Share sale disputes
Paul Raftery looks at typical disputes that arise during share sales, as well as how to bring, defend and avoid claims.
Prior to the COVID recession, the mergers and acquisitions market had been particularly buoyant with deal volumes and transaction values at all-time highs. In the competitive sellers’ market that existed in 2019, quality businesses could demand premium process resulting in record transaction values.
Fast forward 12 months and the prospects are much changed for everyone. It’s no surprise that there has been a rise in share sale disputes over the period: buyers who feel they have overpaid or that the business has underperformed; sellers who feel that the target business downturn is exceptional and COVID related and resist being blamed for the situation; advisers pressed to confirm whether the terms of expensively negotiated contacts fully anticipated and dealt with the situation that the target business has now gone through.
As in any downturn, whilst transaction volumes decline, disputes increase.
Now is an appropriate time to look at the typical issues which arise when the parties to a deal fall out and claims occur. The aim, in this the first in a series of articles on this topic, is to give an outline summary of the typical issues that occur: how to best bring or defend a claim, and how to best avoid the situation arising in the first place.
The intention is to shine a light on issues relevant to disputed transactions completed over the past year or two and to explore ways in which they can best be progressed or defended. Looking forward, with transaction activity reviving as private equity and trade buyers compete for those quality businesses on the market or who see distressed value in the market, what lessons can be learned to protect against future disputes when buying or selling any business whose current performance and future prospects may be so difficult to accurately assess?
Warranty and indemnity claims
One of the most common types of disputes arises from the warranties and indemnities given by the sellers.
A warranty is a contractual promise contained within the sale agreement given by the sellers as to the state of affairs of the target company or business at a certain point in time. The negotiation of seller warranties within a sale agreement is generally a complicated process and warranties are often fairly extensive given the inherent liabilities involved in the acquisition of a corporate entity. To be added to the usual range of standard warranties, they typically now include warranties addressing the impact of COVID on a business and its customers; how a business dealt with the furlough scheme and staff issues and return to work generally; whether CBILs loans or tax deferral arrangements were correctly applied for, etc.
The sellers’ defences to the risk of warranty claims are best provided through making full disclosure and negotiating financial claims limits, time claims limits and other exemptions and exclusions in the sale agreement. Sellers will also seek by negotiating the specific ambit of the warranties themselves, particularly to qualify them by reference to knowledge.
This can give rise to disputes as to whether any matter has been fairly disclosed or not, and what is the impact of the buyer’s knowledge (actual or imputed from the knowledge of its advisors) even where a matter may not have been expressly disclosed. Taking care to negotiate the detail of the relevant provisions in the sale agreement, whether for buyers or sellers, can have real consequences when it comes to determining whether a claim can be brought or not.
In the case of claims under the tax deed or under specifically negotiated indemnities, buyers will as usual expect pound for pound recovery without claims limitation. Sellers need to challenge the assumption that an indemnity of necessity means that they have to take 100% of the risk and should also take specific care to ensure that the underlying issue against which an indemnity is sought is tightly defined.
Claims will inevitably still from time to time arise and a surprising number of reported cases highlight the degree to which there can be disputes about whether a buyer has notified its claim correctly, whether as to the detail included in the claim or the timing of delivery of the notice. Take time to document what is required as the prerequisite to bringing a claim as clearly as you can, and then follow that process.
The first port of call when claims arise is often recourse to hold back against either retention sums or deferred/earn out payments. This is where the negotiation of a detailed set off provision is critical in determining the rights of the buyer to do this. Thinking through the practical requirements of these provisions will be time well spent. As a buyer up against a claims time limit as it is, will you be happy to look back at the agreement and see that you agreed, that before you could make a set off, you needed to have taken the time at your own cost to have obtained a QC’s opinion on the merits and quantum of the claim? Conversely, as a seller, were you to note that the buyer can set off merely if, in its reasonable opinion, it thinks it has a claim, and in whatever amount it reasonably self asserts, is the value of the claim?
The market has seen a marked increase over the past few years (even in the sub £10m deal space) in the uptake of warranty and indemnity insurance to cover off the risk, particularly buy-side policies. We won’t delve into the detail and complexities of these policies, other than to briefly note that whilst they can be put in place speedily, the earlier that cover is sought and the longer the Warranty and Indemnity insurers have to assess risk, the better. Premium levels are, however, likely to rise as the insurance market generally hardens in the face of the downturn and the upturn in claims.
