The Latest on Private M&A Deal Points: Part I – Indemnification

January 28, 2016

The Market Trends Subcommittee of the Mergers and Acquisitions Committee (the ABA Subcommittee) of the Business Law Section of the American Bar Association recently released its latest edition of the Private Target M&A Deal Points Study (the US Study) which analyzes acquisition agreements for transactions completed in 2014 involving US private targets being acquired by US public companies. Last year, the ABA Subcommittee released the 2014 Canadian Private Target M&A Deal Points Study which analyzes acquisition agreements for transactions signed in 2012 and 2013 involving Canadian private targets being acquired by Canadian public companies (the Canadian Study). This article is a first in a two part series highlighting and comparing various deal points reported by the US Study and the Canadian Study as well as those reported by the prior editions of these Studies.[1] The focus of this article is on indemnification matters. The trends revealed by these Studies are interesting but it is important to bear in mind that referring to deal point studies is not a substitute for reasoned negotiations.

The Study Sample

The US Study and the Canadian Study have a number of differences in terms of study samples. The US Study, like prior editions, is based on a much larger sample: it includes almost double the number of agreements reviewed in the Canadian Study. Also, even with an increase in the proportion of Canadian transactions with values over C$100M, a comparison of the US Study and the Canadian Study show that US deals are still typically larger than Canadian deals.

  Prior US Study US Study Prior Canadian Study Canadian Study
Number of Deals 136 117 64 60
Range of Transaction Values US $17.2M to US$4.7B US $17M to US$5B C$5M to C$2.25B C$5.6M to C$5.8B
Transactions Over $100M 63% 65% 11% 31%

 

Indemnification

Survival Periods

Purchase agreements typically specify the time period during which representations and warranties (and sometimes covenants) survive closing. The US Study and the Canadian Study show that the survival period for representations and warranties in most deals is between 12 and 18 months with more transactions in the 18-month category. A survival period around 18 months is typical in both countries as most problems may be uncovered with that period: buyer will have had time to run the business and will be able to perform at least one post-closing audit. The US Study and the Canadian Study show that Canadian deals are, however, still more likely to have a survival period that is greater than 18 months. Parties to a purchase agreement will also typically agree that certain representations and warranties should have a different survival period for a number of reasons (these are referred to as carveouts), including when they are an essential component of the deal (also known as core representations). The US Study and the Canadian Study also show some differences in the use of certain carve outs to survival. For example, the representation on capitalization is carved out in 76% of deals included in the subset in the US Study, while in the Canadian Study, the representation on capitalization is carved out in 33% of deals included in the subset. However, this may at least partly be explained by the fact that there is almost double the percentage of asset deals in the Canadian Study when compared to the US Study (33% versus 17%).

  Prior US Study US Study Prior Canadian Study Canadian Study
Survival Period : Less than 12 months 2% 1% 1.7% 0%
Survival Period: 12 months to 18 months 83% 75% 32.4% 58%
Survival Period: More than 18 months 12% 16% 57.2% 35%
Silence 1% 0% 7% 4%
Express No Survival 2% 6% 1.7% 4%

 

Types of Damages/Losses Covered

These deal terms are largely consistent with the Prior US Study and the Canadian Study. Very few agreements limit damages to out of pocket expenses. Most agreements are more likely to be silent on incidental damages. Most agreements are also more likely to be silent on diminution in value and almost equally likely to expressly exclude consequential damages or be silent on that heading. When the parties are silent on a heading of damages, they are leaving it up to a court of competent jurisdiction to determine whether such damages are recoverable under applicable law and in light of the definition of damages chosen by the parties. According to the US Study and the Canadian Study, one difference between Canada and the US remains punitive damages: Canadian agreements are almost equally likely to be silent or exclude punitive damages, whereas most US agreements expressly exclude punitive damages. The higher percentage of agreements that are silent with respect to punitive damages in Canadian deals is likely as a result of punitive damage awards being rare in Canada, and when granted, the awards being smaller: accordingly, punitive damages are likely less to be of a concern for many sellers.

