© 2000 A. Paul Mahaffy. All rights reserved.

A. Introduction

Many asset and share purchases fail to close because standard representations and warranties can't be satisfied by the seller, or because eventual recovery from the seller for breach of them would be unlikely. Effective due diligence often reveals risks which a buyer is not prepared to assume, even with a reduction of the purchase price. Although the seller may agree to indemnify the buyer against these risks, the buyer may not want to rely on the indemnity alone. The buyer may want to defer payment of the purchase price until the risks are significantly reduced or eliminated. The seller, however, may not want to assume any risk of non-payment and may instead demand payment of the purchase price immediately without incurring any residual liability.

So what's a business lawyer to do in order to save the deal? Can the parties agree upon representations and warranties that will be enforceable?

Fortunately for buyers and sellers, and their respective counsel, there are available a number of techniques which help the parties to close their deals even though some of the standard representations and warranties cannot be fully satisfied, or there are serious doubts about the creditworthiness of one of the parties to honour post-closing indemnity or installment payment obligations. This article provides a brief overview of some of these techniques.

B. Representations, Warranties and Indemnities

The need for standard representations and warranties

Standard representations and warranties are usually needed to identify the possible risks associated with a deal and to allocate those risks between buyer and seller, especially those risks which aren't easily quantified. If one party's representation or warranty proves to be incorrect, then the other party is entitled to seek compensation. A seller's refusal to give a representation or warranty because it doesn't have the necessary knowledge overlooks this need for risk allocation. However, if the seller does refuse, the buyer may nonetheless choose to assume the risk, perhaps because its own investigations have given it enough knowledge to proceed, or perhaps because the seller is prepared to reduce the purchase price.

Relative importance of certain representations and warranties

Which specific representations and warranties a buyer should demand depend upon a number of factors, including the identities of the buyer and seller, the nature and locations of the business being purchased, the business strategy of the buyer, whether the business operates in a regulated industry, and so on.

Some buyers rely very heavily upon the financial statements and other information provided to them by the seller, whereas others don't. A buyer may already be very familiar with the seller's business, possibly as a competitor, supplier or customer, and may be prepared to rely much more upon its own analysis and investigations and demand much less in the way of representations and warranties from the seller.

Since some representations and warranties are more important than others to any particular buyer, the inability of a seller to satisfy them all may not necessarily jeopardize closing. Just as some assets may seem essential to the success of a business and some liabilities almost catastrophic, other assets and liabilities may be almost irrelevant to the value of a business as a going concern and be regarded by a potential buyer with indifference.

For example, the inability of a seller to warrant that it owns or has a license for all of the trademarks it uses in its business may be unimportant to a buyer who wants the business mainly for its real estate and has no intention of using any of the trademarks after the deal closes. However, a third party easement over the real estate could kill the entire deal. Or the inability of a seller to warrant that its equipment is in good working order and free from encumbrances may be unimportant to a buyer who intends to integrate the operations of the purchased business with its own operations housed elsewhere in more modern manufacturing facilities. Or the inability of a seller to warrant that its lease is in good standing and is assignable may be unimportant to the buyer who intends to relocate the business to another province.

On the liability side, a lawsuit commenced by a major customer might be viewed quite differently from one commenced by a small supplier, just as a products liability claim against a business with strong consumer brands may be viewed differently from an environmental claim against an industrial business, even though the monetary amounts claimed may all be the same.

Indemnities

It is now standard practice to include in a purchase agreement an indemnity clause under which either party will indemnify the other for breaches arising in part from false representations and warranties. The indemnity clause provides better protection for a buyer because it creates an action to enforce a contract, not just an action for damages for breach of contract. It also often sets out the procedure to be adopted by both parties in the event that a claim should arise, including the allocation of responsibility for carriage and cost of defending an action instituted by a third party.

But while providing a more direct cause of action, the inclusion of an indemnity clause in the purchase agreement is not without some risk. A buyer enforcing an indemnity clause, as compared to suing on a breach of a representation or warranty, must preserve the interests of the seller or else jeopardize its right to be indemnified. It must also preserve any rights that may be available to the seller to recover from a third party. Ordinarily indemnity rights can be lost if the seller is not given prompt notice of a claim.