Completion accounts disputes
All transactions involve some form of accounts check to adjust the price to reflect actual figures at completion. Still, the most common way of doing this is via completion accounts — a set of accounts drawn up to the completion date and prepared in the months after completion. Once agreed, the accounts serve to adjust the price by reference to key financial metrics as at completion as shown by those accounts and as compared against the estimated position as at completion.
In more seller-friendly times than at present, there had been a marked rise in an alternative price accounts mechanism, the locked box accounts structure. A form of pre-agreed completion accounts is considered to be more seller-friendly and avoids most of the uncertainty at completion about what the final price will be, and which exists when completion accounts are used.
However, completion accounts remain the most popular price adjustment method and in more buyer-friendly times their use is only likely to further dominate.
The scope for dispute with completion accounts is significant. How to define key metrics such as debt, cash and normal working capital was an area for dispute before COVID. Working out and agreeing what EBITDA (or its new formulation EBITDAC) should be or what normal working capital requirements ought to be tested at is now even more challenging.
Although parties may seek to mitigate these risks by appending a pro forma set of accounts to the share purchase agreement or agreeing an extensive set of specific polices to apply to the production of the accounts, the difference in the subjective opinions of the relevant parties is something which is almost impossible to account for. The more care that is taken to specify the detail of the definitions used, the accounting policies to apply and to illustrate to almost journal-level entry what the account should look like, the better.
Completion accounts provisions will usually provide for matters to be referred to an expert where the parties cannot agree. This, in itself, can prove problematic where there are no fixed criteria by which an expert will be appointed, or one party is unhappy with the choice of expert or associated costs of experts, and care is needed to think through the specifics of how this is to happen. Again, taking time to work through how an expert is to be appointed and how to resolve disputes about that choice is time well spent, as compared to simply relying on default provision in the contract that may not have been given specific attention.
The problems with earn outs…
Where to begin! Sellers and their advisors have — often rightly enough — been very wary of earn out provisions as the inherent risks are obvious. Will the financial metrics to determine the earn out consideration be manipulated by the buyer? Will the buyer run the business in a way that reduces the chance of the earn out being hit, whether cynically or as it properly regards itself as acting in the best long term interests of the target by doing so? What risks are being run as to the ability of the buyer and the target to be able to fund the earn out?
Given problems in assessing the impact of COVID on the target company, more and more deals have an earn out component to help test the ongoing effects of COVID on the target.
Clearly defining the accounting policies and definitions used in key metrics such as net profit is key to avoiding dispute, ideally as with completion accounts aided by a detailed pro forma set of earn out accounts to act as a guide to what the accounts should look like.
This will not rule out all areas of dispute, but it will help. For example, there may be disagreements between the parties as to whether particular costs are above or below the EBITDA line. Additionally, parties may disagree on how to treat particular one-off, exceptional or non-recurring items, where their treatment has not been sufficiently specified in the relevant part of the sale agreement.
Finally, the appropriate method of calculating included items in the measure of profitability. If a specific method is not agreed on in the sale agreement, typically this would be expected to follow the same principles and methodologies applied by the target, pre-deal. The difficulty, and matter for disagreement, arises when the target has been transitioned to the buyer’s own policies for internal or external reporting, and where there is no precedent treatment in the pre-deal accounts to fall back. In that instance, both parties will seek to apply their own judgement. From the sellers’ perspective, ensuring that the agreed hierarchy of accounting policies follows the norm of firstly specific policies, secondly by historic target policies, followed thirdly by GAAP, will be key.
It is not unusual for the buyer to make structural changes to the target business post-completion, not least to line up the new business with its existing operation. These changes to accounting, IT, HR and other operational functions will come at a cost to the target business, and recharged costs to the target in respect of services provided by the buyer. Whether these additional costs or recharges are accounted for in the relevant measure of profitability is often a matter from which disputes can arise. In this scenario, agreeing a specific accounting disregard for such charges is more likely to be acceptable to the buyer than seeking to prohibit them from being levied at all.
Either party may allege that the other has manipulated the trading of the business, before or after completion, in order to depress or inflate the amount of additional consideration payable under the earn out. So, following their post-completion review of the target, the buyer argues that the previous management has deliberately underspent in certain areas, which will require rectification at the buyer’s cost. For example, where (in the buyer’s view) an inadequate amount has been spent on staff training, marketing or advertising. Alternatively, the argument may be that previous management may have accelerated the recognition of revenues or been overly optimistic in certain subjective assessments in the accounts, such as provision for liabilities.