  Prior US Study US Study Prior Canadian Study Canadian Study
Damages Limited to Out of Pocket Expenses 9% 5% 0% 4%
Silent on Incidental Damages 67% 74% 69% 75%
Includes Incidental Damages 16% 4% 9% 7%
Excludes Incidental Damages 17% 22% 22% 18%
Silent on Diminution in Value 69% 72% 85% 78%
Includes Diminution in Value 14% 11% 7% 13%
Excludes Diminution in Value 17% 17% 8% 9%
Silent on Consequential Damages 44% 44% 54% 45%
Includes Consequential Damages 2% 7% 14% 11%
Excludes Consequential Damages 54% 49% 32% 44%
Silent on Punitive Damages 25% 21% 65% 51%
Includes Punitive Damages 0% 1% 3% 7%
Excludes Punitive Damages 75% 78% 32% 42%

 

Indemnity Baskets

Indemnity baskets establish the minimum dollar amount of certain types of losses a party must suffer under the purchase agreement before the other party is obliged to indemnify it. 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. A basket may also be a “combination” of a deductible and first dollar. These deal terms are largely consistent with the Prior US Study. Both in the US and Canada, most deals have baskets and those baskets cover seller’s/target’s representations and warranties. However, according to the US Study and the Canadian Study, Canadian and US practices diverge on (i) the type of basket used, with first dollar baskets being more common in Canada and deductible baskets being more common in the US; (ii) the size of the basket, with baskets being larger in Canada; (iii) the use of certain carve outs from basket, such as, for example, fraud which is carved of 80% of deal in the US while it is only carved out in 48% of deals in Canada; and (iv) whether baskets cover breach of seller’s/target’s covenants, with such coverage being more common in Canada. In our experience, basket size as or percentage of transaction value tends to be greater the lower the purchase price. This may explain why Canadian basket percentages tend to be higher. It should also be noted that with respect to whether baskets cover breach of seller’s/target’s covenants, our experience would suggest that actual Canadian practice is more similar to US practice where baskets are unlikely to apply to covenants.

            Prior US Study US Study Prior Canadian Study Canadian Study
No Basket 4% 2% 20% 8%
Deductible Basket 59% 65% 14% 36%
First Dollar Basket 32% 26% 59% 50%
Combination Basket 5% 7% 7% 6%
Mean Basket as % of Transaction Value 0.58% 0.65% 0.51% 0.87%
Basket as % of Transaction Value:
-Greater than 1%: 12% 10% 8% 28%
-1% or less: 88% 90% 92% 72%
Basket Coverage – Seller’s/Target’s Representations and Warranties 99% 99% 100% 100%
Basket Coverage – Seller’s/Target’s Covenants 27% 17% 72% 68%

 

Another type of basket is known as an eligible claim threshold or a minimum loss 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 US Study and the Canadian Study, eligible claim thresholds are used in roughly one third of transactions, and slightly on the rise on both sides of the border.

  Prior US Study US Study Prior Canadian Study Canadian Study
Eligible Claim Threshold 30% 38% 19% 27%

 

Indemnity Caps

Purchase agreements may also contain a cap on certain indemnification obligations which sets out the maximum amount a party can recover for losses. The US Study and the Canadian Study indicate that in the US, all, and in Canada, almost all, deals with a survival provision include a cap, but that (i) caps are generally lower in the US; and (ii) certain carve outs are more common in the US, such as for example, the due authorization representation, which is carveout of 76% of deal in the US and only in 22% of deals in Canada, even though our experience would suggest that Canadian practice on many of these carveouts are similar to US practice.

