HOW WARRANTIES ARE USED TO ALLOCATE RISK IN CORPORATE ACQUISITIONS, AND THE RISKS INVOLVED

Introduction

The Black’s Law Dictionary defines acquisition as a term that is widely used in the description of a variety of transactions that involves the sale and purchase of what could be an asset of a business that is operational or total ownership of a business entity operating the given business. The talk of acquisitions cannot go without mergers being mentioned.  Despite the size or nature of involved parties or the entity that has been acquired, the major issues of concern are the same and cut across all acquisitions known.  Narrowing down to corporate acquisitions, it is interesting to note that warranties are used to allocate risk in one way or another depending on the type of business entity. The issuance of these warranties more often than not involves a lot of risks if what experts say is anything to go by. Risks that if not managed well could turn out to be detrimental in as far as the interests of a business are concerned. The Enterprise Act 2002 acts as a controller of mergers in the UK. All in all, every business entity in the corporate world today is well aware of the topic of risks. Therefore the use of warranties to allocate risks in acquisitions involving such corporate institutions is not something new under the sun.

There are at least two forms of corporate vehicles in each jurisdiction that is manned by right-minded officials. These are private companies and public companies in simple terms. For many countries, up to and including the United Kingdom, there are regulations that govern how acquisitions are made, especially those that involve the acquisition of a public company and for a company that has had its shares listed on an investment market. Here in the UK, it is a requirement that company share acquisitions have to strictly follow a formal ‘offer’ process where all terms regarding such acquisitions are laid, and this is governed by the City Code on Takeovers and Mergers Talking of acquisitions, there are two main types of acquisitions; one being the sale and purchase an operating business’ underlying assets and the other being the sale and purchase of a company that is privately owned. With that in mind, this sets up a stage for extensive research.

This text seeks to give a detailed explanation of the procedure by which warranties are used to allocate risks in the above-mentioned corporate acquisitions, taking keen consideration of all risks involved. It also seeks to explain the various crucial steps that are necessary to take when trying to mitigate risks. To achieve this, this research is going to focus on case studies of corporate institutions that are based in the United Kingdom, and whose names and details will be discussed at a later stage, and divulge into the finer details of each entity, coming up with a relevant conclusion for the same. Also, the research intends to take yet another deep and keen look into the risks that are involved in corporate acquisitions. On top of that, there is every intention to give a solution or a recommendation as to what and how it is best deemed fit to ameliorate each risk. Finally, a conclusion would be thus drawn from the same, giving precise answers to the research question that has been alluded to above.

For the institutions that will be discussed, the process by which warranties are/were used to allocate risks will be looked into. In addition to that, the risks involved for particular entities shall be discussed, where they originate from and why. After that, there is every intention to suggest ways in which these risks can be ameliorated.

Chapter One

Use of Warranties to Allocate Risks

The corporate world today, more so in the United Kingdom is characterized by an emerging trend where the use of mergers and acquisitions (hereinafter referred to as M&A) is the order of the day, and where representations and warranties are crucial in the M&A of companies that are privately held. Strategic acquirers, as well as private equity buyers in the United Kingdom, are reported to be becoming increasingly confident in the use of warranties and representations, in what has continued to provide meaningful benefits to all parties engaging in an acquisition As has been the norm over the years, representations and warranties by a seller are the major talking points of acquisition. They are more often than not negotiated heavily both parties engaging in a given acquisition.  In any given traditional M&A transaction as has been the norm since time immemorial, the seller takes the step to agree to indemnity for the buyer in the event that the seller’s representations and warranties are breached.

In any acquisition under the law in the UK, the principle of caveat emptor must always prevail. Caveat emptor simply means that the buyer should beware, he should be made aware of any negativities that could be detrimental to the process of an acquisition, or what could follow after the deal is closed. A buyer is always at risk of having the newly-acquired assets or shares being subject to liability, among other factors that place a buyer at a disadvantaged position. It is therefore custom that a custom that a buyer needs to be granted some form of contractual assurances on the safety of assets, liabilities and operations from the seller. These assurances are usually made in the form of representations and/or warranties, as usually render a certain level of comfort from within the buyer. The degree by which a buyer qualifies the representations and/or warranties of a buyer depends on the buyer’s knowledge and his or her own investigations into the same.

