The Merger & Acquisitions Market Trends Subcommittee of the Merger & Acquisitions Committee of the American Bar Association’s Business Law Section recently released the “2019 European Private Target M&A Deal Points Study.” (American Bar Association members can download the study by clicking here).
More than 40 lawyers from 16 countries contributed to this study, a follow-up to the “2017 European Private Target M&A Deal Points Study”; Portolano Cavallo is proud to be one of the firms co-chairing this study.
The 2019 study tracks commonly negotiated deal points in share purchase agreements for the acquisition of private targets in Europe signed or closed in 2017 and 2018, and it is based on more than 100 sample private M&A deals meeting the following criteria: (i) transaction value was at least EUR15 million; (ii) transaction was structured as a pure share deal (i.e., asset deals and mixed deals are not covered by the study); and (iii) targets or a substantial part of their assets/operations were located in Europe. The study does not cover the acquisitions of European targets whose shares are publicly traded.
The nature of the study is multi-sectorial, but the industry sectors most strongly represented are: Industrial Goods & Services (25%), Transportation (12%), Construction & Materials (12%), Financial Services (11%), and Telecommunications & Media (10%). From a value standpoint, the large majority of the deals are in the mid-market (from EUR15 million to EUR80 million), while only a small percentage (less than 30%) exceed a value of EUR320 million.
The study contains a review of the most common points negotiated in M&A deals by European practitioners, including comparisons with the 2017, 2015, 2013, and 2010 European Private Target Deal Points Studies, and the 2019, 2017, 2015, and 2013 US Private Target Deal Points Studies. This includes financial provisions, pervasive qualifiers, most common representations and warranties, conditions for closing, indemnification, and dispute resolution provisions.
Although the sample base for the study is, statistically speaking, somewhat limited, the study can be a useful tool for transactional lawyers, their clients, and other deal advisors to identify current trends in European M&A practice, as well as to learn more about differences with respect to more advanced US practice.
(a) Financial Provisions
The 2019 study tracked a surge in what is commonly known as a “locked box.” Compared to the 2015 EU study, locked-box deals significantly increased from 17% to 64%, while “closing accounts” suffered a sharp decline from 57% to 37%. An overview of the characteristics and differences between these purchase price adjustment methods, as well an analysis of the possible consequences, is available here. Generally speaking, the “locked-box” mechanism is preferred across European jurisdictions (while it remains uncommon in US practice) over “closing accounts,” as it removes price uncertainty and forces the parties to focus on certain metrics before signing. A “locked box” may also allow buyers to focus on post-closing integration rather than on post-closing price adjustments.
With a specific focus on deals with post-closing purchase price adjustments and relevant metrics, the comparison between the 2019 study and past EU private deal studies shows a substantially flat trend regarding the working capital adjustment metric, a small increase in earnings, a small decrease in assets, and an appreciable increase in debt (76%) and cash (42%).
(b) Pervasive Qualifiers
The 2019 study focuses on (i) “Material Adverse Effect” (MAE) clauses, and (ii) “Knowledge” qualifiers.
(i) MAE/MAC Clauses
MAE clauses are often heavily negotiated between the parties and allocate to buyer and seller risks of loss that may result from adverse circumstances occurring in the target’s business between signing and closing. How the parties define a “material adverse effect” (or material adverse change, or “MAC”) may be relevant for purposes of (i) determining whether a buyer has grounds to “pull the plug” on a deal, and/or (ii) interpreting the scope of application of certain representations. Indeed an MAE definition may be used (1) to qualify various representations, warranties, and covenants, establishing a threshold for determining the scope of disclosure or compliance relating to risks associated with changes in the target’s business; and (2) to delineate the circumstances under which a buyer would be permitted to exit a transaction without liability (e.g., as a condition precedent to the buyer’s obligation to close the deal). Usually the events constituting a MAC are then qualified by a listing of other events (“MAC exceptions”), precluding buyers from walking away from a deal or seeking renegotiation of material terms on the grounds that a MAC has taken place.
