Economic Risk in Commercial Agreements
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The document outlines strategies for transferring economic risk in commercial agreements, emphasizing the importance of controlled drafting, due diligence, and the use of representations and warranties. It addresses the implications of liability structures, the significance of deposits and escrow arrangements, and best practices for managing risk in purchase and sale agreements. Additionally, it highlights the need for careful negotiation of terms to protect both vendors and purchasers in the agreement process.
Economic Risk in Commercial Agreements
- 1. Welcome Economic Risk in Commercial Agreements
- 3. Glen Lekach Miller Thompson, LLP
- 4. Economic Risk In Commercial Agreements GLEN LEKACH
- 5. Overview • Transferring risk in the context of purchase and sale agreements and other commercial agreements such as supply agreements, service agreements, employment agreements, loan agreements and the like • Parties expend considerable effort to transfer risk to avoid or reduce liability or an event of default
- 6. Practical points on strategies to transfer risk • Use of definitions • Control drafting • Due diligence • Parties to the agreement • Use of deposits and escrows • Representations, warranties, and indemnities • Boiler plate
- 7. Controlling Drafting • Avoid temptation to allow Vendor’s solicitor to draft the purchase agreement • Controlled auction exception • In other agreements, to the extent possible, the party receiving the benefit should draft
- 8. Four reasons to control drafting – timing of negotiations • (timed in accordance with turnarounds of drafts and disclosure of information) – obtaining information • (use of broad terms such as representations and warranties to see where push-back occurs) – protecting of the Purchaser • (if vendor drafts, protection of purchaser is of no interest) – detecting deficiencies in other side’s drafting is difficult
- 9. Strength of Bargaining Power • Determine the relative bargaining positions: – client who is not afraid to walk (able to take hard positions) – client who needs the deal (will make concessions) • Deals fail where lawyers are not sensitive to this dynamic (e.g. lawyer intransigent on every point regardless of client’s position)
- 10. Drafting for Different Types of Agreements • Custom may drive content • Good business sense should drive content • E.G.: a commercial real estate agreement often needs no indemnity • Good drafting: definitions, interpretations, covenants, representations and warranties, conditions to performance, indemnities, general matters • Don’t follow standard form agreements, if they do not suit the transaction
- 11. Parties • Use of a co-covenantor: – Determine solvency of Vendor – Shell Purchaser – Vendor financing – Assignment of contracts – Vendor liquidating assets and distributing proceeds to shareholders
- 12. Parties • More than one Vendor or co-covenantor • Joint liability • Several liability – Problems exist where one party is insolvent and the other party is in management and works for the party having a claim • Joint and several liability • If co-covenantor unrelated • Parties who are jointly liable should enter into side agreement allocating liability amongst them
- 13. Execution of the Purchase Agreement • Interim period if signing occurs before closing • Material adverse changes during interim period or reps and warranties not true • Execution of purchase agreement on or near the closing • Sometimes cannot avoid interim period where regulatory approvals need to be obtained or third party consents required
- 14. Deposits • Useful where: – Purchaser does not have deep pockets • Risk of walking away before closing – Co-covenantor does not have deep pocket or no co- covenantor exists – Committing a Purchaser to a transaction • “Skin in the game”
- 15. Deposits • Deposit can offset the Vendor’s damages if Purchaser fails to complete • Liquidated Damages – not a penalty – should not be excessive, extravagant, or unconscionable – should estimate actual damages • obtain acknowledgement from Purchaser that it is a genuine pre-estimate of damages
- 16. Escrow Holdbacks • A holdback of some of the purchase price • Useful where: – to fund indemnity claims post-closing – to fund claims for post-closing adjustments – Vendor will be wound up post-closing – no co-covenantors are present
- 17. Escrow Holdbacks • Funding of earn out – Vendor wants funds secured up front • Use of tranches – release holdbacks in one or more tranches – term of holdback can correspond with survival of reps and warranties • Loss of key customer or employee or other risk – For the benefit of the Purchaser
- 18. Due Diligence • Purchaser’s desire to investigate – unrestricted before signing – use confidentiality agreement – between signing and closing – often just confirmatory due diligence • Vendor’s desire to limit investigation – If due diligence is broad and Puchaser discovers problem, Purchaser walks • Limited reps and warranties = greater due diligence – Required because likely no claim against Vendor if problem arises
