In the past, a buyer that intended to fund the purchase price for an acquisition using third-party debt financing would frequently try to negotiate for a condition precedent in the purchase agreement that made its obligation to close subject to its being able to secure the third-party debt financing that it required. If the seller agreed, as historically sellers often did, this condition precedent had the advantageous result of eliminating the risk that the buyer might end up being under an obligation to close the transaction without having sufficient financing to do so.1 The current trend, however, is for sellers to be unwilling to agree to this type of condition precedent. As a result, a buyer that is not able to obtain sufficient third-party debt financing to finance the purchase price for an acquisition is at risk of being sued by the seller (for damages and/or specific performance under the purchase agreement) if it doesn't manage the risk of a financing failure in some other way.
This article introduces two other ways in which a buyer can manage the risks associated with failed financing: (i) by obtaining debt financing commitments from its lender with limited conditions precedent; and (ii) by agreeing with the seller that the seller would be entitled, as its sole recourse, to a reverse breakup fee in the event of a failed financing. The article also highlights the related considerations for buyers and lenders or sellers, as the case may be. Subsequent articles in this series, which will appear in the coming weeks, will consider limited conditionality commitment letters and break-up fees in significantly greater detail for readers who are interested in learning more about the possibilities they offer.
Limited Conditionality Commitment Letters
Under a commitment letter, which the buyer will obtain prior to executing the purchase agreement, the lender will commit to lend the buyer sufficient funds on the closing date to finance the purchase price for the acquisition provided that certain specified conditions are met. A typical commitment letter will generally include all the following conditions: (i) all the representations and warranties made by the buyer in the financing documentation with respect to itself and the target must be true and accurate on the closing date, (ii) all the security interests to be granted to the lender must be perfected by closing, (iii) successful syndication of the debt facilities must be completed, (iv) there must be an absence of a material adverse change (MAC) relating to the business of the target and/or the buyer, (v) there must be an absence of a MAC in debt financing markets and (vi) the lender's due diligence investigation of the buyer and the target must be completed and satisfactory to the lender.
For a buyer that is not able to get a financing condition in the purchase agreement, a commitment letter with all of the conditions listed above is not ideal. There is a risk that some of the conditions to receive the financing set forth in the commitment letter will not be met even though all of the conditions to closing in the purchase agreement will be met, which would put the buyer in a position in which it has an obligation to close the transaction despite it not having received financing to fund the purchase price. Because the current trend is not to have financing conditions in purchase agreements, buyers put increased pressure on lenders to agree to commitment letters with significantly less conditions, and some lenders have agreed to provide "limited conditionality" commitment letters.
In limited conditionality commitment letters, most of the conditions listed above are replaced by much more limited "SunGard clauses". A SunGard clause limits (i) the representations and warranties that must be brought down at closing as a condition to funding to (a) those regarding the target that are made in the purchase agreement that, if not true and correct, would give the buyer the right to terminate its obligations under the purchase agreement, and (b) certain specified representations regarding the buyer (and, in some cases, the solvency of the combined group after the closing of the transaction); and (ii) the security that must be provided or perfected at or prior to closing as a condition to funding.2 By matching the representations and warranties in the commitment letter that must be true and accurate with the representations and warranties in the purchase agreement that must be true and accurate and removing all of the other conditions to financing, there is significantly less risk to buyers that the closing conditions under the purchase agreement will be met even if the conditions to the lenders funding are not met.
Lenders that consider providing "limited conditionality" commitment letters will need to:
- evaluate (i) the representations and warranties relating to the target in the purchase agreement, (ii) the ability of the buyer and the seller to amend the purchase agreement without the lenders' consent, and (iii) whether it is appropriate in the circumstances to require the buyer to make any other specific representations and warranties;
- evaluate the security needed at closing;
- assess whether it is appropriate in the circumstances to require any other conditions to protect themselves, such as conditions relating to syndication of the facilities or a MAC relating to financing markets; and
- consider conducting and completing due diligence at an early stage.
Buyers, on the other hand, should:
- keep in mind that each condition precedent in favour of the lender in the commitment letter that does not have an equivalent condition precedent in favour of the buyer in the purchase agreement represents a risk to the buyer that it could have an obligation to close the acquisition pursuant to the terms of the purchase agreement while the lender does not have the obligation to provide the debt financing needed to fund the purchase price; and
- be concerned with additional provisions that can increase the cost of the facility, such as broad flex rights.
