Covid-19 and acquisition transactions: impact on warranties and disclosures
J. Sagar Associates, Bengaluru
J. Sagar Associates, Bengaluru
While India continues to see a sharp rise in coronavirus cases, India Inc is striving hard to get back to business as usual.
Though the crisis is far from over, dealmakers are not deterred from pursuing their next discovery. However, the onslaught of Covid-19 has led to a significant change in the way acquisitions are conducted in India. While some buyers in the market are on ‘wait and watch’ mode, others are looking to purchase even in these unpredictable times.
Issues such as valuation are delaying due diligence timelines, and the risk of dropouts or walking away has increased. In this uncertain climate, parties need to consider the risk factors in the current volatile market and the potential impact the pandemic may have on people, business, and growth while they are engaged in negotiating transaction documents.
A specific area that may need to be re-evaluated in entirety is warranties and disclosures in transaction documents. Serious consequences and liabilities may arise if the warranties package is poorly negotiated or a standard ‘pre-Covid’ version is used.
Significance of warranties and disclosures
In a standard acquisition, the seller generally gives the buyer ‘representations and warranties’ and ‘disclosures’ in relation to the business. A representation is a statement affirming the existence of certain facts that induce the other party to enter into an agreement; a warranty is a promise of indemnity if such assertion turns out to be inaccurate or false. Buyers generally seek representations and warranties to further support their due diligence.
The wording of ‘representations and warranties’ gains significance because courts tend to strictly interpret contracts between parties. The underlying assumption is that the contract would have been vetted by their legal counsels, or rather, that the parties knew exactly what they were entering into. It is important to assess the impact of each warranty and the exceptions.
The new ‘standard’ warranty package
The unpredictable Covid-19 market will impact sellers’ willingness to stand by certain warranties that were considered ‘standard’ before the pandemic. It is commonplace for sellers to hesitate to sign a document with an extended list of warranties. This hesitation will only increase as certain warranties are at risk of being breached as a result of Covid-19 or the lockdown that was imposed in its wake. Warranties that are otherwise considered necessary, such as those requiring the company to warrant their compliance with law, would also need to be re-evaluated. This could delay filings which, in turn, may result in unintentional breach.
Buyers, on their part, will tend to sharpen their scrutiny of representations pertaining to disclosed and undisclosed liabilities. Warranties in relation to financial statements and adequacy of reserves, business continuity plans, and status of contracts will need to be more carefully examined at the time of signing and closing. Representations and warranties in respect of disaster preparedness, data protection and privacy, and other emergency and risk management processes would be part of the new ‘normal’ warranty package.
Sellers should try and ring-fence warranties relating to Covid-19 and seek materiality and knowledge qualification. Appropriate disclosure in respect of Covid-19-related items would need to be made to prevent any potential breach of warranties. Issues like the following should be disclosed to the buyer:
• employee layoffs;
• deferred benefits such as increment and unpaid bonuses;
• terms of new borrowing;
• general credit stress;
• details of onerous contracts;
• potential penalties or liquidated damages; and
• restrictions in use of leased premises.
Buyers who are unsure about closing the transaction may consider a ‘bring down’ of their representations and warranties to the date of closing. If the sellers are unable to fulfil the requisites for closing, the buyer may choose to walk away from the transaction.
Another critical provision is the sellers’ disclosure schedule and the updates made before the date of closing. If the sellers have the ability to update the schedule, buyers need to be alert and closely monitor the impact of subsequent disclosures. From the buyers’ perspective, the document should include a clause that gives them the right to walk away from the deal in case the disclosure relates to something beyond their risk appetite. Sellers should try and negotiate for a materiality threshold such that not every disclosure gives the ‘walk away’ right to the buyers.
Act of balancing
No two transactions are the same. As the commercials vary significantly, acquisition deals should have a fair allocation of risk to the extent possible. Sellers should avoid providing forward-looking warranties, particularly those in respect of performance of business, continuity of employees, or any other unpredictable item. Forecasts will have their own limitations in these uncertain times.
Buyers should be mindful of the potential breaches, reliability of valuation or assessment conducted in pre-Covid times, technology sophistication, and the ability to run the business as is.
A careful study of the affairs of the seller/company before such statements are made or accepted may be a sound safeguard. Disclosures by the seller/company may prove to be a good starting point for such assessment.
Structuring disclosure schedule and its impact
Sellers make use of disclosure schedules to record exceptions to representations and warranties. Disclosures qualify the representations and warranties provided by the sellers and seek to limit their liabilities in respect of such disclosure.
These disclosures limit the buyers’ rights under the warranties clause by excluding the item disclosed from the scope of warranty and indemnity. This is precisely why a buyer, or an investor, may not accept all disclosures. Disclosures may have two implications: If the buyer accepts the disclosure, this may limit the seller’s indemnity obligation. However, if the disclosures are material, then the buyer may seek uncapped indemnity or, in some cases, even choose to walk away from the deal. Certain disclosures may also result in reopening commercial points such as consideration.
New trends in deal making
The pandemic and the humanitarian crisis may fade, but their impact on the way transactions are conducted are here to stay. As is customary, sellers provide for detailed representations and warranties, which may be categorised as follows:
• fundamental warranties (those affecting title to shares and ability of parties to contract);
• business warranties; and
• tax warranties.
As Covid-19 will impact all three categories, there is a need to examine whether each of the statements needs to be worded differently. A way out of the debate on the warranties package could be to research the possibility of any innovative insurance products that may help close the deal. If available, such products will, of course, come with due diligence by the insurers, and one may even expect intense involvement of these insurers in the transactions.
Vendor due diligence as a norm may make a comeback again, particularly for mid- to late-stage companies. These companies will be conducting diligence to ascertain lapses and non-compliance, and to determine what disclosure to make to investors or buyers. Depending on the financial status of the target or the seller, buyers may expect a certain security amount to be set aside in an escrow. These holdbacks will be a hard sell in several deals in India, but they are not unusual in uncertain times.