Sellers usually attempt to narrow the MAC definition and expand exceptions in order to shift risk to buyers. In doing so, sellers may bolster the certainty of a deal’s closing and their ability to preserve deal pricing. Buyers, on the other hand, strive to shift the risk to sellers by expanding MAC elements and reducing the number and scope of the exceptions allowed, thereby reserving for themselves a greater opportunity to walk away from the deal or to renegotiate deal terms. In negotiating these terms, advisors should carefully consider the interplay between the wording used in the transactional documents and the statutes in place in several European jurisdictions on force majeure and its impact on contractual obligations.
The 2019 study shows that MAE clauses are included in 63% of the analyzed SPAs (in line with the past), and usually defined (66%, in line with the 2010 study – 62% — while the 2017 EU study reported 23% of defined MAE clauses, the 2015 EU study only 4%, and the 2013 EU study 10%). Inclusion of carve-outs in MAE definition is also a constant trend (52% do not include any carve-outs, while 48% provide for some carve-out; among these, 82% do not include any limitation on “disproportionate effects” – this figure was only 36% in the 2017 EU study, in line with the 2015 and 2013 EU studies).
In this respect, it will be of interest to see the impact of the 2020 COVID-19 pandemic on MAE/MAC clauses in M&A deals across Europe. Given the uncertainties several practitioners had to deal with in the first quarter of 2020, one might expect that parties will increase the time spent negotiating these clauses.
(ii) Knowledge Qualifiers
Typically, sellers will attempt to mitigate their exposure by limiting the scope of their representations and warranties using “knowledge” qualifiers. Usually, negotiations focus on the definitions of (x) “actual knowledge”; (y) “constructive knowledge”; and (z) “knowledge group.”
A standard negotiation on knowledge usually sees sellers wanting knowledge to be defined as “actual knowledge,” so as to have no investigation requirement and no uncertainty as to the application of the standard. Conversely, buyers attempt to define knowledge as “constructive knowledge,” so that sellers will be deemed to know what they could have known with reasonable investigation. If buyers succeed, then sellers want to limit this investigation obligation to a discrete group of senior management and their direct reports in the target business. If so, however, buyers should ensure this group is not too limited and that it includes people who are knowledgeable about the target’s operations.
The 2019 study reports a majority of use of “actual knowledge” only (54%), and a more or less equal split between the others (18% actual knowledge plus constructive knowledge, without express investigation requirements; 10% actual knowledge plus constructive knowledge, with express investigation requirements; and 18% undefined knowledge). Regarding the “knowledge group,” the large majority of cases provide for identification of specific individuals or officers (68%).
(c) Representations and Warranties
Representations and warranties are statements of fact and assurances made by the parties, and they are always a key negotiation point in every M&A deal. Representations and warranties usually cover certain standard areas but, depending on the actual business carried out by the target company, they may be extensively tailor-made, and they also may be limited by sellers via inclusion of several limitations and qualifiers (e.g., materiality, monetary thresholds, knowledge, scope, time, disclosure schedules, etc.).
The 2019 study results can be summarized, under a general viewpoint, as follows:
- Most included representations (e., 50% or more): financial statements – “fair presentation” (86%); and
- Least included representations (e., less than 50%): “no undisclosed liabilities” (48%); “full disclosure” (38%); and “compliance with law” (20%).
“Financial Statements – Fair Presentation” representations protect buyers against liabilities not resulting from the financial statements of the target, by shifting the risk of those liabilities to sellers. Usually, buyers require sellers to represent that “the financial statements of the company are true, complete and correct and prepared in accordance with accounting records of the target company and the past practice,” and to guarantee that all the formalities for approval of the financial statements have been duly performed and that there have been no changes or new liabilities since the date of approval of the last financial statements. Conversely, sellers attempt to narrow the scope of this representation by limiting the nature and type of the liabilities required to be disclosed to liabilities that would be required to be disclosed as liabilities on financial statements prepared in accordance with GAAP and inserting knowledge qualifiers, as well as GAAP-qualified “fair presentation” principles.
“No Undisclosed Liabilities” representation protects buyers against unknown liabilities by shifting the risk of unknown liabilities to sellers. Again, buyers want sellers to represent and warrant that there are no target company liabilities (contingent or otherwise) other than those expressly identified on a disclosure schedule, reflected or reserved against on the balance sheet, or incurred in the ordinary course of business since the date of the most recent balance sheet. Sellers, however, want to limit the nature and type of the liabilities to be disclosed to buyers to those required to be disclosed as liabilities on a balance sheet prepared in accordance with GAAP (i.e., unknown contingent liabilities are excluded from coverage).
