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MAC Clauses and Indemnification MAC Clauses and Indemnification Provisions in M&A Deals

Crafting Terms to Minimize Transaction Risks and Post‐Closing Disputes

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, NOVEMBER 29, 2011

Today’s faculty features: Todd B. Pfister, Partner, Foley & Lardner, Chicago Jeff J. Litvak, S enior Managing Director— Forensic Litigation, FTI Consulting, Chicago Kevin D. Kreb, Partner, PricewaterhouseCoopers, Chicago

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MAC Clauses and Indemnification Provisions in M&A Deals

November 29, 2011

5

Today’s Presenters

 Todd Pfister

Foley & Lardner LLP

 Kevin Kreb

PricewaterhouseCoopers Foley & Lardner LLP PricewaterhouseCoopers

 Jeff Litvak  Jeff Litvak

FTI Consulting

6

MAC Clauses and Indemnification Provisions in M&A Deals Agenda Indemnification Provisions in M&A Deals



Negotiating MAC Clauses



Negotiating Indemnification Provisions



Negotiating Indemnification Provisions



Reassessing Common Provisions Favorable t S ll to Sellers



The CPA’s Role in Pricing MAC and Benefit g

• f the Bargain Claims



M&A Issues – From Dispute to Resolution

7

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

M&A Issues From Dispute to Resolution

7

MAC Clauses and Indemnification Provisions in M&A Deals Indemnification Provisions in M&A Deals

Negotiating MAC Clauses Negotiating MAC Clauses

8

Negotiating MAC Clauses What is a MAC? What is a MAC?



Means of allocating risks between signing and closing



Increasingly relevant given turbulent world Increasingly relevant given turbulent world

–

Terrorist Attacks, Wars, Financial Crises



MACs used in different parts of agreement

–

Representations & Warranties – “Stand-Alone” condition

S t t ti di f MAC i i d t



Separate representation regarding nonoccurrence of MAC since a given date



Modify representation regarding given subject to indicate absence of event, etc. leading to a MAC



Used alone in about 36% of deals*

–

Closing Condition – “Back Door” condition

–

Closing Condition Back Door condition



The Agreement includes an “Absence of Change” representation and a condition “bringing down” the accuracy of the seller’s representations and warranties.



Bringdown condition enables a party (typically the buyer) to terminate the agreement and get

• ut of the deal if the condition is not met

U d l i b t 9% f d l *



Used alone in about 9% of deals*

–

A majority of deals include both Stand-Alone and Back-Door Conditions*

*2011 SRS M&A Deal Terms Study, analyzing private-target deals between July 2010 through September 2011 (“2011 SRS Study”) 9 ( 2011 SRS Study )

Negotiating MAC Clauses What is a MAC? (cont’d ) What is a MAC? (cont d.)

 Sample closing condition provision:

“B ’ bli i h i “Buyer’s obligation to consummate the transactions contemplated by this Agreement is subject to the satisfaction of the following conditions: g . . . The representations and warranties of Seller contained in this Agreement were accurate as of the date of this Agreement and are accurate as of the Closing Date except for any inaccuracy that would Closing Date, except for any inaccuracy that would not reasonably be expected to result in a [MAC].”

10 10

Negotiating MAC Clauses What is a MAC? (cont’d ) What is a MAC? (cont d.)

 Simple “MAC” definition: “Material Adverse Change” means any material adverse

change in the business, results of operations, assets, liabilities or financial condition of Seller condition of Seller

 Drafting Issues to Consider –

Inclusion of forward-looking standard?



From July 2007 through July 2010, a forward-looking standard was included in MAC definition 68% of the time* definition 68% of the time



“Could be” (22%) vs. “Would be” (61%) vs. other (17%) *

–

Double materiality “problem”

–

Inclusion of “prospects” in MAC definition?