- 19. Conditions Of Closing • All reps, warranties and covenants must be true or performed – what if they aren’t? • Vendor does not want Purchaser to be able to walk away if there is a minor breach • Breach must be material • Define “materiality” – If possible in a monetary amount – Tied to amounts agreed upon prior to making indemnity claim • Consequences of waiver of breach – Right to sue or no right to sue
- 20. Failure To Satisfy Conditions Of Closing • Where unmet, allow the Purchaser to rescind the agreement without any liability • Vendor liability upon rescission • Vendor does not want to be liable unless matter was reasonably capable of being performed – E.G. loss of customer
- 21. Use of Best Efforts • To ensure covenants, agreements, et cetera are fulfilled at closing • Take all actions within control and best efforts in respect of matters beyond control • For Vendor: – Use of “reasonable commercial efforts” reduces cost – If “best efforts” is used, define it to exclude extraordinary expenditures
- 22. Jurisprudence on “Best Efforts” • Atmospheric Diving Systems Inc. v. International Hard Suits Inc. (1994), 89 B.C.L.R. (2d) 356: – it imposes a higher obligation than a “reasonable effort” – it means taking all reasonable steps and leaving no stone unturned – it includes doing everything known to be usual, necessary and proper – may not be economically viable – it is not boundless – commercially reasonable is an economic test: namely, does not need to be done if it does not make sense financially
- 23. Representations and Warranties • Subject of lengthy negotiations between counsel • Certain basic reps and warranties are normally uncontroversial: – due organization, due power and authorization, no conflicts with laws, all governmental and other consents obtained, legally binding obligations, all approvals obtained and maintained, no litigation and compliance with applicable laws • Given the numerous types of legal entities that exist, use generic language like “organization” rather than “corporation” to capture all forms
- 24. Specific Representations and Warranties • Deal specifically with the maker or its business • Risk-shifting reps and warranties • Used in share sale, credit agreement, or asset sale • ‘Vendor friendly’ versus ‘Purchaser friendly’ • In credit agreements, must remain true throughout term of loan facility • In purchase agreements, the length of the term of the truthfulness can be negotiated
- 25. Risk Transfer Techniques • Liability of Vendor: – ‘absolute’ versus ‘material’ or ‘best of knowledge’ – Key: who bears the risk of an unknown problem • Use a fair approach to expedite negotiations • Purchaser’s reps and warranties are generally limited – exception exists where Vendor financing provided • Watch out for Vendors who attempt to avoid giving detailed reps and warranties • Due diligence in lieu of reps and warranties may be inadequate where purchaser dues not understand the business
- 26. ‘Best of Knowledge’ • Vendor should seek to define this term: – restricted to the actual knowledge of designated senior officers • Purchaser should be resist ‘best of knowledge’: – If used, it should compel representatives to conduct diligent inquiries • For corporations, determine whose knowledge
- 27. Knowledge qualifiers • Shifts risk to Purchaser • e.g. “to the best of the knowledge of the Vendor, there are no hazardous substances on the lands that form part of the purchased assets” • Often an unwarranted transfer of risk – who should bear risk for unknown liability?
- 28. Knowledge Qualifiers • Consider whether the risk being transferred is acceptable • Resist fundamental risks: – title to assets – existence of encumbrances • ‘after due inquiry’
- 29. Materiality • Used in conjunction with words such as change, effect, affect, default • The threshold for materiality can be used to transfer risk • Often defined as a monetary amount – sometimes materiality cannot be quantified in dollars (E.G. loss of licence) – aggregating of small breaches • Defining materiality gives certainty to levels of disclosure
- 30. Material Adverse Changes • Used in conjunction with conditions precedent, reps and warranties, covenants, and events of default • Tension between quantitative and qualitative material adverse changes • Overly-broad clauses may be found void by a court for ambiguity
- 31. Material Adverse Changes • Carve-outs for Vendor: – short term changes – political or market change – natural disasters/terrorism/sabotage – changes resulting from the agreement itself – disclosed matters – changes in GAAP/ASPE – failure to meet earnings estimates – changes in industry – requests by governmental authorities
- 32. Material Adverse Change (MAC) • Invoking a MAC clause: – mixed law and fact – objective and subjective standard applied – depends on the knowledge of the party invoking the clause – make sure definitions in loan agreement and purchase agreement are the same, where financing obtained
- 33. Ordinary Course or Business • Vendor may limit risk by excluding from reps and warranties matters in “the ordinary course of business” • If so, only abnormal matters are caught by the reps and warranties • Typical wording – “except as may arise in the ordinary course of business”