The “full disclosure” representations aim both at ensuring that sellers have disclosed all information relating to the target company that would be material to a buyer in evaluating the interests to be acquired, as well as qualifying that information as “true, accurate and not misleading.” Usually buyers want to include full disclosure representation and expand it to require full disclosure, with no knowledge qualifier, of any fact that would materially adversely affect the assets, business, or financial conditions of the target company or its business. Conversely, sellers attempt to exclude any full disclosure representation, or at least to limit its language by inserting knowledge qualifiers and the like.
Through “Compliance with Law,” buyers require sellers to guarantee that all the activities of the target, including its business, are and have been conducted in compliance with law. This representation is usually subject to several qualifiers (e.g., knowledge, materiality, etc.), but it also important to point out that, for certain areas (e.g., Data Protection), the inclusion of a general “compliance with law” representation is not sufficient for sellers to avoid liabilities (for example, in theory a seller could not be in breach of a “compliance with law” representation but nonetheless could have suffered a material data breach).
As a final remark, the 2019 study figures are basically even when it comes to the notion of express exclusion under the SPA of what are commonly termed “representations implied by law” (e.g., guarantee against hidden defects): 52.5% (included) versus 47.5% (excluded).
(d) Conditions to Closing
In the case of a time gap between signing and closing, the parties usually require the fulfillment of certain conditions before completion; depending on the case, there might be conditions that both parties must satisfy, or conditions binding only one party. These might include regulatory or antitrust authority approval for the execution of the transaction described in the SPA, third parties’ consent, absence of material adverse changes, or performance by sellers, before the closing, of certain actions relating to the target (e.g., reorganization of the target/carve-out, etc.).
The 2019 study “Conditions to Closing” data are consistent with those of previous EU studies: the study confirms that in almost all the analyzed SPAs, representation and warranties shall be true and accurate (i) both at signing and closing (when non-simultaneous – 75%) and (ii) in all material respects (94%). The majority of the SPAs analyzed do not include a MAC clause (66%), while the large majority (84%) include, as a condition to closing, the absence of legal proceedings challenging the transaction. Other not-very-common conditions to closing include requirement of a (non-tax) legal opinion from sellers’ counsel (not required in 98% of cases) and retention of employees (not required in 93% of cases).
The above are usually structured as “conditions precedent,” but SPAs can also include “conditions subsequent,” and under Italian law this distinction can make a big difference. Indeed, if the parties provide for impossible conditions precedent (i.e., conditions that cannot objectively occur), the agreement will be null and void, while if there are impossible conditions subsequent, they will be considered void, but the agreement will continue to be valid. However, if conditions precedent and/or subsequent are contrary to mandatory rules, public policy, or morals, the entire SPA shall be considered null and void.
Subjective conditions based on a party’s “mere discretion” (condizioni meramente potestative) are also null and void and, finally, parties can agree that the party having an exclusive interest in the fulfillment of one or more conditions precedent can expressly waive such condition(s), so that it/they is considered fulfilled.
While sellers’ representations and warranties create the basic structure for allocating risks among the parties to an SPA, indemnification clauses represent the foundation of such a structure and its relevant strength and enforceability.
Under Italian law, a specific distinction between “protection by warranty” and “protection by indemnity” does not really exist. However, based on common contractual practice, a warranty clause is generally interpreted as a contractual promise, usually made by sellers in favor of buyers, with regard to a specific circumstance and/or matter and/or event. In the event of breach of a warranty, the buyer would be entitled to ask the seller for compensation for damages suffered as a consequence of the breach of the warranty. An indemnity clause is instead an obligation, usually assumed by sellers in favor of buyers, to hold and keep the same harmless against any breach of the representations provided under the SPA.
Below are the provisions most commonly negotiated under indemnification clauses.
