[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights.]

As a leading shareholder representative for merger and acquisition transactions, we have collected thousands of data points on terms and conditions from our deals (with data and analysis available in our Forsite™ M&A Deal Tool).  In analyzing the data, we have seen a dramatic shift in the survival period for the “fundamental” representations and warranties in merger agreements.  As explained below, this has occurred in response to a ruling by the Delaware Court of Chancery in late 2014.

As background, when negotiating merger and acquisition transactions, the buyer requires the selling company to make multiple representations and warranties regarding, for example, its financial condition, the adequacy of its intellectual property rights, the absence of litigation and claims, and other matters of importance to the buyer.  The buyer then requires the selling shareholders to indemnify the buyer for any losses it incurs based on breach of those representations and warranties.  The seller, seeking finality around the transaction on behalf of its shareholders, negotiates for a limited window post-closing (the “survival period”) during which the buyer may seek indemnification for any such breach.

Our data in the Forsite™ M&A Deal Tool shows that the survival period for representations and warranties is predominately 12 to 18 months, with little variation outside of that range over the past three years.

The buyer, however, will require that certain “fundamental representations” survive beyond that survival period.  Fundamental representations may include matters such as the seller’s capitalization, payment of pre-closing taxes and any breach of representations and warranties based on intentional misrepresentation or fraud.  Historically, those fundamental representations survived indefinitely:  if the buyer at any time in the future suffered a loss based on breach of a fundamental representation, the buyer could seek redress from the selling company shareholders.

In late 2014, the Delaware Court of Chancery issued an important ruling impacting the survival period of fundamental representations.  In Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc., C.A. No. 9405 (Del. Ch. Nov. 26, 2014), the Court ruled that indemnification obligations in a merger agreement that were indefinite and that could equal the entirety of the consideration received in the merger were potentially unenforceable.

Since that time, based on the data in the Forsite™ M&A Deal Tool, we have seen a major shift in the survival period of fundamental representations, with an indefinite survival period dropping from 34% of all transactions in 2014 to 15% in 2015.  We anticipate that the percentage of transactions with indefinite survival of fundamental representations will continue to drop in 2016 as fixed survival periods increasingly become the standard in definitive documents.

Drilling down further into the data, we note that the survival periods for fundamental representations also depend on the specific representations being carved out from the general survival period.  For example, claims for breach of representations based on fraud typically survive for the longest periods:  indefinitely in 51% of all transactions and through the end of the applicable statute of limitations 32% of the time.  Breach of representations based on the capitalization of the seller also survive for extended periods, but the numbers are reversed, with indefinite survival occurring 29% of the time and statute of limitations survival occurring 53% of the time.  Per the chart below, breach of representations based on intellectual property have extended survival periods, but for much shorter time frames than fraud and capitalization:  in 83% of transactions, the extended survival period for intellectual property representations is two years or less.

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights.]

In the definitive agreement for every merger and acquisition transaction, the selling company will make multiple representations and warranties regarding, for example, its financial condition, the adequacy of its intellectual property rights, the absence of litigation and claims, and other matters of importance to the buyer.  Many of these representations and warranties will be qualified as to materiality.  For example, a standard representation may state that “seller’s financial statements represent the condition of the company in all material respects” or that “there are no material claims or lawsuits pending or threatened against seller.”

Although buyers often agree to have representations and warranties qualified by a materiality standard, increasingly those buyers want the seller and its shareholders to indemnify the buyer for losses without regard to the materiality of those losses.  For example, while the seller may represent that there are no material claims pending against the seller at the time of closing, if the buyer suffers any loss from a pre-closing claim (regardless of whether or not that loss may be deemed material), the buyer may want the seller to pay for the defense and resolution of the claim.  Thus, buyers increasingly insist on “materiality scrapes” that remove any materiality qualifiers for purposes of determining buyer’s losses or seller’s indemnification obligations.

