It is safe to say that divergence of the parties’ interests is hardwired into M&A processes. With that in mind, establishing a security for repayment is (or should be) an important factor to account for during transaction negotiations. I am not going to describe the civil law institutions or tools designed to establish various forms of security (e.g. pledge, collateral, guarantee, promissory note, etc.). Instead, I’d like to highlight the issues associated with the need to protect the parties’ interests at particular stages of the transaction, with focus on the methodology of the process. As you will find out by reading my post, incompetent use of security under civil law may result in failure to identify real issues and protect interests, with such security not being worth a dime.
Just to be clear, when I mention an M&A transaction, I do not mean the planned merger of state-run oil refiner and petrol distributor PKN Orlen with crude oil Lotos. Nor do I refer to the last year’s acquisition by chemical Grupa Azoty of the German Compo Expert, one of the world’s top specialized fertiliser manufacturers. By the way, this has been the biggest acquisition (for EUR235m) of a foreign entity by Polish capital since the takeover of Chilean mine Quadra FNX by copper behemoth KGHM in 2012, according to Emerging Europe M&A Report 2018 /19.
The M&A referred to in my post are those transactions that are common on the Polish market, although not always recognized in the stats. Among them are transactions concerning external financing for entrepreneurs (e.g. loans with key assets as loan collaterals), investments in start-ups, purchases of specific core assets/segments of business or the whole business, or other transactions of this kind. Worth millions of Polish zloty, yet rather inconsequential in the global perspective, such transactions are a fairly regular occurrence on the contemporary booming market.
I will try to pinpoint to several practical issues that we may expect in the course of transactions associated with mergers and acquisitions. Careful not to pen a one-sided post, I did my best to present the process from the point of view of each of the negotiating parties.
Negotiations, non-disclosure (NDA), “what you see is what you get” rule
The negotiations have begun. The parties to a potential M&A transaction engage in talks in order to define the terms on which they will agree to close the deal. The following perspectives are represented at this stage.
An investor (e.g. buyer or financing entity) wants to identify the risks to see whether the planned ROR is likely to compensate for them.
The other perspective is represented by an M&A target (e.g. seller/ finance-seeker). On the one hand, they obviously must protect sensitive information bound to be required by an investor who needs it to accomplish their objectives, i.e. assess the risk. That said, it cannot be ruled out that somebody will act in bad faith (competitors) and attempt to fraudulently elicit important information such as know-how.
On the other hand, it is vital for an M&A target to convince an investor that it is trustworthy. Therefore, they must work together during due diligence and share information to the extent necessary for meeting the parties’ objectives and, more importantly, for an investor to make a DECISION.
There is another angle to it: a successful closure helps the target accomplish its objective, which is reduction of its liability. It boils down to the structure of liability principles. Let’s take provisions on the seller’s statutory liability for defects as an example. Pursuant to Article 557 of the Civil Code, “the seller shall be released from the liability on account of the statutory warranty if the buyer knew of the defect at the time of conclusion of the contract.” In the event of litigation, the M&A target may invoke the “what you see is what you get” rule in its defence.
Bearing in mind that the reality is always complicated, we have to find a balance among various interests, such as the need to obtain the highest possible price or the best transaction terms. We also need to be aware that things can go wrong and try to think of what claims to expect if that happens. Therefore, it matters what the investor finds out about the target in the course of the transaction.
This stage of an M&A transaction should involve conclusion of a (good) non-disclosure agreement (NDA). While NDA works primarily to the benefit of an M&A target, sometimes the investor also wants to keep their interests secret from the market.
Given that NDA is an innominate contract (i.e. not regulated by law), we need to make sure that its content is good, i.e. that it really protects our interests and not just pretends to do so.
Here’s is what we should pay special attention to:
- precisely define the acceptable scope of protection (what we want to protect);
- what measures in the scope of use of the obtained data are unacceptable;
- key interests should be protected with a contractual penalty in an adequate amount; otherwise it may be very difficult, if not right impossible, to assert your rights arising from such a contract;
- optionally, the contract may also contain other elements depending on the specific nature of the transaction and the parties’ needs, e.g. granting an exclusive right to negotiate.
Representations & Warranties
Let’s move on. Due diligence having been carried out successfully, we decide to make a deal. We get started on the transaction documentation, including representations and warranties (or reps and warranties), which are of major importance to the process.
Reps and warranties can refer to a number of things, such as legal situation of an M&A target/assets, correctness of retained documentation, liabilities, existing and potential disputes, encumbrances, tax obligations and contracts, as well as correctness and effectiveness of key asset purchases. Its substance will also depend on the nature of the transaction, i.e. whether it concerns shares, enterprise, select assets, etc.
Why are reps and warranties important? In simple terms, by submitting a representation or warranty an M&A target becomes liable to an investor if a submitted representation (warranty) is proven to be false.
I am not going to analyse here the legal nature of reps and warranties, i.e. whether they show similarities with a guarantee or whether liability arises from a warranty or rather from a defect in declaration of will; nor am I to ponder on how the knowledge of an entity submitting a representation or warranty affects their legal nature. What I want to stress, however, is that we must choose one of the available options and word the reps and warranties accordingly. This means providing in a contract for a certain liability regime which, should the worst-case scenario materialize and we go to court, will enable us to assert our claims instead of getting embroiled in a prolonged legal battle, with a lot of hair splitting involved and the court trying to establish what the author had in mind. Therefore, it is of paramount importance to use an appropriate legal support to word reps and warranties, as well as the whole contract, in such a way that our interests are well protected.
Who are the parties to the transaction?
Another important thing is to establish who submits reps and warranties, as well as identify the party to the transaction.
The current market reality makes it super easy to set up a company to which you contribute assets meant to be sold, or intended as an object of a transaction (i.e. financing) with an investor. The same applies to involvement in a transaction of an entity which is part of larger corporate structure.
What could happen in such a case is this: after the transaction has been made and the funds have been transferred to the top layers of a corporate structure, the subject – an M&A target – gets wound up, for instance by liquidation, stripping it of its assets or else – there is more than one way to do it. In other words, our representations and warranties can be the best in the world, yet they could prove to be virtually worthless when it comes to protection of our interests.
The same issue may come up in relation to the party that puts up a security (e.g. warranty, collateral or submission to collection proceedings based on a notary deed under Article 777 of the Civil Code). In one of the transactions that we dealt with, the party receiving the financing offered each of the above forms of security. That said, all of them were established on companies which had both considerable assets (valuable property) and substantial liabilities (a large group of equally well protected creditors). From the practical point of view, theses securities were obviously not worth much. In the course of negotiations and due diligence investigation, we managed to track down the company which held private assets of the business’s primary owners. Establishing security on the tracked company’s shares was what finally satisfied the investor.
Bearing in mind the nature of a particular transaction and business circumstances, we should make sure that an M&A transaction is properly secured at the level of civil law institutions (collaterals, mortgages, warranties, etc.), while the methods of securing individual interests reflect business reality and real risks. This way we can avoid a situation where we end up with plenty of securities and big, fat reps & warranties only to realize that they are sham and unenforceable.