(i) “Sandbagging”; “No Other Representation and Warranties”; and “Non Reliance” Clauses
Under a “pro-sandbagging” clause, the buyer’s remedies against the seller under the agreement are not impacted regardless of whether the buyer had knowledge, at or prior to closing, of the facts or circumstances giving rise to the claim. Thus, even if the purchaser had knowledge of an issue prior to closing it could decide to complete the acquisition, and then make a claim against the seller under the agreement. Conversely, under an “anti-sandbagging” provision the buyer’s post-closing recourse will be limited to matters about which the buyer knew at or prior to closing.
The 2019 study reports 50% included anti-sandbagging clauses, as compared to 12% that included only pro-sandbagging clauses.
As to “No Other Representation and Warranties” and “Non-Reliance” limitation clauses, the figures included in the 2019 study are quite balanced, with 31% of cases in which both “No Other Representations” and “Non-Reliance” clauses are included; only 33% of analyzed SPAs include “no other representations” clause, while 26% did not provide for any such clauses. Finally, only 9% provide for a “Non-Reliance” clause only.
(ii) “Survival” and “Time Limitation to Assert Claims” Clauses
This type of provision provides an expiration period for indemnification claims made under the representations and warranties. Survival periods usually range from 6 months to 3 years (12 to 24 months is most common).
With reference to what are known as “fundamental warranties” (such as organization and standing; no insolvency; title; etc.) usually a longer time can be provided (5 years) and the same usually applies to certain “business warranties” (such as tax and employment), which usually have a survival period equal to the relevant statute of limitations (typically 5 years under Italian law).
The 2019 study shows no big surprises emerging with regard to these clauses, with a constant majority of an average duration of 18 months (34%), followed by a time period of 24 months (28%) and then of 12 months (17%). Such time periods usually apply to “business representations,” while other (usually longer) time periods are provided for “fundamental warranties” (e.g., ownership of shares). In addition, specific representations (such as taxes) provide a “statute of limitation” period in the vast majority of cases.
(iii) “Damages” and “Losses” Definitions
Parties often negotiate what type of damages can be recovered when establishing definitions for “damages” or “losses.” Under Italian law, it was debatable whether it was possible to include what are known as “punitive damages” (typical under US/UK law) in those definitions; some authors argued that this category of damages has been introduced into the Italian legal system through certain provisions, such as Section 96, third paragraph, of the Italian Code of Civil Procedure, and the Italian Supreme Court finally accepted inclusion of those types of damages under Italian law (see decision SS.UU. No. 16601/2017 of the Italian Supreme Court).
The 2019 study confirms the results of previous EU studies regarding the inclusion of specific definitions of “damages” (72%); when damages are defined, typically the analyzed SPAs are silent on incidental and punitive damages, while the right to claim indemnification for consequential damages is largely expressly excluded.
(iv) “Baskets,” “Thresholds,” and “Deductibles”
Baskets and deductibles are designed to provide sellers with assurances that, even in the event of breach of a representation or warranty, they will not be approached for immaterial claims. In case of a basket or threshold, when buyers’ losses exceed the agreed-on basket or threshold amount, sellers are liable for the total amount of the losses. In case of a deductible, when buyers’ losses exceed the agreed-on deductible amount, sellers are liable only for the excess amount of the losses above the deductible. Sometimes we can find a combination of a basket or threshold and a deductible. After the parties have concluded that a basket or deductible is appropriate, the parties are then left to determine the amount to set for the basket or deductible (which may be based on a percentage of the transaction value).
The 2019 study confirms that the most common basket is a threshold (56%), followed by a combination of threshold and deductible, while the category of deductible only is negligible, and a no–basket provision scenario is more common. As to quantification of baskets, when it is a threshold, this is equal to or less than 0.5% of the value of the transaction in 42% of cases, while when the basket is a deductible, the scenario in which it is comprised between 0.5% and 1% of the transaction value and the scenario in which it is equal to or less than 0.5% of such value account for 38% each. Finally, 95% of baskets apply to breaches of seller/target’s representations and warranties, with no carve-out provided (62%).
A cap limits sellers’ indemnification obligations either by a set amount or based on a percentage of the transaction value. Caps are widely used in European practice, and parties usually focus their negotiations on the size of and exceptions to the cap.