It is interesting to note that a company is treated as a separate and distinct legal entity that is capable of surviving beyond the death of its handlers as was held in Salomon v Salomon, an old UK case that sets a precedent for this research. In the words of Lord Halsbury “Either the limited company was a legal entity, or it was not.  If it was, the business belonged to it and not to Salomon.  If it was not, there was no person and nothing at all, and it is impossible to say at the same time that there is the company and there is not”

Definition of Representations and Warranties Insurance

One would ask, perhaps, what the definition of the two could be, and it is therefore deemed important that a clear definition of the two terms is set at the onset of this research, for the purposes of clear communication. Representation and warranties are a policy of insurance that is crucial in M&A and are fashioned to protect against losses that could be incurred as a result of the seller’s breach of representations during the conclusion of an agreement for an acquisition to take place. The key points to factor in such a transaction include the fact that the insurer charges a fee called a premium for issuing the said policy. This is usually 2-3% of the coverage limits. For example, if the policy’s coverage amount is £10 million, then the premium could be in the regions of £200,000 to £300,000.

In addition to that, another key factor worth noting is that the policy coverage is an amount equivalent to a tenth (10%) of the purchase price for the M&A. There is yet another deductible amount that is omitted from the coverage and is usually a minimum of 1% of the purchase price of the merger and acquisition. In the UK to be precise, these transactions also involve standard exclusions to the coverage, such as price adjustments and covenant breaches by the seller which are not catered for in monetary terms according to the underwriting of such a given company. It is interesting to note that not all representations and warranties of the seller are covered. The insured party could be either the buyer of the seller, though in most times it is always the buyer. About the premium payment, it is a fee paid upfront once. Subject to negotiations with the insurer, the policy term is usually between three to six years for many companies here in the United Kingdom.

The Process by which Representations and Warranties are Obtained

The first step usually beings with an application for insurance, which must be completed, and a buyer or a seller approaches an insurance broker to solicit quotes from insurers. The insurer would want to be served with various information among others, the parties to the M&A, the amount of coverage being sought, the form that the acquisition agreement takes, online data room of the seller, the diligence report of the seller given by the buyer and the Disclosure Schedule of the seller in connection with the acquisition agreement.

This process usually takes place in two parts, one being an indication of interest that is free and non-binding, while the second part being that of an underwriting process that calls for an upfront payment of a diligence fee. After this, the window for negations of the specific terms of the policy is open. Some of the key issues that form part of the agenda for negotiations between the buyer and the seller include who pays for the insurance, whether there is sharing of the deductible amount, whether the buyer would rely on the insurance policy exclusively, whether the seller retains liability in the event of a breach of representations and warranties and the question as to whether the seller would be held liable for some losses exceeding the insurance policy limit, losses which are termed as ‘extraordinary’. Also forming part of the negotiations are the questions as to whether the buyer would want to be indemnified for losses that the seller discloses and are not catered for within the policy, and also whether there is an exposure of what could amount to fraud.

For a majority of the acquisitions of companies that are privately held, there is what is called an escrow which others refer to mas a holdback, which is a portion of the buying price and it forms part of the negotiations in order to offer the buyer protection from any imminent losses that would be incurred resulting from a breach of the seller’s representations and warranties. In other occasions there could be a second escrow, that is meant to offer protection to the buyer if at all there is a reduction in pricing after closing. The seller’s representations and warranties could be all-encompassing, where the seller reveals, among others, financial statements, contracts, liabilities, corporate authorization, employee matters and compliance with the UK law. The Companies Act 2006 allows the City Code on Takeovers and Mergers to compel courts to enforce the rules that arise from the Takeover Code.

According to business law experts, the representations mentioned above serve three key purposes. One of them is that they are essential for the buyer as a confirmation of the due diligence findings and whatever information that is there to tell about the seller. Secondly, if in the event that a buyer makes a determination that the representations made were untrue, he or she reserves the right not to consummate the acquisition. Thirdly, if for any reason, the representations are untrue, the buyer has every right to indemnity according to UK business law.

From the buyer’s perspective, a quick analysis would put any right-minded business person to know that financial statements of the seller are very crucial to this agreement. The statements of income, both audited and unaudited, cash flow and the equity of the shareholders for specific periods are equally important. This would give more confidence to a buyer that when entering a deal of mergers and acquisitions, he or she is not placed at a disadvantaged position that would lead to losses that could have otherwise be avoided.

