the deficiency identified. The exact nature of any adjustments will be the subject of negotiation between the parties and will vary in each case depending on the size of the transaction and the substance of the identified deficiencies. As the sellers are unlikely to be in a position post-closing to verify the existence or cost of fixing any deficiencies, the parties will want to enter into a very detailed agreement that sets out the mechanism for claiming on the holdback, the limit on such claims, how the damages are to be calculated and by whom, and the appeal mechanism.
Representations and Warranties
What are Representations and Warranties?
A buyer relies on the representations and warranties from the sellers in order to determine if it wants to buy the business and if so, at what price. A breach of a representation or warranty can therefore sometimes allow a buyer to walk away from the deal or to close the deal and then recover the damages suffered by it as a result of not getting what it bargained for.
In the public company context, buyers get the right to walk away (assuming that the breaches appear to be over a stipulated threshold based on the purchase price), but after having bought the business, the buyer generally has no recourse as it then owns the target and the buyer will not pursue remedies against the former public shareholders. In the sale of a private company, the buyer often has the right to walk away or close and sue the sellers after closing.
Cybersecurity Representations and Warranties
In the cybersecurity context, the use of representations and warranties in the definitive transaction agreement serves several useful purposes.
First, the representations and warranties verify and supplement the buyer's cybersecurity due diligence investigations. Typically, representations and warranties are drafted to be broad and comprehensive. Where a buyer is basing its price on certain important assumptions about the state of the target, the veracity of those key assumptions must be stated as a representation and warranty from the target. Where a target is not able to fully make that representation or warranty, the target will include one or more exceptions to that representation and warranty, typically set out in a disclosure schedule.
This creates an incentive for the target and the sellers to disclose any known issues at the outset of signing the definitive transaction agreement, because it removes these issues from the scope of the sellers' liability down the line. This also benefits the buyer because it might bring issues of which it was previously unaware to light and presents the buyer with an opportunity to double-check its due diligence. An example of where this may operate is with a representation that the target has not, to the knowledge of the target's management, been the subject of any data breach and the target's management has no reason to think any such breach has occurred.1
Well-drafted representations and warranties can also provide the buyer with comfort on the cybersecurity policies and processes of the target and its adherence with applicable standards. A buyer should request representations that the target has taken prudent action in conformance with industry practice to protect its systems and data against cyberattack, that the cybersecurity measures in place to protect the target's systems are consistent with current industry standards and practices and that the target's cybersecurity policies are sufficient to reasonably ensure secure and proper access to the target's systems and data. The exact form these representations and warranties will take will be guided by the buyer's due diligence, the nature of the target's business and the prevailing cybersecurity climate. For example, where a target operates in a particularly sensitive industry (such as the retail, travel, information technology, or health-related technology industries) a buyer may want to clearly delineate what "industry standards and practices" should mean, as current industry standards might not be robust enough to prevent a data breach.
Following the recent decision by the Court of Justice of the European Union declaring that the United States and European Union Safe Harbour framework is invalid, it is highly recommended that organizations have legal counsel review representations and warranties concerning data handling policies, where appropriate.2 Canadian businesses operating in the United States and/or European Union that transfer information from the European Union to the United States are encouraged to swiftly address alternative approaches to data transfers.
A buyer may also rely on representations and warranties for comfort that the target has conducted its business appropriately. A buyer should request a representation that the target's systems operate in accordance with applicable law and industry standards. A buyer should also request a representation that the target has conducted its business in compliance with applicable privacy laws. Where the target has international operations, it is important that the concept of "applicable privacy laws" captures the different jurisdictions in which the target operates, as privacy law requirements can vary widely by jurisdiction. A target will need to be mindful of this when asked to confirm this representation. Where the target has implemented privacy policies, the buyer should also request a representation to confirm it has operated in compliance with these.
Depending on the scale of the target's operations and the size of the business, it may be appropriate to qualify the cybersecurity representations and warranties by way of a materiality threshold or limit these to the knowledge of the target's management. What qualifications will be acceptable in the circumstances will vary in each case. If any representations are qualified as being to the knowledge of the target's management, the buyer should ensure the correct individuals at the appropriate level of responsibility are included for these purposes, having regard to the target's operational structure.
The target's management will need to understand the nature of the target's systems and operations in order to consider what representations and warranties it is able to give and what qualifications it will need to make. Likewise, the buyer will need to take these factors into account when requesting a given representation or warranty and considering the appropriateness of a qualification.
Where cybersecurity is an important consideration in the overall transaction, the target and buyer should each consider obtaining independent expert advice from an early stage to help guide the due diligence process and subsequent negotiations.
What are Indemnities?
An indemnity is a contractual promise made by one party to another that, if a contemplated event occurs, the first party will compensate the other for any losses the other suffers as a result of the event. Indemnities make it easier for parties to recover losses than it would otherwise be through suing for damages. They are almost invariably used in private M&A transactions.
Indemnities can be limited in time or provide for certain minimum thresholds to be met before the indemnified party can recover losses. Indemnities can also be expanded to allow other parties to recover costs, such as the directors, employees and agents of a party in their personal capacities. Parties can tailor indemnities to provide for the recovery of costs and expenses that traditional damages claims might not cover (such as the full cost and expense of investigating and defending a claim, beyond partial recovery of legal fees that may be awarded by a court) and to the specific circumstances of a transaction (for example, to include or exclude indirect or consequential damages).