In line with the previous studies, the 2019 study report also showed a large majority of caps of less than purchase price but greater than zero (77%), with the inclusion of carve-out provisions in 72% of the analyzed SPAs. With reference to the value, approximately 10–15% of deal value is the most common option.
(vi) “Exclusive Remedy” Clauses
In the event of a breach of a warranty under an SPA, the non-breaching party could theoretically be entitled to claim damages under the general provisions set out in the Italian Civil Code for purchase and sale agreements for movable assets (i.e., Sections 1489, 1490, 1492 to 1495, and 1497). In addition, if damages are pursued under the Italian Civil Code, the non-breaching party theoretically could be entitled to terminate the agreement (see Sections 1453 ff. of the Italian Civil Code).
However, this is not a common route for M&A transactions, since the parties usually decide to include within SPAs what are known as “exclusive remedy” clauses, under which no breach or inaccuracy (even if material) of any representation or warranty given by either party will entitle a party to terminate the agreement or to obtain any relief or indemnification not specifically provided under the SPA. If so, SPAs can provide that indemnification is (a) the exclusive remedy; or (b) the exclusive remedy except in certain situations; or (c) a non-exclusive remedy (i.e., other remedies are available). If the parties remain silent as to whether or not it is the exclusive remedy, general provisions under the applicable law shall apply).
The 2019 study shows that indemnification rights are provided as exclusive remedy in 39% of cases; however, the SPAs including such a provision have several carve-out possibilities, the most frequent of which (40%) refers to the breach of covenants.
(vii) Representations and Warranties Insurance
The study confirms increasing use in Europe of representation and warranties insurance, particularly in middle-market deals (i.e., the inclusion of R&W insurance has more than doubled compared to the 2017 EU study). R&W insurance provides that the insurance company will pay for a loss associated with the seller’s breach of a representation or warranty in the acquisition agreement. R&W insurance policies are negotiated and provide for various terms and conditions associated with coverage. A buyer-side R&W insurance policy, where the buyer is the insured and faces the insurer, is most prevalent in the market. A seller-side R&W insurance policy is available to reimburse sellers for indemnification payments made to the buyer due to a breach of representation or warranty by the sellers. The premium for R&W insurance policies generally ranges from 3% to 4% of the insured amount. The retention (or deductible) under most R&W insurance policies is between 1.5% and 2% of the enterprise value of the target company.
(f) Dispute Resolution Provisions
Finally, M&A lawyers are still on the fence when it comes to deciding between Courts and arbitrators when filing a claim: the numbers are basically even when it comes to applying to Courts (46%) or appointing arbitrators (44%), while the opportunity to provide prior mediation is hardly mentioned in any of the analyzed SPAs. When an arbitration clause is included, the parties usually prefer to have local bodies (88%) involved rather than international panels (for example, the ICC rules are provided in only 9% of the analyzed SPAs). On the one hand, this may be because the vast majority of the deals are in the mid-market sector and, therefore, parties might choose to save money in the case of a litigation proceeding (and international arbitration bodies can be very expensive); however, since past ABA studies also analyzed mid-market deals, the fact that this trend is appreciably increasing might mean that experiences with international arbitration panels and relevant regulations have not been terribly successful so far and, therefore, M&A lawyers suggest that their clients “stay local” and save some money, and – not unexpectedly – perhaps they try to get additional legal work representing their clients before national courts and/or local arbitration bodies.
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After several editions (this is the fifth edition of the EU study), the landscape of European Private M&A is slowly taking shape, with specific trends, highlights, and takeaways being a useful tool for European (and also non-European) M&A lawyers when approaching a new deal, drafting the relevant transaction documents, and facing their counterparties during negotiation sessions. The migration of M&A from the US/UK legal environment to other legal systems (in particular Civil Law systems) created a large number of questions, and issues to be solved, in every jurisdiction. ABA studies provide a snapshot of the answers provided by M&A lawyers across Europe, with some surprises, some confirmation, and, most of all, guidelines and indications for legal operators that can help them navigate M&A deals successfully.
 Transaction value includes capped or calculated earn-outs and assumption of seller’s debt, but not uncapped earn-outs to the extent not yet calculated or target’s debt.