  Prior US Study US Study Prior Canadian Study Canadian Study
No Cap Specified 4% 0% 28% 10%
Mean Cap as % of Transaction Value 16.6% 13.2% 33.6% 49%
Median Cap as % of Transaction Value 10% 10% 25% 40%
Cap as % of Transaction Value:

-Less than 10%

48% 50% 3% 8%

-10%

12% 9% 0% 10%

-Greater than 10% to 15%

29% 22% 7% 5%

-Greater than 15% to 25%

4% 11% 18% 20%

-Greater than 25% to 50%

2% 5% 18% 15%

-Greater than 50% but Less than Purchase Price

0% 0% 14% 17%

– Purchase Price

6% 3% 40% 25%

 

Double Materiality for Indemnification Purposes

A purchase agreement can provide that materiality qualifications in representations and warranties will be disregarded either for the purposes of calculating damages only or for all indemnifications purposes (in which case the materiality qualifications in the representations and warranties exist solely for the purpose of closing conditions or to allow the seller to make representations and warranties it could not otherwise truthfully make without a qualification). This is often referred to as a double materiality scrape. The US Study shows a major shift: 70% of deals with a basket included a double materiality scrape, up from 28% in the Prior US Study (and half of these scrapes were limited to the purpose of calculating damages only). According to the Canadian Study, Canadian practice on these points is significantly different: a double materiality scrape is unlikely to be included and, if it is, it will be limited to the purposes of calculating damages. This is consistent with what the authors are seeing in their practices, although we predict that the proportion of deals with double materiality scrapes will rise in Canada.

  Prior US Study US Study Prior Canadian Study Canadian Study
Double Materiality Scrape Included 28% 70% 11% 11%
If Included, Limited to Calculation of Damages 41% 43% 62.5% 0%

 

Third Party Claims

For the first time, the US Study reports on the provisions that apply when a third party makes a claim or brings an action against the buyer or acquired business after closing. The Canadian Study does not provide information on third party claims provisions (although it will likely be included in the next study). According to the US Study, most deals in the US are likely to (i) be silent on whether buyer can be indemnified for third party claims absent a breach of representation and warranty; (ii) do not require the indemnifying party to acknowledge its liability prior to taking control of the defense of third party claims; (iii) provide some exceptions to the ability to control the defense; and (iv) set limits on the ability of a defending party to settle claims.

  US Study
Silent on Whether Buyer Can Be Indemnified For Third Party Claims Absent a Breach of Rep 78%
Buyer Can Be Indemnified for Third Party Claims Absent a Breach of Rep 19%
Buyer Cannot Be Indemnified for Third Party Claims Absent a Breach of Rep 3%
Indemnifying Party Can Control Defense of Third Party Claims 85%
Indemnifying Party Cannot Control Defense of Third Party Claims 15%
Where Indemnifying Party Can Control Defense of Third Party Claims, Indemnifying Party is not First Required to Acknowledge Liability 62%
Where Indemnifying Party Can Control Defense of Third Party Claims, Indemnifying Party is First Required to Acknowledge Liability 38%
Where Indemnifying Party Can Control Defense of Third Party Claims, Includes Exceptions to Indemnifying Party’s Ability to Control Defense of Third Party Claims 78%
Includes Limits on Ability of Defending Party to Settle Claims 90%

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For further details on these and other deal points, please consult the Studies, which are all available to ABA members on the Markets Trends Subcommittee of the American Bar Association’s Mergers and Acquisitions Committee website.

The authors would like to thank Kim Ton-That for her contribution to this article.

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[1] The Prior US Study analyzes acquisition agreements for transactions completed in 2012 involving US private targets being acquired by US public companies and the Prior Canadian Study analyzes acquisition agreements for transactions completed in 2010 and 2011 involving Canadian private targets being acquired by Canadian public companies.

DISCLAIMER: This publication is intended to convey general information about legal issues and developments as of the indicated date. It does not constitute legal advice and must not be treated or relied on as such. Please read our full disclaimer at www.stikeman.com/legal-notice.

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