Several recent experiences in midmarket M&A transactions have caused me to insist on an unusual representation and warranty from Buyers. In some cases, buyer’s advisers are likely to conduct such extensive due diligence investigations that the Buyer may having more knowledge about the target company’s weaknesses than the seller may be aware of.
In the three instances described in this article, the law firms representing the buyer were top-tier firms of at least 500 lawyers. In two of those cases it was my personal opinion that the conduct of the lawyer representing the buyer came close to the line of “sharp practice” if not actually crossing it.
The first instance involved a sale by my client, a regulated financial institution, of a business unit that operated through brokers. At the very last minute in the negotiation of the purchase and sale agreement, counsel for the buyer asked for an adjustment clause to deal with closing date differences in accounts between the selling entity and its brokers. This was a reasonable request, was discussed with the client regarding the possible scope of the adjustments, and the requested adjustment provision was provided.
Three months after closing, the buyer produced a calculation that resulted from its audit of the purchased business segment, showing aggregate adjustments of $500,000 in accounts of 15 of the seller’s brokers. The nature of the adjustments disclosed in such audit was such that, in my view, there was no doubt that the buyer was aware of the amount that was ultimately claimed, and I informed buyer’s counsel in fairly blunt terms to that effect. My sense was that had either counsel or his client not been aware of the potential amount of this adjustment, his response would have been laced with righteous indignation. I must admit that I did stop short of accusing buyer’s counsel of dishonesty, but I did not hesitate to use the expression “sharp practice” in referring to his request for a “so-called adjustment” provision. I made it clear that if they proceeded with a claim, our position would be that, as a result of their due diligence they knew about the potential adjustment, and their innocuous request for an adjustment provision would be seen for exactly what it was. The request for payment of the adjustment was denied and the buyer was invited, if they thought their position was justified, to commence an action based on the adjustment provision in the purchase and sale agreement. No action was taken by the buyer in the circumstances. I believe that while they might have succeeded in any action, their industry reputation was at risk of being sullied.
As a result, I began to ask, in all sale transactions, that the buyer provide a representation and warranty that “in the course of conducting their due diligence, including any due diligence by their accountants, financial advisors and counsel, they have not become aware of any representation or warranty given by the seller being untrue or inaccurate in any material respect.” The provision went on to state that the buyer was obligated to notify the seller of any such finding, and that if the buyer had knowledge of any such inaccuracy, the buyer could not seek damages from the Seller on the basis of such inaccuracy.
The next sale transaction that I had involved one of my major clients selling a wholly-owned subsidiary to a US buyer that operated in a similar market niche. While the client was highly interested in selling, the instructing officer of the client agreed with me that a refusal to provide such a representation and warranty indicated that the buyer wanted to keep its options open and was looking for a “Gotcha.” When the buyer realized that the seller was prepared to walk in those circumstances, the buyer agreed to provide such representation and warranty, and negotiation of the final provision resulted in the seller agreeing that the onus of establishing that the buyer was in breach of such representation or warranty would rest with the seller but that the buyer was under an obligation to produce all due diligence documents created by its advisors. In addition, the seller could not rely on a breach of such representation and warranty to claim damages but only as a defence against a claim for damages by the buyer. As the expression goes, the seller could use this as a shield but not a sword. The transaction proceeded to closing and the requested representation and warranty ended up being moot.
Not so in the third circumstance. In the sale of a $30 million industrial service business, the US buyer of the Canadian operation refused to provide the requested representation and warranty even with the protective features referred to above. The transaction involved an asset sale by a private corporation with three shareholders, none of whom appeared to be concerned with the risk of giving the buyer a “Gotcha.” After cautioning the shareholders of the risk and reviewing each of the representations and warranties in significant detail, the sellers instructed me not to insist on the representation and warranty that I felt was necessary. The buyer insisted on a $2 million holdback, an amount that was not unreasonable, given the value of the transaction. In the course of leading up to closing, buyer’s counsel inundated our firm and the sellers with a series of slightly modified draft agreements of purchase and sale, every one of which required a significant investment of time. In hindsight my cynical mind interpreted this as an intentional strategy to ensure that the sellers did not look for where they might be at risk.
Sure enough, three months after closing the buyer came up with a closing audit report that showed just slightly less than $2 million worth of adjustments. In my discussions about such adjustments with counsel for the buyer, it was clear to me that he knew about the skeletons in the closet and it was for that reason that they so strongly resisted providing the requested representation and warranty. The claims for indemnification were resisted through an arbitration and the amount of the holdback that eventually went to the buyer was compromised, but not without considerable aggravation for our clients.
In subsequent sale transactions where I have requested this representation and warranty, the usual response has been “that’s not market practice” or “we just want to rely on the seller’s representations and warranties.” My response has always been: “That may not be your market practice but it’s mine.” While I have left the final decision to the client, where the client has opted not to push for such provision, I have insisted that the client sign a letter waiving any claims that might arise as a result of not including such provision and that the client has been fully satisfied with the accuracy of its business representations and warranties.”
Fortunately, the experience described above regarding the sale of the industrial service business has not repeated itself recently.
When I started to practice law 52 years ago, I would never have thought it necessary to include such a provision in any sale agreement. I do not have the same attitude toward the profession today.
Seller beware.