In a private M&A transaction, indemnity clauses typically cover breaches of representations and warranties and any failure by a party to comply with the covenants in the definitive transaction agreement. However, the parties may also wish to negotiate stand-alone indemnity provisions to cover specific liabilities or risks identified in the due diligence phase of the transaction.
Typically, if a buyer is to recover any losses arising from a cybersecurity incident under a definitive M&A transaction agreement, it will do so by relying on the general indemnity granted for a breach of the representations and warranties in the agreement.
Just as the representations and warranties will need to be tailored to the specific target and transaction, so will the indemnity provisions. Here are some specific points for the parties to consider in negotiating the indemnity provisions in the transaction agreement as they may relate to cybersecurity matters.
- To whom should the indemnity apply? As noted above, an indemnity may be expanded to cover an indemnified party's directors, agents, and subcontractors. For example, directors owe broad fiduciary duties to the corporations they manage, which may extend as far as ensuring that their organizations manage and secure data appropriately. For example, in the United States, directors have been named in derivative actions brought by shareholders for allegedly breaching duties in relation to the management of cybersecurity risks by failing to implement internal controls to prevent data breaches.3
- Should any cybersecurity liabilities warrant specific consideration? Liability in an M&A transaction is frequently limited by minimum thresholds for individual or aggregate claims. However, liabilities arising from compromised proprietary information, such as loss of trade-secrets, may warrant a special carve-out from the general basket.
- Should the cybersecurity representations and warranties survive for a longer period of time than the others? A buyer should consider the length of time required to fully integrate the information technology systems of the target, as well as to secure the target's network following the closing of the deal, in negotiating the survival period of cybersecurity representations and warranties.
- When should an indemnifying party receive notice of cybersecurity issue? Consider the notice required to be provided to an indemnifying party, as well as the permitted involvement of the indemnifying party in the defense or settlement of lawsuits against the buyer resulting from cybersecurity breaches. For instance, the indemnifying party may want to be notified of significant cybersecurity attacks to the target's system as soon as they arise.
As mentioned above, the parties may also agree to a stand-alone indemnity for specific concerns identified through due diligence. While a broadly drafted indemnity clause may arguably cover cybersecurity issues, parties in particular industries may want the protection of more specific indemnity provisions, as the broadness of a given indemnity clause is ultimately a matter of contractual interpretation. Where there is a real risk of cyberattacks, the buyer should consider implementing a stand-alone clause so that the transaction agreement clearly reflects the consensus ad idem of the parties, being that the parties clearly intended to address the risks of cyberattacks.
There are numerous contractual mechanisms by which a target and buyer can apportion cybersecurity risk. In the public company sale process, it generally will be a matter of conducting enough due diligence, both documentary and through interviews with management, to give the buyer comfort that any issues have been factored into the price being offered to the public shareholders. In the case of a sale of a private company, where the selling shareholders may be available to be sued after closing or have agreed to have some of the purchase price held back, what will be appropriate in any given case is the subject of negotiation and will depend on the circumstances at play, including the information revealed in the due diligence phase of the transaction and the nature of the target's business and operations.
A buyer will benefit from comprehensive representations and warranties in the transaction agreement regarding the target and will want to ensure these representations and warranties cover known data security breaches and speak to the adequacy of the target's systems and cybersecurity policies and practices. For its part, the target should ensure it can confirm the requested representations and warranties and otherwise qualify these by knowledge or materiality where appropriate.
The parties to an M&A transaction should consider cybersecurity concerns in setting the price and, in the case of private transactions, by apportioning liability through the indemnity provisions of the definitive transaction agreement, particularly as these may relate to the indemnified parties, and the survival period for the representations and warranties. In certain circumstances, the parties might want to consider stand-alone indemnities for cybersecurity matters, such as where there is a real risk of cybersecurity breaches. At the end of the day, the sellers' representations and warranties are only one aspect of a transaction to consider when the buyer wants to protect against the risk of cyber-attacks. Targets and buyers are encouraged to review other operational policies, such as guidelines covering employee access to data, to build a more comprehensive cybersecurity regime.
In the final entry of this installment series discussing cybersecurity issues in M&A transactions, we will discuss cybersecurity insurance as a mechanism for the buyer and target to manage the risk of incurring losses arising from cybersecurity breaches.
1 Given that a target's track record with past data breaches will be telling not only of its cybersecurity liabilities from such breaches but also of its vulnerabilities and the risk of future breaches, this should already be a focus of the buyer's due diligence. A target will need to carefully review its records (with the assistance of an expert, if necessary) to ensure it is able to give this representation, and should ensure it conducts this review regularly throughout the transaction process.
2 For more information, please see Kirsten Thompson, Daniel G.C. Glover, Breanna Needham, Barry Sookman and Charles Morgan, "Europe's Top Court Invalidates 'Safe Habour' Data Transfer Framework" http://www.canadiantechlawblog.com/2015/10/13/europes-top-court-invalidates-safe-habour-data-transfer-framework/>.
3 Following Target Corporation's data breach in December 2013, derivative lawsuits were filed against directors of Target Corporation. Briefly, the claims are for breach of fiduciary duty and waste of corporate assets, as the directors allegedly failed to implement any internal controls at Target designed to detect and prevent such data breaches. See e.g., Collier v Steinhafel et al, No. 0:14-cv-00266 (D Minn) (filed January 29, 2014).
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.