This article is written by Kumari Saloni, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
Mergers and acquisitions (‘M&A’) of private companies in India can be structured in different ways. For example, asset transfer, business transfer, share acquisition, joint venture, etc. depending upon the financial and non-financial objectives of the transaction, tax considerations, etc. Generally, in an M&A, the definitive transaction usually happens in two steps,
(a) the signing of the definitive agreement(s) and
(b) closing of the transaction (or actual performance of the obligations).
The transaction technically culminates in closing, however, there are many disputes that may arise even after closing. These disputes may arise from the conduct of the parties that may have happened pre-closing but were discovered post-closing, or conducts that may have happened post-closing. This article discusses the most common post-closing disputes that arise in private M&A in India and the steps parties may take to avoid those disputes.
Breach of post-closing covenants
In the definitive agreements, parties (buyer and seller) provide for certain post-closing covenants/obligations like, non-compete, non-solicitation, confidentiality, non-interference with customer/supplier relationships, etc. to survive the closing, and sometimes, even the termination of the agreement. Certain post-closing covenants may even put restrictions on the manner of utilization of the investment money by the seller. The seller may also be put to certain post-closing obligations to rectify minor non-compliances, breaches, etc. as identified in the due diligence, or obtain certain pending approvals, etc. Further, the buyer may be required to provide similar employee benefits for certain periods as were provided by the seller, indemnification to outgoing directors/officers of the target, etc.
However, putting these covenants without adequate detailing may cause disputes post-closing or may at least incentivize the other party to exploit these shortcomings. Thus, parties should carefully negotiate them in the definitive agreements.
For example, in a non-compete clause, the definition and scope of ‘non-compete’, range of business activities and the geographical extent to which it would apply, and the duration for which it would apply, all should be clearly provided in the agreement. The buyers should carefully identify the most important business operations of the seller, their coverage, etc., and should mandatorily specify them in the non-compete clause. The sellers should also, considering their future business plans and endeavors, try to restrict the scope of this covenant. Similarly, in non-solicitation clauses, the range of employees/workmen (current/former/future) who would be subjected to non-solicitation and for how long, etc. should be clearly provided.
However, even after carefully negotiating these covenants from a commercial angle, issues may arise in terms of the enforceability of some of these covenants from a legal angle.
For example, a non-compete covenant that restricts the seller from carrying out certain businesses may be hit by Section 27 of the Indian Contract Act, 1872 that renders the agreement restraining trade void to that extent. However, an exception is made where the sale of goodwill is involved, but even in that case, the restraint has to be reasonable. Further, even in transactions not involving the sale of goodwill, the courts may allow non-compete covenants that put a reasonable restriction when such reasonable restriction technically does not ‘restrain’ the seller’s trade. However, the determination of ‘reasonable restriction’ is very subjective, so parties should ensure that the restriction is reasonable given the nature of the business(es).
Breach of representations and warranties
Parties make various detailed representations and warranties (‘R&W’) to each other in the definitive agreement. The seller/target would typically represent certain facts about itself, its business, its financial conditions, compliances, etc. Similarly, the buyer may represent its financial competence to affect the acquisition, about the fulfillment of compliances (if any) required for the transaction, etc. Warranties are certain promises regarding doing or abstaining from doing something in relation to the transaction.
Parties use R&W to allocate the risks that they might incur from the information provided/promises made by the other party and relied upon by the first party for entering into the transaction. The sellers would typically want a restricted and a very specific R&W clause while the buyers would want the opposite. A seller may want to limit its representations only to the matters that were in its ‘knowledge at the time of making such representation in its ‘knowledge’ or were ‘material’ to the business. A buyer may want to extend representations to even those facts that were in the ‘constructive knowledge of the seller or the matters that the seller could have known on making reasonable efforts. The R&W clauses are thus drafted after multiple rounds of negotiation and with extreme caution. Taking such a cautionary approach during a negotiation may save the parties of disputes regarding breach of R&W that might have happened post-closing.
Dispute regarding indemnity claim in R&W breach
However, parties may still get into disputes regarding breach of R&W. Generally, R&W is backed by indemnity clauses, so, on the breach, the aggrieved party may raise an indemnity claim against the other party. Disputes may arise on the question of whether those indemnity clauses would cover the alleged R&W breach. The parties would want to limit the time period post-closing in which an indemnity claim can be raised. The indemnifying party would want only ‘actual compensatory’ losses incurred to the indemnified party due to the alleged breach to be covered by the indemnity and would want to exclude consequential or exemplary damages. The indemnified party would, on the other hand, want to cover even consequential and remote damages like loss of profits, or diminishment in the value of the business under the indemnity clause. Any ambiguity in the indemnity clauses would give rise to disputes regarding the allocation of the risks arising out of the breach of R&W on the parties.
If the court/arbitral tribunal holds that the said breach would not be covered under the indemnity clause the remedy would be governed by the law of contracts under which breach of warranties and breach of representations are treated differently. For claiming remedy for breach of representation, the materiality of the representation to the transaction is important, while for breach of warranty, damages are awarded even for breach of immaterial warranties. Further, breach of representation makes the contract voidable at the option of the aggrieved party (Sections 18, 19, Indian Contract Act, 1872), while breach of warranty entitles the aggrieved party to damages and not a repudiation of the contract (Section 12, Sale of Goods Act, 1930). In any case, any such breach would entail litigation and hence, uncertainty.
