Canadian Private Mergers and Acquisitions Deal Points Study
By Brendan Downey and Robyn Finley
The Canadian Private Mergers and Acquisitions Deal Points Study is a study organized by the Mergers and Acquisitions Committee of the American Bar Association (ABA) that seeks to illustrate trends and market standards to help answer the question "what is 'market' in Canadian M&A?" To help answer this question, a working group of Canadian lawyers (the Working Group) analyzed 90 publicly available acquisition agreements (the Agreements) for transactions signed in 2016 and 2017. The study also included some data from 2018. To qualify for consideration in the study, each Agreement had to involve Canadian private targets that were acquired or sold by public companies and had to meet the following additional criteria:
- the deal value was more than CAD $5 million;
- the target was not in bankruptcy;
- the parties were dealing at arm's length; and
- the governing law was Canadian law.
While the trends that the study reveals are interesting, the economic landscape in 2016 and 2017 looked very different than it does in 2020, even before the COVID-19 pandemic took hold of the global economy. As such, the answer to the question of "what is market?" may be different now than it was even six months ago.
The study and its limitations
The study presents its findings against a continuum of evolving trends in Canadian M&A by comparing data collected from the Agreements against data collected under similar studies completed in 2014 and 2016, as well as data collected in the United States. It is therefore instructive to see how commercial preference has evolved over the intervening six years and how it differs between the two countries.
There are, however, a number of practical limitations to the study. For example, acquisitions by private companies are not captured, as all of the Agreements were sourced from SEDAR. Another limitation arises from the relatively small number of Agreements comprising the sample set. Because the study reports most of its findings in terms of the percentage of agreements reviewed that contained a particular contractual mechanism or treated a particular issue in a certain way, percentage differences and changes from year to year that appear significant may only represent a difference of a few agreements. In an M&A marketplace where thousands of private targets are acquired every year, this practical limitation is readily apparent. Moreover, sample size may also affect our interpretation of the study's findings to the extent that the study compares Canadian and American trends from year to year. On first impression, the year-to-year fluctuations present in some of the "points" that the Working Group considered are significantly greater in Canada than they are in the United States. But this could simply be a reflection of the fact that there is more American data available to the ABA, so the greater fluctuations in Canadian trends may be attributable to smaller data sets.
In terms of general deal classification, the consideration and form of the deals that comprised the study's data set are as follows:
- All cash: 49%
- All shares: 14%
- Mixed: 36%
Form of deal
- Asset: 27%
- Share: 64%
- Mixed: 9%
While the Working Group did not provide a more detailed breakdown, it is notable that cash is the most common form of purchase consideration. In fact, approximately 85% of Agreements involved at least some cash.
Of the 90 Agreements reviewed in the survey, approximately 20 were in the oil and natural gas sector. The study did not indicate whether the breakdown of oil and natural gas transactions that the Working Group analyzed followed the breakdown above.
Purchase price adjustments
79% of the Agreements contained a post-closing purchase price adjustment, representing an uptick of approximately 6-7% since the previous studies were released. Of these, 34% of Agreements included a separate escrow mechanism to secure the adjustments. Where an Agreement provided for a post-closing purchase price adjustment, approximately 50% included the payment of a preliminary adjustment at closing based on the target's estimate, and approximately 20% of these estimates were subject to purchaser consent, representing a 25% decrease in purchaser consent rights since the previous study periods.
In the Agreements that the Working Group looked at that included a post-closing purchase price adjustment, the purchaser prepared the closing balance sheet 59% of the time. This represents nearly a 20% decrease from the 2016 study, but is generally consistent with the allocation of responsibility identified in the 2014 study. The authors do not speculate on the cause of this intervening anomaly, but it may be a function of the limitations of the data set. In terms of balance sheet methodology, GAAP appears to be on an upward trend (increasing gradually from 19-32% over the three study periods), whereas GAAP Consistent with Past Practices has seen a 20% fall from the 2014-2016 periods. Again, it is not clear what is driving these shifts or whether they illustrate a larger trend or not.