Companies and other business entities enter into mergers and acquisitions for different reasons. For example, Sun Pharmaceuticals and Ranbaxy, some of the major leading companies in the UK with branches worldwide, entered into an agreement of acquisition for Sun Pharma need help in filling in its therapeutical gaps in the UK and in the US. This would be deemed to be a way in which the company would gain better access to emerging markets on top of strengthening its presence in the local market. Another example is that of Commercial Metals Company (CMC) and Tata Consultancy Services (TCS) which was a merger that was ventured into in 2015 with the aim of consolidating both businesses. Five years down the line, economies of scale seem to have been achieved, with more focus on operational efforts being illuminated. Other mergers include Virgin Media and O2 who recently announced a staggering £31 billion merger that caught many by surprise. For companies that wish to merge or enter into an acquisition deal with a company in the UK, total observations of the rules as dictated by the Companies (Cross-Border Mergers) Regulations 2007 are mandatory.

What a Typical Representations and warranties Insurance Policy looks like

Such a policy will place high regards on the following;

• That the name and address of the insured party are appended.
• That the limit of liability is clearly defined in the agreement.
• That the deductible amount is clearly stipulated.
• That the representations and warranties are contained the agreement of acquisition.
• That the policy period is stipulated as well.
• That a mechanism for dispute resolution, should any conflict arise, is clearly stipulated.
• That all conditions applicable to the policy in terms of among others, payment of premiums are clearly stated.

Benefits of Representations and Warranties Insurance

There are a number of benefits that come with insurance associated with representations and warranties. For the seller, one, it can pave way for the reduction or the total waiver of the seller’s indemnity when a breach of representations and warranties occurs. Also, an escrow holdback can also be reduced or totally waivered, since it would make a significant reduction in the proceeds that the shareholders of the seller would receive at the closing of the agreement of acquisition. Thirdly, a clean exit for the seller is provided with few contingent liabilities that come with the M&A. Over and above that, the seller and in many occasions his or her counsel also get to feel legally ‘comfortable’ when an acquisition agreement has been made and there are representations and warranties in black and white. This gives a quicker resolution in finalizing an agreement of acquisition and eliminating the possibilities of lawsuits instituted by the buyer seeking compensation for any breaches as a result of an acquisition agreement having gone wrong.

From the buyer’s point of view, his or her bid can actually be made to look more attractive should there be no escrow or holdback required. This is because the buyer would always rely on  insurance for indemnity. As if not enough, another benefit yet on the part of the buyer that comes with entering into an agreement of mergers and acquisition is the fact there is guaranteed extension of time for the buyer to go through the representation and warranties, hence the ability to discover underlying problems that the seller failed to disclose in what is a breach of the principle of caveat emptor. Sources well placed in this sector opine that should this happen then a buyer has the opportunity to revoke the agreement instead of settling for less. To add to that, there is also the advantage of improvement of the likelihood of a buyer to prevail on a claim under such a policy.

Benefits that are mutual for both parties include the fact that the use of warranties and representations in an agreement of acquisitions simplifies and speeds up the process by which negotiations are made towards the conclusion of such an agreement. The seller would more often than not find himself in a position where he has less interests in the negotiations if especially its likelihood of surviving closing is close to null. Be that as it may, if in a deal that is characterized by post-closing indemnification by the stockholders of the seller, there is little interest on the part of the seller because the insurance will cover all losses so there is less need to resist materiality caveats. Therefore, this part of the deal can thus be concluded in quick fashion.

Chapter Two

The Risks involved in giving Warranties and Potential Solutions for Amelioration

While in an agreement of mergers and acquisitions, it is very wise to acknowledge the fact that there are a number of risks involved in giving warranties. Risks that if come to reality the buyer is most likely to be dealt the biggest blow. Business experts from their experience in transactions advice that while it is good to risk, it is equally important to be risk-averse for the best interest of a business entity. Most risks are normally bored by the person that undertakes to give the warranty.  Here in the United Kingdom there are a number of risks, some of which are particular for the nation given so many factors that are hard to knock off, as is discussed in the subsequent paragraphs to come. The Financial Services and Markets Act 2000, otherwise known as FSMA, regulates issuers and financial markets in a bid to cushion potential victims from incurring losses.