C. Ways to Arrive at Enforceable Representations and Warranties

Qualifying the representation and warranty

If a seller is unable or unwilling to give a standard representation and warranty, and the buyer is not prepared to remove it entirely from the purchase agreement, there are ways of qualifying it to make it suitable for the seller to give. Precise exceptions to a standard representation and warranty can be spelled out, either in the text of the purchase agreement or by way of the disclosure schedules. Or the representation and warranty can be limited as to materiality, perhaps by way of monetary levels. Or, alternatively, it may be limited as to reasonableness, or restricted to the "knowledge of the seller".

Shortening or lengthening the survival period

Most purchase agreements provide for the survival of the representations and warranties after closing to avoid some old case law which suggests that they will otherwise merge on closing. The question usually is how long they will survive after closing. The buyer will ordinarily demand that they should survive forever so that if a breach of warranty is discovered, the buyer can make a claim on it. On the other hand, the seller will seek a much shorter duration, attempting to avoid any residual liability for an extended period and arguing that the buyer should be able to discover any problems within a limited period after closing.

A common starting point in negotiations is to provide that representations and warranties relating to the title of assets exist indefinitely, those relating to tax matters survive until the expiry of relevant assessment or reassessment periods, and those relating to ordinary business matters survive until the end of an appropriate business cycle. However, depending upon how unable or unwilling a seller may be to give a particular representation and warranty, shortening the survival period for it may be enough to induce the seller to give it and allow the deal to proceed. A buyer reluctant to proceed, by contrast, might be encouraged to commit if the survival period for a particular representation and warranty is extended well beyond the period which would ordinarily apply.

Closing audit

The use of a closing date audit may help to dissuade a buyer from seeking overly extensive representations and warranties, or help to deal with a seller's request to remove or qualify them. Any liabilities which might arise or increase from the date of the latest audited financial statements of the purchased business will presumably be disclosed in the closing date audit. Depending upon what the audit reveals, a post-closing purchase price adjustment or recourse to a holdback fund may then take place.

Holdbacks, earn-outs and other deferred payment schemes

A buyer is ordinarily concerned about how financially viable a seller will be after a deal closes and whether the seller will have enough funds to satisfy a breach of warranty claim. This concern is increased when the seller, having sold its business, is likely to become a corporate shell or be wound up and dissolved after the sale.

Such concern often results in a demand for a deferral of at least part of the purchase price, either as a series of installment payments or as a reserve or holdback fund against which any claims a buyer is entitled to make for breach of warranty may be set off. On closing, the deferral is often evidenced by a promissory note for the balance of the purchase price.

Instead of demanding a deferral by paying in installments or holding back funds, a buyer may demand an "earn-out" arrangement under which the purchase price is only paid out of, or is adjusted to reflect, the income actually "earned" by the purchased business after the deal closes.

For a seller who is prepared to receive the purchase price from the buyer in installments, there is the possibility of having to sue the buyer in the event the buyer defaults in payment of an installment and appears unwilling or unable to pay the balance owing. In the event the buyer becomes insolvent, the seller may rank merely as an unsecured creditor, unless the promissory note which is usually taken is otherwise secured.

Taking security

To avoid the possibility of ranking only as an unsecured creditor of the buyer, the seller may take back security for all or a portion of the unpaid purchase price. In an asset purchase, the seller may take a mortgage on the purchased freehold lands or a general security agreement over the purchased assets, either in first position or behind the financial institution providing an operating line of credit or other funding. In a share purchase, the seller may take a pledge of the purchased shares until the purchase price is paid in full.

Since a buyer relying upon the indemnity of the seller runs the risk of ending up as an unsecured creditor of the seller, similar security from the seller may be demanded by the buyer before proceeding to close. Given the possibility that the seller may be become merely a corporate shell without any assets, a buyer may instead demand credit support from third parties.

Guarantees from creditworthy related parties

If a buyer is unwilling or unable to charge assets or pledge shares as security for the balance of the purchase price, the seller may be prepared to accept the guarantee of a company related to the buyer as alternative security. If a seller will have insufficient assets to support its own indemnity after closing, the buyer may be prepared to accept a guarantee from a company related to the seller. Guarantees may be limited to a specific value or may be unlimited to cover all potential obligations.

