Risk management in M&A
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How is risk managed in M&A transactions?
Recent news articles have highlighted the impact of Brexit and its associated uncertainties on deal activity in the mergers and acquisitions (M&A) space in Britain. Nonetheless, uncertainty is no stranger to an M&A transaction and parties have for a long time relied on warranties (among other contractual protections) to mitigate some of the risks inherent in an M&A transaction.
1. The need for warranties in M&A transactions
In the context of an acquisition of shares or assets of a business, the principle of caveat emptor or "buyer beware" applies. There is limited protection under statutory or common law for a purchaser if the bargain turns out not to be what is expected, unless it is a case of misrepresentation or fraud which is often difficult to prove. In order to mitigate this risk faced by the purchaser, there is a need for contractual statements in the form of warranties which are contained in the acquisition agreement.
2. What is a warranty?
A warranty is a promise in a contract which, if proven to be untrue, may give rise to a claim in damages against the warrantor for breach of contract. In the context of M&A transactions, warranties are factual statements contained in the acquisition agreement generally in relation to the target's business and profitability, as well as assets and liabilities.
The two main purposes of warranties in an M&A transaction are (i) to elicit information about the target by compelling the seller to disclose as much as possible against the warranties, and (ii) as a mechanism for risk allocation by providing the purchaser with a contractual remedy if the assurances given prove to be incorrect and the value of the target is consequently reduced.
3. Managing risk through warranties
In light of the above, warranties in an acquisition agreement are often the subject of intense negotiations between the purchaser and the seller. Here are some categories of warranties of which a seller will generally be very wary or cautious at first instance.
Forward-looking warranties - these warranties are tricky because they are by nature impossible for a seller to disclose against.
Warranties that require a value judgment in order to determine if disclosure is required - these warranties contain vague or ambiguous language that may prove problematic should the parties disagree on its interpretation upon the discovery of a potential breach. An example would be a warranty on the existence of contracts entered into by the target which contain onerous terms.
Duplicated or overlapping warranties – such duplication or overlap, whether in the same specialist area (eg, intellectual property or real estate) or across different areas, should be eliminated so the substance of a particular commercial position is only negotiated once. Otherwise, the position that either party has secured may be undercut or contradicted by a duplicated or overlapping warranty.
Warranties whose subject matter is not important or relevant - depending on the type of company or asset being acquired, the inclusion of certain warranties may not be appropriate or relevant. For example, warranties on physical stock in a warehouse would likely be irrelevant if the target is a financial services firm.
Incomprehensible warranties - These warranties should be deleted at first instance as it is impossible to advise on or disclose against a warranty that is not understood. Such warranties may be common in emerging market transactions in which legal advisers are drafting in a language that is foreign to them. The parties should therefore seek further clarification.
Jerrold Yam is an associate at Baker McKenzie.