Conversely, sellers who have ceased to have operational control over the business, post-completion, may consider that the buyer has deliberately manipulated certain matters in order to depress the amount of additional consideration payable. This may relate to overspending on discretionary areas, deferring the recognition of revenues within the earn out period, or taking a more pessimistic approach to provisioning. Each of these actions would, in contrast to the position above, have the effect of depressing the financial results in the short term.
Finally, there is the issue of exactly how the business will be run post-completion. This can be an issue whether or not the sellers may have remained in the target and remains in (ostensible) management control. The buyer may legitimately expect a free hand within reason in how the business is run, in areas such as pricing, client take on, risk polices, staff hire, capital expenditure or the merging of the business with another part of its operation. Few buyers will concede to the seller's demand for a veto on these issues and not all lend themselves to an alternative accounting add back or disregard to produce accounts unaffected by these changes. There is no easy solution to this issue, but certainly from the sellers’ side, if detailed protections are to be built into the sale agreement, it’s likely to be necessary to have pre-agreed this at the heads of terms stage, in order to be able to successfully negotiate these protections into the sale agreement.
Despite these issues, earn outs are still typically seen as the best way to bridge the price expectation gap between parties, and their use is only likely to increase as a way of dealing with the inevitable difficulty of judging the impact of COVID on the business and the degree to which its impact will endure.
Breach of restrictive covenant
Whether buying the business and assets or share capital of a target company, the buyer will usually expect specific forms of restrictive covenant protection to prevent the sellers from establishing a competitive business that could adversely affect the goodwill of the target. The provisions will apply for a particular period of time and will range from preventing the sellers from engaging in a competing business to soliciting the existing employees of the target for a new venture.
In order to ensure that restrictions are enforceable, the buyer must ensure that the restrictions are no wider in scope than is necessary to protect the buyer’s legitimate interest in the business of the target. In the event that the buyer overreaches this mark, the restrictions will be unenforceable. Matters such as the time period for and territory in which the restrictions will apply will be factored into the judgement of whether restrictions are, in fact, enforceable.
There is a reasonably well-understood set of standard restrictions by type and duration in sale agreements and it is rare for those issues to be contentious points of negotiation or to be set at levels unlikely to be capable of being enforced. Where both parties need to take care is in clearly defining exactly what the business is that the sellers are not to compete with, and what specific carve-outs (if any) are to be agreed that deal with any overlapping business interests the sellers may retain.
Prevention is better than cure
Taking time conducting due diligence or as sellers responding to it, is always sensible. Remember as sellers that answering due diligence enquiries is not necessarily the same thing as making acceptable disclosure — buyers will rarely, if ever, accept as “disclosed” an information dump of detail.
Be clear in the share purchase agreement as to exactly what information has to be provided for a warranty claim to be made; how notice of claim is to be served; what are the practical and mutually commercially acceptable tests to be applied before set off can be claimed.
Non-disclosed problems will still arise which is where well-negotiated time and claims limits will assist sellers in avoiding claims and conversely ensure buyers are not barred out, depending on the thresholds set.
Warranty and Indemnity insurance is now far more cost-efficient and readily available, but bear in mind that insurers will still expect thorough due diligence to have been conducted. Give yourself the best chance of having effective and well-priced cover by engaging with the Warranty and Indemnity insurers early in the process.
Specify as much detail as you can in accounting policies and procedures and use detailed pro form accounts to avoid confusion to the extent possible.
Iron out contentious areas, where possible, at heads of terms stage especially in areas such as the specific degree of earn pout protection be granted to sellers.
Take time over the specific drafting of restrictive covenants, not just the time limits and the time periods, but the detail of the business being protected and of any carve-outs being offered.
Take specific care over dispute resolution; what matters are subject to expert determination; how are the experts both to be appointed and to act.
Ensure you understand and take time to specifically negotiate the detail of the back end legal boilerplate provisions of the share purchase agreement; they all matter and can come back to haunt you.
Look out for other articles in this series which explore some of the related issues in more detail, such as the importance of getting the notice and other basics of initiating a deal claim right, dispute resolution choices, the true measure of damages in share sale warranty disputes, and drafting tips to avoid claims.