Environmental Risks

One of the major issues of concern in many agreements of acquisition is environmental risks. Environmental risks, as a matter of fact, tend to have an adverse impact on mergers and acquisitions, if what experts say is anything to be believed. According to the experts, environmental risks can expose its head at any point during the procuring of an acquisition agreement up to and including the stages of negations of the purchase and sale agreement terms as well as the closure of the deal. In addition to that, management of financial performance after a deal has been struck can be curtailed by environmental risks, not forgetting that a future exit strategy may also be cut short thanks to environmental risks.

Mitigating Environmental Risks

For environmental risks, the Pollution Legal Liability (PLL) seems to be the most amicable way to ameliorate environmental risks. It is an explicit route to take, according to well-known experts in this area, and that it is broad because it defines environmental coverage in terms of property damage, third-party bodily injury, business interruption and natural resource damages among others. PLL is a policy, an environmental insurance policy that is fashioned to mitigate risks that come with the ownership, development or operation of a business entity which could be a site or a facility for that matter. PLL can be best applied as the main coverage in instances where there is a need to make provisions of dedicated limits, longer policy terms, coverage for new conditions and also broad coverage around sites of operations. Some of the benefits that come with PLL include the fact that there could be policy terms that are as long as 10 years in a bid to make facilitation of a long-term hold as well as an exit strategy in the same spirit. Also, another benefit is that PLL is a coverage response that with the help of incessant legal processes, has been validated.

Away from Pollution Legal Liability, another sure way in which environmental risks can be made less severe is by the deployment of Representations and Warranties Insurance. Warranties and representations that touch on environmental factors are usually made reference to in the purchase and sale agreement. There is need for provisions of documented descriptions of known conditions, and this is included in the due diligence of both parties, the buyer and the seller. The representations and warranties usually cover environmental risks that fall under the category of ‘loss’ and ‘breach’. There is a need for a loss to be associated with breach for coverage to be triggered. For instance, for this to be considered in an environmental scenario, there could be a discovery of pollution condition that was omitted by the seller, in what was a breach of the principle of caveat emptor (let the buyer beware). The insurer would be thus obligated to pay for losses.

Since time immemorial, the use of PLL has been the traditional way of dealing with environmental risks, but reports indicate what has been a turn of events in the recent times, with other measures such as Representations and Warranties taking center stage in this debate. For a sound environmental risk management exercise to be executed, there is need for intensive research as situations tend to vary.

The Risk of Unforeseen Circumstances

While taking part in an agreement of M&A, there is a need to be wary of potential risks. These risks are usually identified and amicable ways of ameliorating them are devised.  But there are instances where some circumstances are unforeseen to say the least. Such is the existence of the current global pandemic in the form of Corona Virus, commonly known as COVID-19, which has caught all economies flat-footed with barely any resolutions to curb the losses imminent. This is a disease that has literally ‘gone viral’ globally, bringing most business operations in the world to a standstill from 2019 December to date. Whether this will come to an end remains to be a question of ‘let us wait and see’. While the viral disease continues to spread to various people around the world on a massive scale and in a very short period of time, mergers and acquisitions have been adversely affected, with many businesses having to close down due to lack of operations, following many government directives for people to stay home.

From a historical analysis, the world of mergers and acquisitions has weathered many storms, up to and including the burst of the dot-com bubble that took place in 2000-2002 as well as the Great Recession of 2007-2009. For many of these economic crises, uncertainties in business have seen most buyers delaying or having second thoughts as to whether it is the right time to push through with such deals. Fast forward to the current global pandemic, and things are quite different. The levels of appetite of investors and buyers are on the low, next to zero.  Unlike in the past where M&A have been affected but have managed to weather the storm, analysts say that there has also been a sea change in as far as the manner in which M&A transactions are gone about. With all stakeholders limited to working remotely while staying at home, many businessmen and women have laid back, waiting for directives from economic experts as they continue to make adjustments to these trying times. That being said, the unprecedented outbreak and spread of the disease can be classified as an unforeseen ‘calamity’.