Thus, given the uncertainty in the outcomes of an R&W breach in a post-closing dispute, parties may adopt some other remedies that would cover the risks of the parties in a guaranteed manner. One such measure is warranty and indemnity (W&I) insurance. It is an insurance policy meant to cover losses that parties may incur for breach of representation, warranty, or any covenant by the other party. However, it generally has certain exclusions, for example, those representations and warranties that were made with actual knowledge of the alleged party that they might not be true/would be breached, are typically excluded. W&I insurances have huge potential to bring down various post-closing disputes, however, they are still at their early stages in India. Due to lack of demands, and lack of adequate companies offering this service, the premiums on these insurances are quite high in India. However, experts seem optimistic about the future of W&I insurance in India to cover R&W breaches in M&A deals.
Purchase price adjustments
Another common post-closing dispute occurs relating to Purchase Price Adjustments (PPAs) adopted by the parties wherein the final determination of purchase price is deferred to some future date and such determination is made by accounting for the events that had occurred during the intervening period that had some bearings on the valuation, working capital requirement, etc. of the target. So, instead of exact purchase consideration in the definitive agreement right at the time of signing, some upfront consideration provision is made and the balance amount (payable on closing or on some other future date) is adjusted as per the changes in the working capital, net assets, net debts, etc. of the target in the intervening period. So, if in the intervening period, the target augments its assets or working capital, it would have a corresponding increase in the final purchase price offered by the buyer. Similarly, any loss in the assets or working capital would have a corresponding decrease in the final purchase price.
These changes are more often than not dependent upon various variables, some of which may not even be in the parties’ control, like any force majeure or a less severe yet unforeseen event.
This uncertainty may lead to potential post-closing disputes (and even on-closing disputes) between the parties. Thus, it is important that parties keep the PPA provisions extremely watertight. In addition, PPA provisions must include the accounting principles/financial matrix to be used, specific methodology of calculating the adjustments, the exact timeline of which accounts would be drawn, etc. to avoid common post-closing disputes relating to the accounting principles and methodologies used in calculating PPAs. They may also establish an escrow account to secure the payments pursuant to the PPAs.
Earnouts
Prone to post-closing disputes is one other kind of price adjustment strategy in which the buyer defers determination and payment of the final purchase consideration. This is known as the earn-out mechanism. Under earnouts, typically a part consideration is paid upfront and the balance amount is deferred subject to achievement of certain predetermined post-acquisition goals in the business as agreed between the parties. Earnouts are useful when the buyer and seller have different expectations about the financial performance of the target. In that case, making the payment of the balance consideration as subject to some post-acquisition milestone helps the buyer hedge the risk of the uncertainty arising out of the difference in expectations of the parties. Parties may agree to provide for either seller-managed earnouts or buyer-managed earnouts. In the former, the seller works in achieving the post-acquisition milestone while retaining the management and control of the company for the duration of the earnout period. In the latter, the seller’s role is more passive and restricted. In India, earnouts are generally buyer-managed.
Typical earnout disputes relate to the calculation of the earnout amount at the time of its payment. Generally, earnout clauses have very complex and vague accounting standards/calculation methods to be followed by the entity post-closing. Buyers would want to put the standards that would reduce the earnout amount, while sellers would want the opposite. If this dispute is not anticipated and properly negotiated in the agreement beforehand, it may cause disputes post-closing.
Another category of disputes may be regarding the roles of the two parties in managing the company during the earnout period as per the definitive agreement. This is because in buyer-managed earnouts, since the seller and buyer would work together in achieving the milestone, disputes regarding day-to-day affairs, certain business decisions, etc. may happen, and in some cases, rather frequently.
To avoid such disputes, both parties should ensure that their respective roles in the company during the earnout period are clearly defined to minimize the possibility of any overlaps/disputes. Further, for the seller, given that the achievement of the agreed-upon milestone is a condition precedent for the balance payment and that in buyer-managed earnouts the seller’s rights/role would be restricted, it is important to carefully negotiate the scope of its role in the management during the earnout period. Sellers should properly assess the capabilities of the business with its new management and based on such assessment, should be pragmatic in deciding upon the milestone to be achieved. It should also ensure that they have good coordination with the new management and the short-term goals of the two are also aligned well so that the milestone is achieved swiftly and smoothly and the seller gets its consideration amount to its satisfaction. On the other hand, the buyer should also ensure that the said milestone is not incompatible with the plans (especially, the short-term plans), it may have regarding the company and the process of achieving such milestone does not have adverse implications on its future plans for the company.
Conclusion
Post-closing disputes arise after the parties have executed definitive agreements (signing) and performed their contractual obligations (closing). Hence, the parties would be bound by various legal and contractual obligations, breach of which would have their consequences (both financial and non-financial) if the disputes reach arbitration/litigation. However, a careful examination suggests that most of the post-closing disputes are of the nature that can be avoided by thorough due diligence, proper disclosure of risks by the parties, and by careful and pragmatical negotiation and crafting of the definitive agreements. Doing so would help the parties to pre-assess and pre-address in the agreements the risks that may lead to post-closing disputes, thereby leading to actual ‘closing’ of the transaction on closing.
References
- https://globalarbitrationnews.com/post-ma-disputes-resulting-from-earnout-clauses-20161219/#:~:text=Typical%20disputes%20between%20the%20parties,reasons%20why%20the%20agreed%20conditions https://www.lexology.com/library/detail.aspx?g=454f89d1-99bf-4bc2-a025-d33225a81c9c
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