A crucial point in almost every M & A transaction is the negotiation of clauses regarding representations and warranties.1 An often-used clause is the compliance representation. Compliance representations or compliance with laws representations are typical sell-side representations. In such a clause, the seller represents that the target company has conducted its business in accordance with all applicable laws.
This article intends to provide an overview of the purpose and use of compliance with laws representations, followed by aspects regarding negotiations of such representations and finally highlighting possible challenges and pitfalls of compliance representations.
2. Purpose and Use of Compliance Representations
The purpose of compliance representations is to allocate responsibilities and liability between the parties. Understandably, the new owner of a company does not wish to be responsible for legal breaches committed by its predecessor. Furthermore, compliance representations can create incentives to improve the disclosure process in the course of a transaction.
For more than a decade all standard US M & A purchase agreements concerning private targets contain compliance representations. According to the 2017 Private Target M&A Deal Points Study of the American Bar Association (ABA), such clauses were included in almost every of the reviewed transactions.2 As can be seen in Graphic 1, only 1 percent up to 2 percent (in 2008 even 0 percent) of the purchase agreements reviewed by the ABA did not contain compliance with laws representations.
The situation in Europe is different. As can be seen in Graphic 2, compliance representation clauses are used regularly in more than three-quarters of all purchase agreements.3
In our practical experience, in Germany, the sell-side usually does not object to include such provisions in purchase agreements. Only in cases where compliance issues could be a key concern, they will be contested and negotiated. The results of the studies confirm our own experience.
In European purchase agreements are usually subject the scope of compliance representations are subject to negotiation. Classical areas of negotiation are knowledge qualifiers, time limitations and notice requirements.
In the US, compliance representations are, according to the 2017 ABA study, rarely qualified by knowledge. In Europe, almost every second purchase agreement containing compliance representations, then includes a knowledge qualifier. However, limitations regarding the time of compliance are more common in the US than in Europe. In Europe, every third of four compliance representation clauses cover present and past compliance. As regards notice requirements, no significant differences exist between the US and Europe. If any notice is covered in compliance representation than it is usually a notice of violation. Notices of investigations are rarely included.
3. Negotiation of Compliance Representations
Negotiations of compliance with laws representations depend on the perspective. The common sell-side preference is to limit representations. A possible way to achieve this is to give a compliance representation as regards current compliance only. Having the ABA studies in mind it might be hard to achieve such a limitation inEurope. Nevertheless, it seems to be reasonable to negotiate time limitations regarding past compliance, e.g. the previous three years, if a representation concerning past compliance cannot be excluded.
Source: American Bar Association, Business Law Section, Mergers & Acquisitions Committee, M&A Market Trends Subcommittee, Private Target Mergers & Acquisitions Deal Point Study, 2017, page 41.
Source: American Bar Association, Business Law Section, Mergers & Acquisitions Committee, M&A Market Trends Subcommittee, European Private Target Mergers & Acquisitions Deal Point Study, 2017, page 42.
Source as regards the US: American Bar Association, Business Law Section, Mergers & Acquisitions Committee, M&A Market Trends Subcommittee, Private Target Mergers & Acquisitions Deal Point Study, 2017, page 40.
Besides time limitations, a seller can limit the representation by using different qualifiers, i.e. knowledge qualifiers or certain materiality qualifiers. Possible materiality qualifiers are provisions which provide that the breach of the compliance representation shall have a material adverse effect (MAE) on the business or that the violated law is material to the target company’s business. A typical knowledge qualifier in a compliance representation is a “to the best knowledge of the seller” wording.
In addition, the exclusion of certain areas of law is a possible way to limit the scope of compliance representations.
Usually, it is not in the interest of the buy-side to have provisions that limit the seller’s representation regarding compliance with laws. Buyers do not want to be liable for someone else’s misconduct. Therefore, broad compliance representations without limitations are in their interest.
4. Possible Challenges and Pitfalls
A possible challenge concerning compliance representations is to synchronize general compliance representations with the more topic-oriented ones, which include compliance aspects in certain areas of law, such as environment or data protection. In particular, the topic-oriented representations are something the sell-side should be aware of, especially in the context of the EU General Data Protection Regulation (GDPR) since mid-2018 or in the case of highly regulated businesses. Intensively negotiated limitations of topicrelated representations containing compliance with environmental or data protection laws should not be made ineffective by a broad and unlimited general compliance representation. A lack of synchronization of general compliance representation and topic-related compliance representation may result in a significant liability risk for the sell-side. Therefore, a clarifying statement in the context of an accurate synchronization of these clauses will be helpful.
A further challenge of compliance representations is the question who determines whether a breach occurred. Many compliance with laws representation clauses do not cover this aspect. This causes a risk of post-transaction disputes whether there was a breach or not. To mitigate this risk, the purchase agreement should provide appropriate provisions. The parties may provide that a final decision of a court or an authority is decisive for the determination of a breach. Furthermore, it is recommendable to define potential decisions. If there is no court or authority proceeding, it is possible to agree on an expert proceeding. In such a case, an independent expert, e.g. nominated by both parties or even by a third party, should decide if a breach of a compliance representation occurred. Notices of investigations by governmental entities or similar authorities or notices of violations may help as well.
The target company faces various risks in the event of compliance breaches. Not only fines imposed by authorities, claims filed by privates (e.g. antitrust law), but also severe damages to the reputation of the target company are possible. In Germany the compensation of damages in an M & A transaction is usually not governed by the statutory law but by a negotiated special contractual liability regime. In our observation, most purchase agreements do not provide for a special regime for the damages caused by a breach of compliance representations. The general contractual liability regime of a purchase agreement may be sufficient to cover direct damages, e.g. fines, but is often insufficient with regard to indirect damages. Negotiating compliance with laws representations, the parties and legal advisors should have in mind not only the scope of the representation but also the compensation of direct as well as indirect damages.
5. Summary and Recommendations
Finally, the sell-side party should be aware that in times of high enterprise valuations, buyers tend to use a broad compliance guarantee to reduce the purchase price by conducting special compliance reviews. For the seller the best way is to reject a compliance representation.
If this is not possible, the focus of negotiations should be on the scope of such a representation. There are various possibilities to limit this scope. Time limitations, knowledge qualifiers, materiality qualifiers, notices and law limitations are possible ways to achieve this. Purchase agreements should provide for precise provisions regarding the determination of breaches as well as their consequences. In particular, the compensation of indirect damages caused by infringements of compliance representations is challenging. The lack of case law in Germany causes uncertainty. That is why careful drafting of compliance representations is all the more important.
- Whether share purchase agreement, asset purchase agreement or merger agreement. ↩
- American Bar Association, Business Law Section, Mergers & Acquisitions Committee,
M&A Market Trends Subcommittee, Private Target Mergers & Acquisitions Deal Point
Study, 2017, page 41. ↩
- American Bar Association, Business Law Section, Mergers & Acquisitions Committee,
M&A Market Trends Subcommittee, European Private Target Mergers & Acquisitions
Deal Point Study, 2017, page 42. ↩