Ameliorating Unforeseen Risks

One would then wonder, how then does the M&A world deal with unforeseen risks such as the current global pandemic? In most transactions that involve M&A, there is usually a term included going by the name ‘Material Adverse Effects’ which is barely used according to what researchers say has been going on. This is most important in the closing conditions, and the buyer is not obligated to bring the acquisition to an abrupt end if the seller finds himself in a compromising situation of a material adverse effect. The material adverse effect clause seeks to distribute risks between the buyer and the seller in a way that would be fair and in the best interests of all parties for the duration that the adverse effect takes place. So, in the case of the current global pandemic, Corona Virus, the question as to whether the outbreak falls in the category of the adverse effects would depend on the contractual language used between the buyer and the seller in the conclusion of the M&A agreement.

To cut the long story short, buyers and sellers in the future transactions involving M&A are advised to take advantage of the Material Adverse Effects clause so as to see a business sail through instead of the buyer having to curtail the deal prematurely because of unforeseen circumstances that could have otherwise been planned for.

Risk of Incomplete Due Diligence

Due diligence is a rather important aspect in an M&A agreement. This is so because it gives the buyer the ability to make confirmation as to whether pertinent information about the seller is true, information such as contracts, finances and other important issues of facts. Due diligence in the simplest terms can be best explained to be an audit or rather an investigation of any investment in a move tailored to confirm facts which could otherwise have a direct impact on the decision the buyer makes as to merge or make a purchase either positively or negatively. During this process, research is conducted to affirm whatever a seller has alleged in his or her representations. By having gathered this and other relevant information, a buyer is well placed at a position to make a firm decision as to whether to continue with the deal or not. Be that as it may, incomplete due diligence can be very detrimental in as far as the interests of a buyer are concerned. When due diligence is incomplete, there is every likelihood that a buyer is going to make decisions based on half-truths.

If what London School of Economics Professor Paul Willman says is to believed, over half of agreements involving M&A in the UK usually do not see the light of day thanks to incomplete due diligence. Buyers have found themselves victims of a breach of the principle of caveat emptor, and have had to live with the fact that they made a wrong decision and could have made a better one had they completed due diligence. Many buyers have thus found themselves counting losses in what could have been avoided if they knew better, so to say. This, therefore, paints a picture that due diligence is very essential and if not completed then there are consequences, which are indeed dire, to follow.

If for any reason there is a fraudulent deal that is believed to have taken place either as a result of a coalition between two business entities or one of the parties duping the other, the courts in the UK are always ready to help. In Re Bugle Press Limited, section 210 of the Companies Act was used to disqualify an attempt by two companies to dupe a third one, which was the minority shareholder, by forming another company under a different name and attempted to enter into an acquisition agreement contrary to the law.  The court held that this was a bare-faced attempt to give the fundamental principles of company law a wide berth and operate outside the law. Lord Justice Cohen in his wisdom opined; “The company was nothing but a legal hut, built round the majority shareholders and the whole scheme was nothing but a hollow shallow.  All the minority shareholder had to do was shout and the walls of Jericho came tumbling down.” The same opinion was held in Gilford Motor Co. v Horne. From the foregoing, litigation in case of a fraud that may be as a result of misrepresentation on the part of the seller and is aided by incomplete due diligence by a buyer’s team is not a mechanism for ameliorating risk but just a solution if push comes to shove.

Mitigating the Risk of Incomplete Due Diligence

The surest way of eliminating the possibility of such risk is, therefore, conducting complete due diligence, complete investigations to determine the credibility of all facts alleged. What steps, therefore, are involved in due diligence? The truth is that M&A are complex in nature. Th process of due diligence from an analytical point of view takes more than just what it sounds like. As a matter of fact, it takes several weeks, or months depending on so many factors. The first step towards complete due diligence is assembling a team that would be tasked with the responsibility of conducting due diligence. This team needs to consist of financial and legal experts with all the know-how that M&A call for. Secondly, the next step would be the gathering of documents that are deemed fit for the agreement. A due diligence team needs to create a detailed checklist of all they need to confirm and of the documents that are needed for this to take place. The exact documents here depend on a variety of facts, up to and including the type of business, the size of busines, among others.