In analyzing the data in the Forsite™ M&A Deal Tool, we found that over the past four years, 82% of the transactions where we served as Shareholder Representative included a materiality scrape provision:

The concept of materiality can arise in multiple contexts within an M&A transaction, and the materiality scrape clause may apply narrowly or broadly depending on the parties’ negotiations.  For example, materiality may be a factor in the following clauses:

1. A condition to closing an M&A transaction may be that there has been no “material change” in the seller’s business between the time of signing the definitive agreement and closing the transaction.
2. As noted above, the seller’s representations, warranties and covenants may be qualified by a materiality standard.
3. Seller’s obligation to indemnify the buyer against claims and losses may be limited to material losses.

A broad materiality scrape “reads out” the materiality clause from all of those provisions.  This can lead to unintended results; for example, every business will change in some immaterial way on a daily basis, so eliminating the materiality clause from the closing condition (no. 1 above) could render closing of the transaction impossible.

More typically, the materiality scrape applies to either or both of (a) the seller’s representations, warranties and covenants for the purpose of determining whether any breach has occurred (no. 2 above) and (b) calculation of losses arising from any breach (no. 3 above).  Data in the Forsite™ M&A Deal Tool indicates that the majority of the time, the materiality scrape applies to calculation of losses:

In the context of calculating loss, the buyer often argues that establishing a claims deductible is the best way to protect a seller from small claims rather than limiting the buyer’s ability to seek indemnification to only “material losses.”  Buyers further assert that fixed deductibles bring certainty to the issue, avoiding post-closing disputes over the definition of “material” in the context of any given transaction.

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights.]

At the closing of many merger and acquisition transactions, a portion of the consideration in the deal is set aside to create a shareholder representative expense fund.  This expense fund can cover expenses that may be incurred on behalf of shareholders during the post-closing period.  For example, the selling shareholders may need to engage an accountant to analyze and dispute the buyer’s calculation of a purchase price adjustment, engage attorneys to defend against an indemnification claim made by buyer or engage attorneys to enforce the selling shareholders’ rights related to a potential earn-out.

In analyzing the data in the Forsite™ M&A Deal Tool, we found that over the past four years, 74% of the transactions where we served as Shareholder Representative included an expense fund.  We recommend that every transaction include an appropriately-sized expense fund.

If an expense fund is not established at closing, the shareholder representative may be limited in its ability to engage professional service providers to protect the interests of the selling shareholders.  One alternative to establishing an expense fund at closing is, when a post-closing issue arises, to raise funds as needed from the selling shareholders.  However, a number of dynamics make that practice difficult:

• Windows to respond to purchase price adjustment calculations, claims, disputes and earn-out analyses can be very narrow, leaving insufficient time to raise the necessary funds.
• Selling shareholders may have different capacities or desires to contribute money post-closing to defend a claim for indemnity or prosecute the selling shareholders’ rights.
• Some selling shareholders—particularly the larger funds—may need to cover a disproportionate amount of the costs if smaller shareholders are unwilling or unable to participate.
• Often times it can be impractical to solicit contributions from all shareholders.
• Non-participating selling shareholders may question or potentially dispute the terms of any expense fund contribution (g., priority of recovery, interest payments and other benefits of participating in providing expenses funds to the shareholder representative).
• The shareholder representative must be cognizant of providing information about a dispute broadly to the selling shareholders. It could be discoverable in litigation.

Setting up an expense fund at closing avoids all of these issues.  It both proportionately burdens all selling shareholders with their pro rata contribution and proportionately benefits selling shareholders by providing protection.  In addition, buyers are well aware of the amount of the shareholder representative’s expense fund at the initial closing, and that can influence how aggressive a buyer may be in calculating working capital and earn-outs, and bringing claims for indemnification against the selling shareholders.

Moreover, the shareholder representative typically seeks advice and approval from major selling shareholders before engaging professionals and otherwise incurring expenses payable out of the expense fund, allowing the selling shareholders to maintain a level of control over how the expense funds are utilized.  Finally, upon resolution of all issues in a transaction, any unused portion of the expense fund is distributed pro rata back to the selling shareholders.

Accordingly, we advise that all selling shareholders establish an appropriately-sized expense fund for the shareholder representative to both protect the selling shareholders’ interests and avoid issues that can arise through attempts to raise an expense fund post-closing.