- 34. Covenant to Disclose Misrepresentation • ‘no ambush’ clause – Purchaser reps that it has not become aware of any circumstances which would constitute a breach by the Vendor – Allows Vendor to fix problem or establish that the Purchaser made no reliances • A Purchaser should avoid such clause – SWAT team – Purchaser may not have enough facts to fully understand consequences – Disputes over who knew what
- 35. Pricing • General rule: – The more risk the Vendor retains, the higher the purchase price. – Receiver sales are ‘as is’, so the price is often very low
- 36. Use of Disclosure Schedules • Numerous schedules attached to the agreement: – Vendor discloses material facts – Vendor discloses exceptions to otherwise absolute representations and warranties – Vendor discloses no litigation which has been commenced against the corporation – e.g. ‘Except as set out in Schedule “B” there are no encumbrances against the purchased assets’
- 37. Use of Disclosure Schedules • Time consuming, so not popular with Vendors • However, it is advantageous to Vendor: – Reduces risk of Purchaser seeking indemnifications later – Vendor should consider making over-disclosure • Vendors find completing schedules onerous, so they sometimes take shortcuts • Use cross-references or language that disclosure in one schedule qualifies other schedules or other disclosures
- 38. No Failure to Disclose Representation • Purchasers often use an all-encompassing representation and warranty • Problem: highly risky for Vendor • Solution: – qualify it with knowledge or materiality – specifying that an objective standard applies – except matters such as projections or judgment calls
- 39. Absence of Change in Events • A rep and warranty that there are no changes in the business since the date of the financial statements • These clauses are common in purchase agreements • Clause should be qualified: – Vendor is not responsible for general economic conditions or in conditions in the industry – MAC exceptions
- 40. Multiple Parties • Ensure that reps and warranties are specific to a particular Vendor • Agreements often miss this point • Take great care to review the wording of each rep and warranty
- 41. Bring Down Certificate • A certificate that the reps and warranties are true at the closing date • Risk for the Vendor that, if not true, a claim can be made by the Purchaser for breach • Put in exception that they will be true “except as set forth in a closing certificate” to allow for change – then no breach – Purchaser then forced to waive or not close
- 42. Survival of Reps and Warranties • Most agreements specify that the reps and warranties will survive the closing for a period of time • This is a significant risk for the Purchaser as it loses ability to sue after the survival period expires
- 43. Survival of Reps and Warranties • Purchaser should seek no time limit for the titles, corporate existence, fraud, misrepresentations • Purchaser should seek extended time limit for tax liabilities, interest, or penalities
- 44. Indemnities • Carefully worded indemnity can add significant protection for the Purchaser • At common law, there is no liability for damages that are too remote • Negate common law duty of mitigation
- 45. Indemnities • Indemnities often provide indemnification for actual legal expenses • Prudent Vendor will take steps to soften the effect of the indemnity
- 46. Indemnities • Carve outs: – Punitive and aggravated damages – indirect damages – loss of profits – insurance – tax benefits result – Purchaser could reasonably have mitigated – Recovery from third parties
- 47. Limiting Vendor’s Liability • Consider limiting the Vendor’s liability to a maximum amount: – FMV – Vendor not liable for any amount in excess of the difference between the purchase price to be paid by the Vendor and the fair market value of the Purchased Assets (other than goodwill) • Limit the indemnity to reps and warranties under the purchase agreement or documents delivered at closing • Limits only apply to reps and warranties not covenants • Establish deductibles
- 48. Limiting Vendor’s Liability • Purchaser should ensure that limitations on liability only apply to breaches of reps and warranties • Purchaser should ensure the indemnity states the following: – any breach of a rep or warranty is deemed to be suffered by the Purchaser, dollar for dollar
- 49. Thresholds, Caps and Deductibles • Deductibles ensure that the Vendor is not liable for de minimis claims • Tipping Basket: if the threshold amount is reached, Purchaser can claim for all loss suffered • True Deductible: the Vendor receives the first $X free, and the Purchaser’s claims are limited to those in excess of $X
- 50. Double Dipping • Basket clauses are a risk allocation matter • Purchaser should ensure that the Vendor does not double dip • Double dipping occurs where there is both basket clause and reps and warranties qualified by materiality
- 51. Conclusion • Lawyer’s primary role is to minimize risk • Do not be afraid to question commonly used documents • Success will be heavily dependent on the client’s bargaining position
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- 54. Stay in Touch Thank you for joining us! Verona Thibault President, SEDA @saskecdevassoc @growourregion [email protected] 306-384-5817 Glen Lekach Miller Thompson, LLP [email protected] 306.347.8322