in any M&A transaction between the transaction parties. Depending on the structure of the transaction in question and the circumstances surrounding it, M&A practitioners have access to a number of different tools to assist the parties in risk allocation. Once specific risks have been identified, creative combinations of these tools can often be used to bypass negotiation deadlocks and create a risk allocation structure that permits the deal to go forward in a manner acceptable to all parties.
In order to properly allocate risks, the parties, in particular the buyer, must have a common and detailed understanding of the various legal, financial and business risks affecting the M&A transaction. The primary source of this information is usually the buyer’s due diligence of the seller. Other important sources are often the buyer’s knowledge of the seller’s industry and the associated legal and financial environments.
Once risks are identified, each party must evaluate the potential exposure inherent in each identified risk and the impact of that exposure on the overall value of the M&A transaction from the point of view of that party. Risks can then be allocated among the parties using the tools described in this article.
The first, and most obvious, tool for allocating risk is the purchase price itself.
In the ideal world, the purchase price agreed upon by the parties would take into account all known risks associated with the proposed transaction and the quantifiable exposure associated with those risks.
Certain types of unquantifiable exposure can also be allocated by making some portion of the purchase price contingent on the occurrence of certain events. Contingent price mechanisms (often referred to as
‘earn-outs’) are usually used to allocate business and financial risk and are often tied to the target’s quarterly or annual financial results (e.g., earnings, revenues, etc.) for some period following the closing of the transaction. Often, the additional purchase price paid in connection with an earn-out is calculated using a formula based on the specific performance measures with a minimum level of performance required for any payment and an overall cap on the total payment amount. Earn-outs can also be tied to specific business goals such as the retention of certain employees or customers or meeting production targets during a defined period. In truth, an earn-out can be tied to any risk factor associated with the target business as long as the results on which it is based can be adequately defined and verified.
Another effective pricing tool is the post-closing purchase price adjustment. These adjustments are used to increase or decrease the purchase price (via a ‘true up’ payment
g risk allocation – driving force behind the m&a process
by walt lemaNSKi
from one party to another) at some point after the closing of the M&A transaction in order to allocate risk associated with one or more matters, usually financial, that affect the value of the target and cannot be precisely determined prior to closing.
Frequent uses include adjustment for unexpected changes in the current assets and/or liabilities of the target (often referred to as a ‘working capital adjustment’),
valuation of inventory or even the costs associated with certain events expected to occur after the closing, such as settlement of litigation.
While in theory adjustment of the purchase price would seem to be the ideal way of handling risk allocation in an M&A transaction, in practice many factors affect this tool’s utility. First, the purchase price is often agreed upon early in the process (often in a letter of intent) when a significant part of the information necessary to determine risk is not yet available to the buyer and, in some cases, may not even be known by the seller.
Once this information becomes available, sellers are usually reluctant to accept any reduction in the agreed upon purchase price. Also, many risks may not be known at the time of the closing or the potential exposure may not be quantifiable in a way that lends itself to a pre-closing purchase price adjustment. Even contingent price mechanisms and post-closing purchase price adjustments are inherently limited in the types of risks they can effectively allocate, and can be very difficult to implement in public company acquisitions. As a result, practitioners often need to look to other risk allocation tools.
Risk can also be allocated through the legal structure of the M&A transaction. Whether a transaction is structured as an equity or asset acquisition, merger or some type of
hybrid will, as a matter of law, affect whether the buyer acquires or the seller retains a number of risks. Asset acquisitions generally favour the buyer with regard to most risks while equity acquisitions are usually more favourable to the seller. To a large extent, risk allocation in mergers is defined by the applicable state statute. While in many circumstances the structure of an M&A transaction may be predetermined by overriding factors such as tax, regulatory or contractual considerations, the parties should nonetheless be mindful of the risk allocation effect of the deal structure and, where possible, adjust the structure to meet risk allocation considerations. Even where the overarching structure is predetermined, it may be possible to take advantage of a multi-step or hybrid transaction to allocate specific risks. As an example, it may be possible to assign certain assets or liabilities (and thereby allocate the attendant risks) to a subsidiary of the target and subsequently spin off the subsidiary or distribute the assets and/or liabilities directly to the target’s
owner.
If a risk cannot be allocated through either a purchase price or structural tool, there are also a number of contractual tools available.
To the extent that allocation of a risk requires one or more parties to perform certain
actions after the closing of the transaction, the transaction documents should contain covenants specifying the actions to be taken and the associated timeline for compliance.
Allocation of unknown or general risks and confirmation of actions required to be performed prior to closing can normally be accomplished through appropriately devised representations and warranties. To be most effective, representations and warranties should not be generic but should be tailored to the applicable industry, regulatory and financial environment and specifics of
the target identified through buyer due diligence.