Out of the same subset of Agreements that include post-closing adjustments, the most common form of adjustment has consistently been a working capital adjustment (representing between 70-80% of adjustment mechanisms reviewed since 2014). The actual breakdown is as follows, although we note that 32% of Agreements contained multiple adjustment metrics which accounts for the overlap in the numbers below:
- 6% based on earnings
- 79% based on working capital
- 25% based on debt
- 7% based on asset value
- 13% based on cash
- 25% "other"
Approximately half of Agreements that provided for a post-closing working capital adjustment did not expressly exclude tax assets and tax liabilities in the calculation, while 15% expressly excluded them. The frequency with which tax-related items were included in the calculation has fallen nearly 30% from 2014.
Earn-outs are a pricing structure where a vendor must "earn" part of the purchase price based on the performance of the business following the transaction. Very few of the Agreements reviewed (16%) included an earn-out as part of the post-closing adjustment:
- 36% based on revenue
- 29% based on earnings / EBITDA
- 29% "other"
- 7% "indeterminable"
Of those Agreements that included an earn-out, the plurality (29%) contemplated an indeterminate earn-out period; however, 50% of earn-outs fell somewhere in the range of 12-24 months. In terms of a purchaser's subsequent operation of an acquired business during the earn-out period, 14% of Agreements included a covenant to run the business consistent with past practice, and 29% of earn-out provisions identified in the Agreements permitted the purchaser to operate in its discretion. None of the Agreements expressly disclaimed a fiduciary relationship with respect to an earn-out.
Material Adverse Effect clauses
82% of the Agreements included a definition of Material Adverse Effect (MAE), 10% used the expression but did not define it, and 8% did not include it at all. The definition of an MAE can be desirable for purchasers to the extent that the occurrence of an event that has a material adverse effect on the target business would allow them to walk away from the deal or, potentially, benefit from a reduced purchase price. Vendors, on the other hand, want to limit the scope of a MAE and exclude forward-looking language that allows purchasers the flexibility to abandon the transaction.
The most vendor-friendly MAE definitions are those that are forward-looking and contemplate adverse effects on a target's results and its prospects. Of those Agreements that defined MAE, 69% were forward-looking, but only 35% included an express reference to the target's business prospects. 78% limited the effect of an MAE by including express carve-outs—occurrences having a material adverse effect on a target that would nevertheless be excluded from relief under an MAE clause. As these numbers have remained relatively consistent since 2014, this may have represented "market" for the allocation of benefits and burdens under an MAE, prior to the first quarter of 2020.
It will be interesting to see how future deals reallocate the risk of MAEs, particularly the risk to a targets' business prospects in light of the economic consequences that a global event such as a pandemic may have and the potential for future events of a similar nature. Vendors will continue to seek to limit a purchasers' ability to abandon a transaction, even in the face of unprecedented market conditions, but purchasers will have an increased incentive to negotiate some sort of protection for themselves in case prevailing market conditions materially alter the value of the business being acquired.
The study did not analyze the presence or content of force majeure clauses in the Agreements. Anecdotally, the precise meaning and scope of a force majeure clause and its associated definition has generated significant interest in the legal community as a result of the pandemic. Going forward, we expect to see greater specificity in the settled definitions of force majeure, and perhaps more negotiations devoted to whether a pandemic and the resulting economic fallout should be included or carved out from force majeure provisions.
Reps and warranties
(a) No Undisclosed Liability (NUL) Representation
NUL representations convey that all material liabilities have been disclosed. Generally, NUL representations involve the vendor making a representation to the purchaser certifying that the target company has "no undisclosed liabilities". The inclusion of NUL representations has declined from a 90% rate of inclusion in 2014 to 79% in 2017. It is less common in Canada to include a NUL representation compared to the US (79% of deals compared to 97%).
(b) "Compliance with Laws" Representation
Compliance with Laws clauses stipulate that the parties to an agreement will abide by applicable laws. Often the vendor gives the representation that the target has operated its business in accordance with applicable laws. Vendors generally seek to include certain limitations that narrow the scope of the representation.
The inclusion of a representation related to compliance with laws fell to 89% in 2017 from 96% in 2016. It is included in virtually every deal in the US and that was the case in Canada in prior studies. However, it is clear that despite the recent drop, a Compliance with Laws representation appears to be 'market' in Canadian M&A transactions.