After that, the next step would be to review all gathered information with the intention to verify them. It is at this point that if the buyer has any question, he or she is at will to clear any doubts in mind. The buyer reserves the right to ask for any additional information for the sake of clarity, the principle of caveat emptor in literal practice. The due diligence team could look for ‘red flags’ at this stage in order to stop what would be an undesired loss for the part of the buyer. During the review process, the team could make a determination as to whether the deal is worth entering into, or disclose whether they are having second thoughts. Finally, after the above have been said and/or done, a purchase agreement writing would be the last thing to do, and it should be sent to the target company to make an approval. The buyer at this stage gives an okay if he or she so wishes to pursue the deal. By so doing, complete due diligence shall have been deemed to have been done, hence minimizing the possibility of incurring unprecedented losses.

Risk of Integration Issues

After the conclusion of M&A agreement, there is the risk of issues of integration showing it ugly face just after the conclusion of an acquisition when people plan to get down to business. According to the recently released EY Global Capital Confidence Barometer report, issues of integration between the companies in a merger or an acquisition arise more often than not.  These issues could either be operational or cultural. M&A are involved organizational changes that could impact companies in different ways. If in the case of an acquisition, there is every possibility that the companies involved or the management of the companies involved could continue to operate independently for a long time. What this means is that some friction is bound to be experienced, and analysts say that the cost of operations could rise for no apparent reason. On top of that, cultural differences could also take the driving seat in leading the newly formed business entity towards failure. Research done by Forbes magazines avers that 95 per cent of executives in the world acknowledge the fact that culture plays a very vital part in the integration of employees and managers. So, while one company may be traditional and driven by results, the other may be entrepreneurial and focused on innovations. Coordination in such an environment would be thus critical.

Ameliorating the Risk of Integration Issues

The risk of integration from an economic expert’s point of view should not be something problematic enough to threaten the success of any business entity. This is to say that issues dealing with integration are issues that could be well managed. First, if it is a merger that has taken place, then time would be the only solution to mitigate this, in the sense that with the employees of one company given time to interact and socialize with their counterparts from the second company that partook to enter the agreement of a merger, they are more less likely to harmonize with time. As a matter of fact, experts claim that they would exchange ideas with one another, in what would be an added strength and advantage in as far as the newly formed company is concerned. The two groups of people would thus engage each other and join efforts towards achieving the same goal.

If for any reason it is an acquisition that has taken place, then the best thing to do would be to integrate the members of the company acquired into the system of the acquirer company, and ensure that they toe the line. This could be best done by the acquirer company hiring a designated team for this purpose, to train and guide the ‘new’ employees on how to go about business at the behest of the new employer. It is a noticeable fact that in both cases, it would only take a matter of time for integration issues to be done away with if the right thing is done at the right time and by the right people. To conclude this, the risk of integration issues may not be as serious and demanding as the risks of incomplete due diligence, and unforeseen circumstances are.

Conclusion

To wrap it up, it goes without saying that a just as analysts point to it, mergers and acquisitions in the United Kingdom have become more of the daily trend in as far as the business community is concerned. More and more business entities continue to enter into deals of mergers and acquisitions, agreements that are entered into with the interests of all parties in mind. These agreements are guided by underlying principles such as that of caveat emptor, among others. The process by which warranties are used to allocate risks in corporate institutions is a well clear procedure that is well known to business companies. It requires a lot of patience, and any hurry to rash into such a decision is uncalled for, because some crucial stages like due diligence if skipped may turn out to be the biggest mistake ever made by a company in as far as M&A are concerned. When all goes well in the dealings, then there is every reason for everybody to smile because it is normally a win-win situation for both parties. Both the buyer and the seller usually walk away with something positive to look forward to in the near future.

However, just like in any business transaction and as all business entities are cognizant, there is a lot of risks involved in mergers and acquisitions.  For example, there are risks of environmental factors which could come in the form of pollution just but to name a few. Also, there is also the risk of unforeseen circumstances, which could rather be termed as contingencies Such is the current global pandemic, the surge of the Corona Virus popularly known as COVID-19, which has threatened the global economy, bringing it to its knees. As of now, it is something that has left economic and legal experts sceptical, with a lot of uncertainty as to whether the M%A should continue to take place. It is a major issue of concern that needs a lot of thinking to come up with most applicable solutions for the current times. Be that as it may, the risks mentioned above could be mitigated in one or another, and this makes it possible for risk to be minimized to the lowest levels possible for the sake of M&A.

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