Co-authored by Radhika Arora.
With the Kenyan banking sector being brought into the spotlight for a projected increase in Mergers and Acquisitions (M&A), it is important for businesspersons to have a basic understanding of this type of transaction. Buyer protection in any M&A is at the forefront and is also the reason that any Share Purchase Agreement (SPA) in a majority of cross-border transactions is composed primarily of the seller’s representations and warranties. The need for this protection is particularly enhanced when there is more than one potential buyer involved in the transaction from the outset, as multiple potential buyers give the seller a chance to sway the representations and warranties in the SPA to its favour, leaving the buyers vulnerable in the event that the target company does not perform as projected.
The scope and detail of these representations and warranties are often heavily negotiated and tailored to reflect not only the essence of the target company and its business, financial status and operations, but also the relative negotiating strength of the buyer and the seller. Representations and warranties also help in providing information to the buyer, thereby allowing for a fair allocation of risk between the contracting parties with respect to the matters covered by the representations and warranties.
Representations and warranties, for purposes of simplicity, may be defined as “promises” – they are the contractual tool that buyers and sellers use in an M&A transaction to allocate the risk of any imperfections in the deal. On the other hand, indemnities serve as “protection” to the buyer for issues related to the target company that are discovered during the due diligence. What are some of the important representations, warranties and indemnities that a buyer should look out for within an SPA?
Balance Sheet Warranties
The balance sheet warranty in an SPA is arguably the most important warranty for a buyer, as it paints a complete picture (to the extent possible) of the financial standing of the target company. It normally entails a warranty over all, or at least the important, balance sheet data. However, it is common practice to extend the warranty to the income and loss statements of the target company, as well as to the notes in the financial statements.
A diligent buyer to a transaction should ensure that he is not only receiving a subjective (soft) warranty but also an objective (hard) warranty. The difference is that the seller´s objective warranty confirms that not only has he complied with applicable law, but also that the balance sheet is objectively true, and thus gives a complete and fair view of the assets, financials and earning position of the target company. Furthermore, objective warranties are governed by the law of strict liability, which means that a buyer can bring an action against the seller regardless of whether or not the defect in the target company that accrued and was linked to the balance sheet was the direct fault of the seller. A subjective warranty on the other hand, confirms that the provisions of the balance sheet warranty are in compliance with applicable accounting principles.
It should also always be borne in mind that balance sheet warranties do not extend to the period between signing and closing of the transaction, which means there is often a period (usually a couple of months) where if the situation of the target company changes, the buyer will have little or no protection. In such a situation a diligent buyer should request a “closing balance sheet” which covers this period. Monitoring the performance of the target company during this period, and comparing the returns on the closing balance sheet to the last audited balance sheet, will allow the buyer to ascertain with confidence that the target company is performing as was projected. In the event that the target company does not perform to the standards expected, the closing balance sheet places the buyer in a favourable position to be able to negotiate the purchase price downwards.
Materiality and Knowledge Qualifiers
In negotiating the SPA, the seller and the seller’s lawyers will have an incentive to keep the representations and warranties as narrowly drawn as possible. The buyer, on the other hand, would want full coverage for any possible eventuality and so would ideally want the representations and warranties to be as broad as possible. One way through which a seller tries to limit liability is to qualify the representations and warranties to its “knowledge” or “materiality”.
Materiality qualifiers entail the use of phrases such as, “could reasonably be expected to have a material adverse effect.” Phrases such as these immediately protect the seller for any eventuality that could not reasonably have been foreseen by a third party, or eventualities which to the buyer would be a major development but to the seller are not “material” enough as to warrant a reduction in the purchase price or indemnification from the seller.
Knowledge qualifiers are phrases such as, “to the best of the seller’s knowledge.” Once again, as in the case of materiality qualifiers, these protect the seller from any legal issues that may arise which could not reasonably have been foreseen.
It is therefore important for a buyer to be prudent when reviewing the SPA and to ensure that all connotations of materiality or knowledge are taken out from the seller’s representations and warranties, so as to achieve complete coverage and protection even after the transaction is complete.
Tax is notoriously known to be one of the most contentious areas of any M&A transaction, as tax liabilities are hard to predict with absolute certainty and often entail the buyer taking a substantial risk. The ideal scenario with respect to tax indemnities would be for the buyer to get full protection in the event of any pre-closing tax liability, arising subsequent to completion. In Kenya however, this is still an emerging area of the law that is yet to be formally legislated upon. Buyers and sellers will usually negotiate the period of time to which the liability for tax extends.
Tax indemnities have the reputation of being the part of any SPA where the buyer’s and seller’s lawyers will have to employ their most savvy contracting techniques, especially where it is a cross-border deal. Ordinarily, the process of sending repeated amended drafts of the SPA to and fro will be quite intense as both sets of lawyers attempt to secure the best deal for their respective client. The buyer’s lawyer in this situation will usually have close contact with the target company’s auditors so as to ensure that every problem flagged during the due diligence is covered by a specific indemnity to protect the buyer.
These are provisions within the SPA that limit the amount of exposure the target company, or the buyer, might face in the event that a claim is made against the target company.
Firstly, the buyer must look out for the “survival period” clause in the SPA that dictates the length of time within which a claim may be brought against the seller for any eventuality arising out of the status of the target company as at the time of sale. As a buyer, one should always try and maximize the amount of time to bring a claim, bearing in mind that core provisions (such as ownership of shares in the target company) warrant longer survival periods.
Another important liability limitation to look out for as a buyer would be the “caps”, which are the maximum liability clauses. Indeed it is argued that these are often the single most important clauses in the entire SPA. The main aim as a buyer would be to try and secure as high a cap as possible to ensure maximum protection.