In many agreements, the parties' representations and warranties are qualified by the knowledge of the person making the representation. What exactly constitutes "knowledge" for the purposes of the transaction is therefore important to the person making the representation. Consistent with past studies, constructive knowledge was the most common definition of knowledge identified in the Agreements, appearing in 56% of them. However, this represents a decline from 84% in the 2016 study. Where knowledge was treated as constructive knowledge, 76% of the Agreements defined it to be subject to reasonable or due inquiry and 10% defined it with reference to the position or seniority of the person making the representation. Actual knowledge is a much stricter standard that provides additional protection to the person making the representation, and it appeared in 22% of the Agreements. The balance of Agreements left it undefined.
(a) "Double materiality scrapes"
A "double materiality scrape" is a provision that requires the parties to a transaction to ignore all materiality qualifications (e.g., "material", MAE, "in all material respects", etc.) from the representations and warranties in an acquisition agreement when determining: (1) whether or not a breach occurred; and (2) the amount of indemnifiable losses resulting from the breach. These are purchaser-friendly provisions as they "scrape" away materiality qualifications in a vendor's representations and warranties and make it easier to demonstrate damages sufficient to qualify for indemnification. From a purchaser's perspective, a double materiality scrape means that it does not need to overcome both a materiality threshold for a breach of a representation and a built-in materiality threshold in an indemnity. From a vendor's perspective, a double materiality scrape limits the protection that the materiality qualifiers it negotiated for, if any, provide. For this reason, they are not particularly common in Canada. Of the Agreements that contained materiality or MAE qualifiers, 16% included a double materiality scrape as of signing; 39% included one as of closing. Interestingly, the frequency of both kinds of scrape fell dramatically from the 2016 study period where approximately 65% of agreements that contained these qualifiers contained scrapes of the sort identified in the study.
As a general trend identified in the study, American deals are far more likely to include double materiality scrapes than Canadian deals: 87% of American M&A transactions include these scrapes. Despite the recent drop in Canada, however, the inclusion of a double materiality scrape in Canadian M&A transactions has increased substantially since 2014. This suggests that Canadian parties may be trending towards US practice in this regard.
As we learn more about the effects of the COVID-19 pandemic on the North American transaction landscape, we may see a reversal of a trend towards more double materiality scrapes as vendors negotiate for a higher materiality threshold that would see deals close despite pandemic-related uncertainly and volatility.
(b) Opinions from counsel
Often in the course of commercial transactions, counsel provides written legal opinions in respect of certain matters such as corporate existence or authority to the other parties as a condition of closing. These legal opinions are becoming less common in Canada. In fact, the number of deals requiring opinions has dropped in half since the 2014 study (from 34% to 18%). That said, Canadian deals are still more likely to require opinions from counsel compared to American deals (18% compared to 7%).
Sandbagging refers to the practice of a party claiming a breach of a representation or warranty under an agreement even though the claiming party knew that the other party was in breach at the time the agreement was signed. Anti-sandbagging provisions prevent parties to transactions from using this strategy. 12% of the Agreements included anti-sandbagging provisions, preventing parties from suing for breach of representation or warranty if they knew that it was not true at the time of signing. 22% of the Agreements included language that expressly permitted sandbagging. The remainder were silent.
The preference for silence likely arises from the fact that unless the transacting parties are in agreement as to how they want to address sandbagging, the case law in this area in Canada is inconsistent, so each party at least maintains its ability to argue for or against the position in the future.
An indemnity cap is the total amount of losses and damages that a purchaser is entitled to recover from a vendor in the event of breach, and vice versa. In the context of a commercial contract, the indemnity cap may be set in relation to the purchase price, allowing the party who suffers from a breach to recover up to a certain proportion of the transaction's value.
If an agreement provides that indemnification is the sole remedy, negotiating a fair cap can be important to both the vendor and the purchaser. 67% of the Agreements reviewed in the study explicitly provide that indemnification is the exclusive remedy. On the other hand, 7% specified that indemnification was a non-exclusive remedy. The balance were silent on this point.
In deals with determinable caps, a quarter capped indemnities at an amount equal to the purchase price. Another quarter of the Agreements provided for an indemnity cap that fell somewhere in the range of 25-50% of the purchase price. 16% included an indemnity cap of less than 10% of the purchase price—a number that has doubled since 2016.
In American data reviewed by the Working Group, a clear majority of agreements (60%) include an indemnity cap at 10% or less of the purchase price. The Canadian trend of lowering indemnity caps is likely in response to the apparent practice of relying on relatively low indemnity caps in the United States.