Although the financial assistance prohibitions of section 20 of the OBCA have been removed, care must still be exercised when considering the use of a guarantee or other financial assistance from a CBCA corporation (although Bill S-19 proposes the removal of the section 44 prohibitions). Such financial assistance is void unless it falls within certain statutory exceptions or the corporation can meet a stated financial test. Generally speaking, a wholly-owned subsidiary may guarantee its parent corporation and a parent may guarantee its subsidiary, but sibling corporations cannot guarantee each other unless the test is met. Furthermore, whether specific financial assistance prohibitions exist or not, the directors are still subject to their fiduciary duty to determine that the financial assistance is in the best interests of the corporation to give.

Guarantees, indemnities or bonds from financial institutions

In offering credit support to buyers and sellers by way of letters of guarantee, letters of credit, and performance bonds, financial institutions can help to ensure that the purchase price will still be paid despite a default by the buyer, or that an indemnity obligation will still be met by the seller.

For example, if a portion of the purchase price is to be deferred, a letter of guarantee may be issued by a financial institution in favour of the seller to ensure that payment of such portion is made. A letter of guarantee is usually an irrevocable and unconditional contract to pay when a demand for payment is made. Unlike documentary letters of credit which are ordinarily used for import / export transactions and which require certain prescribed documents to be presented to the financial institution before payment can be made, letters of guarantee are often paid simply upon demand. They are also often fully secured by liquid investments before being issued. A fee of 2% per annum of the letter of guarantee amount is normally charged.

Escrow agents

Instead of deferring payment of the purchase price, a buyer may be required to pay all or part of the purchase price on closing to an escrow agent. An escrow agent is ordinarily a neutral party such as a trust company appointed by a buyer and seller to hold cash, securities and other property in safekeeping until certain events take place. The escrow agent is responsible for ensuring that the conditions precedent to the release of the property are indeed met before such release. The escrow agent may not only hold the property in safekeeping following the closing of an asset or share purchase, but may also invest the property in accordance with investment instructions, and provide timely reports and prepare necessary financial and taxation statements.

Ordinarily an acceptance fee (often around $2,500) will be charged by the escrow agent for reviewing the escrow agreement and any related documents, entering into the escrow agreement, and attending any pre-closing and closing meetings. Thereafter an annual maintenance fee will apply (again around $2,500 for securities held, possibly more for large cash balances), plus transaction fees for any investments bought or sold and reports rendered.

M&a insurance

As a way of reducing or replacing a contentious indemnity clause or any escrow requirements otherwise imposed upon a seller in a purchase agreement, m&a insurance is available from a number of commercial insurance companies that have dedicated m&a practice groups. Some of these specialized policies provide representation and warranty coverage which effectively transfers the risks addressed in a purchase agreement's representations and warranties to an insurer. Premiums for this type of coverage generally range between 3% to 7% of the policy limit.

Other policies provide litigation buy-outs or cost caps in order to limit the exposure faced by a buyer when buying a business subject to a large lawsuit. These policies allow the parties to a deal to arrive at a monetary cap on all potentially uninsured or underinsured liabilities by transferring the litigation to an insurer with a one-time premium that is factored into the cost of the deal. The deal can then be closed without fear that unanticipated claims expenses may adversely affect the earnings of the purchased business after closing. The premium for these policies will depend on the nature of the underlying risk.

All of these policies are highly manuscripted to ensure that they mirror the underlying deal, and can be purchased by either buyer or seller. Representation and warranty insurers will use their own lawyers for due diligence and ordinarily review a copy of the purchase agreement, financial statements of the buyer and seller, and a copy of the due diligence information requested and received between the buyer and seller. Insurers providing a litigation cost cap will usually review the relevant court documents. For all of these policies, the insurers will generally not subrogate against the insured parties unless there have been intentional misrepresentations to obtain coverage.

D. Conclusion

While the foregoing techniques may not ensure that every deal closes, or every seller gets paid, or every buyer receives fair compensation for false representations, they at least increase the likelihood of such things happening. As business lawyers, we would be grateful if all of our deals closed.