Good deals gone bad lessons learned from recent M&A disputes
22 March 2023
22 March 2023
The global economic outlook in 2023 is bleak. Ongoing geopolitical tensions between the US and China, increasing inflation, lasting disruptions to supply chains and the war in Ukraine are but a sample of news items that continue to dominate headlines. Against this backdrop, the Financial Times recently reported that some of the world’s biggest companies are facing multibillion-dollar write-downs on recent acquisitions, as the era of frenzied dealmaking gives way to increasing economic uncertainty.
Unsurprisingly, the number of disputes over M&A are expected to increase. So, what happens when a good deal goes bad? In this article, we provide an introduction to the types of disputes that commonly arise in a cross-border M&A context, followed by some lessons learnt from recent matters.
M&A disputes are as varied as the deals that give rise to them. They turn on factors such as the type of company involved, the jurisdictions and industries in which they operate, the acquisition structure (e.g., share sale, asset sale and merger, etc.), the sale process (e.g., auction sale or private treaty) and, of course, the terms of the acquisition documents (including things like the governing law). That said, we see certain types of disputes arising more commonly than others.
While many acquisition agreements are signed and closed simultaneously, others impose a gap between signing and closing where certain conditions must be fulfilled before the target can legally be transferred. These conditions vary considerably but can include the need to obtain foreign investment approval, approval from competition authorities, approval by shareholders, waiver of pre-emption rights, consents from contractual counterparts (particularly where there are change of control restrictions) and discharge of security over the target’s assets or shares.
Satisfaction of these kinds of conditions are often included as conditions precedent to the closing of a deal. Commonly, the parties are also obliged to use their ‘reasonable endeavours’ (or similar) to satisfy those conditions precedent for which they are responsible.
Disputes can arise over whether or not a conditions precedent has been satisfied (particularly where the drafting is vague as to exactly what is required and by whom) or, if the conditions precedent is clearly not satisfied, whether the party responsible used its reasonable endeavours to satisfy it. When economic conditions deteriorate, these disputes are often tinged with allegations that the relevant party (usually the buyer) purposefully undermined achievement of the condition in an effort to get out of the deal.
Similarly common in deteriorating economic conditions are disputes over ‘material adverse change’ clauses. These clauses again feature where there is a gap between signing and closing and give the buyer the right to withdraw from the acquisition if there is material adverse change in relation to the target within a specified period (usually between signing and completion).
The precise definition of what constitutes a ‘material adverse change’ is crucial to the operation of such a clause and disputes in this area unsurprisingly turn on its interpretation and whether the relevant changes relied on by the buyer fall within it. Is the relevant change sufficiently ‘material’ and ‘adverse’ (usually assessed on an objective basis, by reference to the impact and duration of the event)? Does the change fall within the scope of any express carve out (such as for changes in general economic conditions that affect everyone in the industry)? Did the relevant circumstances already exist at the time of signing and therefore not constitute a ‘change’?
More often, disputes arise after closing. Most common are disputes over alleged breaches of warranties – statements made by the seller as to the state of the business or the information provided about the business (e.g., its accounts). When those statements turn out to be false, a buyer may seek to claim for the resulting loss from the seller by way of damages. These disputes often turn on the scope of the warranties, whether the relevant facts were already disclosed (something which usually precludes a claim), whether the facts were within the knowledge of the seller or its officers (a common qualification on warranties), and the operation of other limitations on liability like time limits, materiality or de minimis thresholds, and liability caps.
Where more specific risks are identified during the due diligence phase of a transaction (e.g., threatened third-party claims against the target), these are more appropriately covered by indemnities – a provision under which a seller promises to keep a buyer whole if the specific risk eventuates. Disputes again turn on the scope of and limitations on the indemnity as well as process issues like whether the seller was provided adequate notice of and consulted in dealing with the relevant loss (especially where there are provisions entitling the seller to participate in the defence of a third-party claim).
Increasingly, warranty and indemnity disputes are being funnelled to insurance underwriting departments as buyers take out warranty and indemnity (W&I) insurance and sellers seek to make W&I insurance the exclusive recourse for certain warranties and indemnities.
Sometimes it is discovered post-closing that a seller failed to disclose critical information which materially impacts the value of the target. This gives rise to claims that the buyer would not have proceeded with the deal had it known the information or that it has significantly overpaid for the target.
Disputes in this area turn significantly on the governing law of the transaction agreements. Some civil law systems impose general obligations of good faith which require a party to disclose critical information about the target during negotiations. A failure to disclose very often prompts a claim for the resulting loss. This is not typically the case in common law jurisdictions, which adopt a ‘buyer beware’ policy, limiting the scope for claims against the seller for non-disclosure of information. Buyers are often limited to alleging fraudulent misrepresentation, a notoriously difficult claim to advance and prove.
The purchase price is one of the most hotly negotiated terms of any deal and often remains a point of friction well after signing. This friction typically comes in two different forms, as outlined below.
First are disputes over the operation of mechanisms which seek to adjust the final purchase price to account for changes in the value of the target between the time of signing and closing, usually as a result of changes in working capital, debt or other financial metrics during that period. These disputes often turn on disagreements as to applicable accounting principles and are highly technical, often being resolved by an accountant through an expert determination procedure.
Second are disputes over earn-out mechanisms, where all or a portion of the purchase price is deferred and determined based on how the target performs over a defined period of time (commonly by reference to profit). Disputes often turn on the measurement of the target’s performance against defined benchmarks (usually a complex question of accounting) and the impact of the buyer’s conduct on that performance (including whether the buyer complied with obligations to operate the business in certain agreed ways post-closing).
So what are the lessons learned from recent experience of these and other types of M&A disputes?
First is the importance of time and money spent upfront in conducting due diligence and contract drafting. We often see parties attempting to limit these exercises to save time and cost but without acknowledging the false economy that this can create. M&A disputes are inflamed and prolonged when risks are either not identified or inadequately bottomed-out in due diligence exercises and subsequently not clearly allocated in the purchase contracts. Comprehensive due diligence and clear risk allocation are always the best way to prevent disputes.
A related point is the importance of clear and effective drafting of dispute resolution provisions in the relevant purchase agreement and ancillary agreements like transitional services agreements. Cases become mired in time consuming and expensive jurisdictional battles as a result of ill-advised attempts to send different types of disputes to different decision makers (acknowledging that the use of accounting experts for certain types of disputes is standard practice), requirements to engage in long and complicated procedures as conditions precedent to commencing formal proceedings, and failures to consider the likelihood of disputes arising under related agreements and the need to provide for those disputes to be heard in a single forum. Hard-fought rights are only as good as the dispute resolution clause included to enforce them. It pays to treat these provisions as more than just standard boilerplate.
Third, parties would be well-advised to take note of notice clauses. Numerous rights in the M&A context, including under warranty and indemnity provisions, can be conditioned upon the proper delivery of contractual notices. Ignore these at your peril, particularly in common law-governed contracts where non-compliance with such notice provisions can deprive you of substantive relief. Pay close attention to requirements as to the form, content, timing and method of service of notices and engage lawyers early to ensure compliance.
Finally, engage experts early. That means both legal experts tasked with advancing the case and accounting experts crucial to resolving disputes around things like purchase price adjustments, earn outs and the quantum of loss. The earlier experts are engaged, the earlier the merits of the case can be assessed, and the earlier steps can be taken to resolve the dispute, including by way of settlement. These experts should ideally be independent of the organisation, so as to provide dispassionate assessment not coloured by involvement in (and potentially the need to deflect blame for) the circumstances leading to the dispute.
Authors: Michael Weatherley, Partner; Julian Lim, Associate