Contractual representations, warranties and covenants allocate risk by providing a contractual remedy to the injured party.
While a breach of contract claim is one way to enforce this remedy, a far more common approach in M&A transactions is for the parties to provide indemnification in the event of a breach. The indemnification tool is very flexible and can be tailored to further allocate transaction risk. The intent of indemnification is to make a party whole for damages suffered in connection with the occurrence of a risk it did not assume.
However, indemnification is generally subject to limitations on the minimum amount of damages required to make a claim (usually referred to as a ‘deductible’
or a ‘basket’ depending on its structure), the maximum liability of the paying party in connection with the transaction or, less commonly, each claim (usually referred to as a ‘cap’), and the period of time after the closing during which indemnification claims can be made (usually referred to as the ‘survival period’). The values of the deductible or basket, cap and the length of the survival period have an important effect on the overall allocation of risk between the parties and are usually the subject of heavy negotiation. Allocation of specific risks can be tailored with an individual deductible, basket, cap and/or survival period or by agreement that indemnification relating to a specific matter will not be subject to any limitation at all. In addition, special indemnification mechanics can be created for known risks to handle a claim in a way tailored to a party’s exposure to the specific risk. For example, a special indemnification provision relating to an ongoing litigation matter of the target might provide that the seller will indemnify the buyer for 100
percent of the costs to the buyer of such litigation up to a fixed amount after which the buyer will be liable for 50 percent of any further costs. While certain studies suggest, and some practitioners will assert, that certain combinations of indemnification terms and limitations are ‘market’ for particular transactions, parties should resist relying on such a crutch and carefully consider indemnification terms in the context of the desired overall risk allocation.
As a practical matter, contractual
indemnification or similar remedies are only as valuable as the ability of the obligated party to pay. In transactions where the obligated party will have deep pockets after the closing, satisfaction of a claim is not usually a problem. In situations where a party’s ability to pay is less certain, various mechanics are available to protect the interests of the other parties including purchase price holdbacks (which provide a source of remedy for a buyer) or escrows (which can be used to protect a buyer or, less commonly, a seller). Terms for the release of funds from either of these payment
mechanisms are also very flexible and can be tailored to fit into the overall transaction risk allocation.
Risk allocation in an M&A transaction is one of the driving forces behind the M&A process. Many tools are available to the practitioner to allocate transaction related risk between the parties. The key is to consider all of the tools available and to carefully tailor them in the context of the entire transaction to achieve the desired result.
Walt Lemanski is a partner and co-chair of the Securities and M&A practice at Patton Boggs LLP.
The Indian Companies Act is modelled on the Companies Act, 1948 of England.
The directors of a company, as natural persons, are entrusted duties, functions and obligations to be discharged for the benefit of the company and its shareholders. A director in modern company law has duties of a fiduciary to the shareholders, but in times of adversity or impending insolvency, they have an obligation to act fairly
and protect the interest of the secured creditors also. As directors, they have the duty to exercise reasonable skill and diligence expected of an ordinary person, in the carriage of the duties and functions owed to the company, other directors and shareholders.
In an M&A transaction, which concerns either a sale of shares, or a sale of
undertaking or a takeover bid, or a related party transaction or stock options in the course of the M&A as consideration for directors, the duty of fairness, good faith and honesty is paramount. Indian law recognises that it is not merely pecuniary interest which determines the contours of conflicts of interest. Any angularity or skew brought to bear on matters of interest whether of a pecuniary nature or of relationships are also abhorrent. The directors have a duty to disclose their interest, the degree of relationships and their financial shareholding and stake in the company and in any transaction or transfer.
Under Indian law, any corporate transaction involving the sale or transfer of the whole
or part of an undertaking of the company requires an ordinary resolution of the shareholders in general meeting. The law mandates that a complete disclosure is made in the Explanatory Statement accompanying the Notice for the meeting convened for approval of the proposed transfer. This position also inures in relation to a Scheme of Amalgamation, demerger, slump sale or exchange through courts or otherwise or when the undertaking is sold as a going concern. In the absence of full and fair disclosure in the Explanatory Statement indicating all nature of interest of the directors, an aggrieved shareholder could petition the company court or the Company Law Board (expected to be converted to a Company Law Tribunal) for action to set aside the decision and sue directors for misfeasance, malfeasance or nonfeasance, as the case may be.
Indian law does not recognise that a
shareholder is conflicted in casting his vote in support of a corporate decision carried out through a vote. Thus though directors may be entrusted with a fiduciary duty and obligations of fairness, honesty and good faith, a shareholder can vote in its own interest.
The law recognises that a director with an interest has to recluse himself from the process of decision making at the level of the board or any committee of the board. This also holds true when takeover of management and control in a listed company is attempted and there are