Buyers, who are interested to have access to a particular asset or a market position, usually adopt strategy of mergers and acquisitions (M&A). However, it may be kept in mind that M&A strategy is not risk free.
There are risks relating to:
(I). Liabilities; and also
(II). Relates to unknown factors.
Where these risk factors are not taken care of, the same can undermine the rational for the desired acquisition. Obviously such dealings require comprehensive due diligence coupled with a thoughtful sale agreement, which may contain warranties and indemnities to guard against unforeseen eventualities. However, all these arrangement still not cover counter party credit risk.1
It is important for buyers to fully understand the legal issues in this regard. The due diligence process depends on the nature of acquired business and its tax and financial issues. Thus the process of due diligence presents a complete picture of the assets and liabilities relating to the specific transaction. At times, though rarely, unsolved issues emerge and this situation can force one to drop the idea of purchasing such an asset. That is why the due diligence effort is required and it helps to negotiate the deal, may be on more favourable terms for the purchaser.
There can be a question, whether or not the scope of due diligence can include innovative investigations.2Of course yes, such type of special investigations depends on different factors and may relate to specific deals, and may be the deal relate to an unusual business, say for example, untraditional trade for which the hiring of services of external advisors may become necessary. These external professionals will conduct legal, tax and financial due diligence. In many cases advisors specific to tasks are also hired along with routine professionals. Because in addition to tax, legal and financial framework, advice is also needed to conduct due diligence in the field of:
(I). Information technology
(II). Insurance
(III). Environmental and commercial realities
(IV). Warranty and indemnity insurance
The investigations so made become part of the available evidence for underwriter's review. This review may call for additional due diligence to be carried out by external advisors, say for example, where the emerging M&A proceedings relate to an online business, the availability of specific information technology report may be needed.
In fact transactional risks are dependent on the nature of acquirer, as the acquisition of the business may relate to investment or trade. These decisions also change the focus of due diligence. Say for example, a trade buyer will focus on value additions to his business by combining the newly purchased business, that is why he may more rely on an in-house due diligence. On the other hand a financial buyer will be more dependent on external advisors because in many cases it may be a different and divergent business, and that is why W&I is used as a risk management tool. In a case of trade buyer the purpose W&I is to strengthen the seller's convenience or to differentiate its bid in an auction process by negotiating more limited recourse from the sellers and supplementing this recourse with W&I insurance. For a PE buyer W&I insurance provide ability to claim directly against insurance for a breach of warranty or indemnity.
In recent years general trends and development related to the 'nil recourse' sale agreement.3
The advantages of such an approach include:
(I). Allowing a buyer in an auction process to differentiate its bid by only requiring a low warranty cap
(II). Topping this up with insurance
(III). Insurance may also be used to facilitate a transaction where the seller, such as a PE firm, is unwilling or unable to give warranties.
(IV). It might be used to protect a buyer concerned about enforcing warranty claims against a seller in financial difficulty or a seller in a foreign jurisdiction.
(V). It can maintain key relationships by eliminating the need for a buyer to bring warranty claims against management sellers or JV partners.
The nature of transactional risk and opportunities for creating values can be sorted out by:
(a) Substituting W&I insurance for a comprehensive due diligence process by the buyer or a full disclosure process by the seller.
(b) Arms-length negotiations conducted with the aim of achieving a balanced sale agreement.
(c) W&I insurance can significantly reduce parties' inherent risk, on both sides of the negotiation.
(d) Can help to minimise the time needed to reach agreement, to overcome hurdles identified during negotiations and, ultimately, to close the deal.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi)
1. Where there is no warranty or indemnity insurance, a buyer cannot recover amounts it ones for claims underwritten relating to warranties and indemnities, whereas insurance in this regard can mitigate business risks.
2. These investigations usually go beyond the traditional approach.
3. The W&I insurance are built into the transaction structure from the outset of the negotiation. This allows sellers, in the absence of fraud, to exit the transaction with very little liability, for example, where seller liability attaches only above the W&I policy limit, and only for a limited set of warranties and indemnities or no liability at all. This structure was initially used by PE firms seeking a 'clean exit' from a transaction and to enable profits of sale to be quickly distributed to investors. The trend is now influencing various types of transaction, and shows no sign of abating.
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