For a detailed discussion of limited conditionality commitment letters, stay tuned for our forthcoming post entitled "The Rise of Limited Conditionality Commitment Letters in Canada".
Financing Related Reverse Breakup Fees3
A reverse breakup fee is a fee payable by the buyer to the seller should the buyer fail to close the transaction for reasons specified in the purchase agreement. If the reverse breakup fee is the seller's sole recourse in the event of a failure of the buyer to close the transaction (meaning that the seller is not entitled to sue the buyer for additional damages or to seek specific performance), providing for a reverse breakup fee will (i) minimize and quantify the exposure faced by the buyer under the purchase agreement, and (ii) eliminate the need for the seller to litigate in order to recover damages. A reverse breakup fee can be a remedy for (i) a limited set of circumstances, such as buyer's failure to obtain sufficient financing, or (ii) a broad set of circumstances, such as any breach of the purchase agreement by the buyer.
When negotiating a reverse breakup fee payable as a result of the buyer's failure to obtain financing, buyers and sellers should consider a number of issues:
- who can terminate the agreement for failed financing and under what circumstances. In this regard, the parties may consider the seller's and the buyer's respective roles in the failure to obtain the financing. For example, a seller may want to maintain its right to sue for damages and/or specific performance if the buyer has not used its commercially reasonable efforts to obtain the financing on the terms set forth in the commitment letter, and the buyer may want to ensure that the fee is not payable if the seller did not reasonably cooperate with the buyer in its negotiation of the financing documents;
- whether the breakup fee will be the seller's sole recourse for the buyer's failure to obtain financing, or whether the seller should be entitled to seek (i) specific performance by the buyer of its obligation to close the transaction, or (ii) additional damages from the buyer above the amount of the fee (especially in a situation where the financing failed as result of the buyer's breach of a representation and warranty or where the buyer wilfully caused the financing to fail);
- the amount of the fee; and
- where the buyer is a shell company, whether the reverse breakup fee will be guaranteed by the parent company of the buyer or, in the case of a private equity deal, its sponsor.
Once the parties come to an understanding on each of these issues, the remedies, termination, and effects of termination sections in the purchase agreement should be carefully reviewed to ensure they are consistent with the parties' intentions. We will provide a more detailed discussion of financing-related reverse breakup fees in a forthcoming post entitled "Reverse Breakup Fees as a Remedy for Failed Financing in M&A Transactions".
As a practical point, before negotiating reverse breakup fees, buyers should identify whether there is a need to manage the risk of failed financing. In this regard, buyers may want to consider the probability of the financing failing, the availability of alternate financing and the significance of the exposure they may face under the purchase agreement if the risk of the financing falling through does materialize. Where the prospective buyer is a private equity firm in an auction context, it will not want to be at a disadvantage due to a perceived reliance on external financing, and therefore might decide that if its external financing fails, it will fund all of the purchase price with equity.
However, if a buyer wishes to manage the risk of a financing failure, it should consider (i) debt financing commitments with limited conditions to funding, and (ii) a reverse breakup fee that would be payable by the buyer to the seller as the seller's sole recourse in the event of a failed financing. A limited conditionality commitment letter minimizes the risk of failed financing while a reverse breakup fee minimizes the exposure faced by the buyer should the risk materialize.
Finally, buyers, lenders and sellers should bear in mind that the provisions in limited conditionality commitment letters and the provisions in purchase agreements relating to reverse breakup fees will vary from transaction to transaction and will depend on the needs of each of the parties. Experienced counsel can help buyers, lenders and sellers asses their needs and negotiate tools that manage the risk of a failed financing for their particular M&A transaction.
1 Most change of control transactions involving a Canadian public company are effected by way of a take-over bid or through a shareholders' approved arrangement. Under Canadian securities laws, in the context of take-over bid that includes cash consideration, "adequate arrangements" must be made before the take-over bid is commenced to ensure that the bidder has the required funds available to complete the acquisition and, therefore, a financing condition precedent is prohibited in such context. There is no such legal requirement applicable to an acquisition through a shareholders' approved arrangement.
2 It should be noted that the limitations on the conditions to funding imposed by such provisions will typically only apply to the funding of the amounts needed at closing and will not affect the conditions to subsequent borrowings.
3 A reverse breakup fee is also known as reverse termination fee.
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.