Luis Gerardo Ramírez Villela
Müggenburg, Gorches y Peñalosa, Mexico City
luisg.ramirez@mgps.com.mx

This article provides an overview of the due diligence aspects of M&A and considers the warranties, representations and indemnities to be negotiated and agreed upon by parties to an M&A in Mexico.

M&A transactions have been increasing in connection with the establishment of business operations in Mexico and although the transactions are primarily focused on cross-border transactions involving the United States and Canada, there has been an increase in operations in connection with European and Asian countries as well.

Regarding the structure of the documents that are used during these types of transactions, the structure of the agreements is based on documents customary for such transactions in the US, which have been adjusted to comply with the applicable laws and standard practices in Mexico.

Due diligence

The due diligence performed by external advisers is relevant for the purposes of evaluating the potential risks associated with the closing of a merger or acquisition, as the case may be. Taking care to carry out a conscious review of the applicable federal, local or municipal laws will allow for the completion of a successful transaction.

Due diligence must consider a comprehensive accounting, corporate, financial, legal and tax review, as well as any related environmental or other specific types of analysis, depending on the target market of the company and its customary business operations.

Below is a brief explanation of each of these aspects, in respect of what should be reviewed and covered by the due diligence process.

Corporate

Due to its importance during a stock purchase, it is necessary to review all the corporate documentation of the company that is to be acquired, including, without limitation, the stock certificates and corporate books. Likewise, it is important to verify that the company has approved the financial statements for each fiscal year and that the members of the board of directors have been ratified.

It should be verified that there are no liens or encumbrances or any other limitations to the ownership of the shares or assets.

Labour

The individual employment agreements and collective bargaining agreements (if any) should be reviewed to confirm that they comply with the applicable legal provisions, as well as all the information and documentation necessary to verify the company’s compliance with its labour and social security obligations for all employees. Likewise, the existence or non-existence of labour disputes involving existing employees of the company must be confirmed. For such purposes, the purchaser must request a certificate issued by the legal counsel of the seller.

Contracts

A review of the contracts is relevant to identify that there are no conditions affecting the ordinary course of business and that there are no clauses or provisions limiting or preventing the closure of the transaction, such as change of control, non-competition or exclusivity provisions.

Intellectual property

A review of the intellectual property rights is indispensable to proving the ownership of the trademarks, patents, software licences and other rights to be transmitted as a result of the purchase transaction. An independent investigation must be performed to verify the status of these rights before the relevant authorities (ie, the Mexican Institute of Industrial Property, National Copyright Institute etc).

Regulation

In regards to regulation, a review should assess the permits, licences and/or authorisations necessary for the ordinary course of business, including those on environmental matters, by virtue of the purchase transaction. As part of the due diligence process, it will be necessary to identify whether such permits, licences and/or authorisations are transferable or not in accordance with the applicable legal provisions to avoid a possible delay in the closing of the purchase transaction.

Tax

During the due diligence process, it must be verified that all the necessary tax returns have been filed, whether federal, state or municipal, within the periods established by the applicable legal provisions.

Litigation

The existence of litigation, claims or conflicts in civil, mercantile, administrative, criminal or any other matter against the company, or any of its officers, that could cause damage or create a contingency, should be disclosed for the purposes of closing the purchase transaction. Furthermore, independent investigations as part of the due diligence process may be carried out to identify other possible risks that could exist related to the purchase transaction.

The due diligence report to be delivered must contemplate the main risks identified in the due diligence process, proposing possible solutions and advising on the possible consequences if these risks have no solution. Once the due diligence report has been reviewed, the corresponding agreement will need to be structured to cover all the potential risks and evidence all the findings under the representations and warranties, including the corresponding schedules.

The considerations for representations and warranties

The establishment of a corresponding representations and warranties section under the purchase agreement (whether stock or assets) is necessary and, therefore, it is important to be diligent during such a process and to coordinate all teams (accounting, financial, legal and tax) in order to understand any potential risks that could have an impact on the transaction.

Customary representations and warranties for this type of transaction will be included in the definitive agreement, including, but not limited, to: the organisation; no conflict; governmental consents and approvals; financial information; litigation; compliance with laws; intellectual property; real estate property; employee and labour matters; taxes; material contracts; environmental matters; insurance; and transactions with affiliates (if applicable).^[1]

External advisers will then have to coordinate a review of the corresponding schedules and determine whether the representations and warranties under the purchase agreement are true and correct, and adjust them prior to execution and, if the transaction is subject to a closing and post-closing process, determine a price adjustment mechanism to the extent necessary.

Survival of the representations and warranties is frequently negotiated between 18 and 48 months, depending on the nature of the representations and warranties, except for fundamental representations that will survive for the applicable statute of limitation. The specific survival term will depend on the results of the due diligence and the negotiations among the potential purchaser and the seller.

Please note that, in all cases, the external advisers must review and jointly draft the representations and warranties, and review the corresponding disclosure schedules to avoid any potential conflict in the future and to identify any misrepresentations that could potentially arise.

Indemnification considerations

In all M&A transactions, structuring the indemnification clauses and procedures is relevant for the protection of both the purchaser and seller, and the impact of drafting a clause minimising the liabilities of the transaction will be important during the business negotiations.

In this respect, the main goal of the indemnification clause is to provide the parties under the relevant agreement with a mechanism for seeking the payment of post-closing damages and losses. The indemnification clause is based on the survival of the representations and warranties and such a process will be triggered upon the existence of any misrepresentation by any party under the relevant agreement.

The most frequent indemnification mechanisms used in M&As for limiting the damages and losses due to a misrepresentation are ‘caps’ and ‘baskets’.

A ‘cap’ is a limit to the liability in the event of a misrepresentation, while a 'basket’ is the threshold amount of damages and losses that must be incurred before indemnification is applicable (this is also known as a deductible).

Regarding the ‘cap’, the standard practice is to set the cap at approximately ten per cent of the total value of the transaction, although this may vary depending on the business negotiations and the value of the transaction. With respect to the ‘basket’, the threshold will be based on the assumption of damages and losses and whether or not the parties agree on the risks allocated to the potential transaction; therefore, deciding on the threshold and the deductible will be the basis of the indemnification process.

In both scenarios, it is necessary to analyse the market and the specific industry subject to the transaction, as well as the results of the due diligence process, in order to negotiate an indemnification procedure that works for both parties and allows them to be in a good standing position upon execution of the relevant agreement and in regards to any potential claim in the future.

It should be noted that, after the closing of any transaction, the purchaser is the party facing the major risk and will be the party seeking higher indemnification. In addition to this, any ‘materiality’ qualifications under the representations and warranties may affect the interpretation of a misrepresentation and, therefore, this may complicate the indemnification process.

Finally, please be advised that to fund any indemnity, the most common structures include the creation of an escrow account, or the holdback of the purchase price. In both scenarios, if the amount is not sufficient to cover the damages and losses, then the party to be indemnified will have to proceed directly in accordance with the dispute resolution mechanism agreed to recover any such damages and losses.