According to the 2009 ABA Study “prospects” included 38% of the time**



According to the 2009 ABA Study, prospects included 38% of the time



According to the 2010 SRS Study, “prospects” included 23% of the time*



Less prevalent in public deals where walk away right for MAC - for public deals announced in 2009, only 1% included “prospects”***

–

Quantify materiality? Q y y



According to the 2009 ABA Study, stated dollar amount included in MAC only 2% of the time (down from 8% in 2004)**

*Source: 2010 SRS M&A Deal Terms Study, analyzing private-target deals between July 2007-July 2010 (“2010 SRS Study”) **Source: 2009 Private Target Mergers & Acquisitions Deal Points Study (“2009 ABA Study”)

11 11

Source: 2009 Private Target Mergers & Acquisitions Deal Points Study ( 2009 ABA Study ) *** Source: 2010 Strategic Buyer/Public Target Mergers & Acquisitions Deal Points Study (“2010 ABA Study”)

Negotiating MAC Clauses What is a MAC? (cont’d ) What is a MAC? (cont d.)

– Inclusions and Carve-outs  Included in MAC definition 92% of the time*  Disproportionate effect qualifier included in MAC definition 88%

• f the time*

 Changes in general economic or political conditions (91%)**  Changes affecting industry as a whole (91%)**  Changes affecting industry as a whole (91%)  Changes in GAAP (60%)**  Changes in law (66%)**  Announcement of Agreement (71%)**

g ( )

 Actions contemplated by the Agreement (60%)**  Acts of God, war or terrorism (55%)**  Case-specific matters, such as pending litigation  Percentages even higher for public company transactions

*Source: 2010 SRS Study **Source: 2009 ABA Study 12 12

Negotiating MAC Clauses What Does Case Law Teach Us? What Does Case Law Teach Us?

 Case Law

–

In re IBP, Inc. Shareholder Litigation (Del. Ch. 2001) (“Tyson Foods”) In re IBP, Inc. Shareholder Litigation (Del. Ch. 2001) ( Tyson Foods )

 Delaware court interpreting New York law  Tyson sought to terminate deal based upon sharp earnings decline of IBP  Court granted specific performance to IBP  In absence of specific language, earnings volatility does not constitute a

MAC

–

Frontier Oil Corp. v. Holly Corp. (Del. Ch. 2005)

B ht t t i t f MAC b d th t d t i t t

 Buyer sought to terminate for MAC based upon threatened toxic tort

litigation

 Court found that requisite likelihood of “catastrophic” result not

established to constitute a MAC

 Potential litigation costs of $15 million to $20 million relative to a deal size

• f approximately $340 million

13 13

Negotiating MAC Clauses What Does Case Law Teach Us? What Does Case Law Teach Us?

–

United Rentals, Inc. v. Ram Holdings, Inc. (Del. Ch. 2007)

 MAC clause excluded the condition of the credit markets in the United States  However, specific performance not granted – the merger agreement was

ambiguous on the subject and evidence established an understanding between the parties that the merger agreement barred the remedy of specific performance

 Cerberus acquisition subsidiary required to pay $100 million termination fee

H i S i lt Ch i l I H t C (D l Ch 2008)

–

Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (Del. Ch. 2008)

 No financing out  Fairly typical MAC out (with limited carve-outs)  Reverse break-up fee if buyer breached (no cap, if intentional breach)

y ( )

 “Heavy” burden rests on party seeking to excuse performance and “poor earnings

must be expected to persist significantly into the future” for decline in target’s earnings to constitute MAC

 Court found no MAC; Buyer liable for all damages  Case may limit ability of buyers to renegotiate price and terms in turbulent market

14 14

Negotiating MAC Clauses What Does Case Law Teach Us? What Does Case Law Teach Us?

 Key Takeaways

Party seeking to invoke MAC to avoid closing bears a “heavy burden”

–

Party seeking to invoke MAC to avoid closing bears a heavy burden to show MAC has occurred

–

Parties may reallocate burden of proof in agreement MAC ordinarily will be measured in years not months (i e

–

MAC ordinarily will be measured in years, not months (i.e., “consequential” change to long-term earnings rather than “short-term hiccup”) Specific metrics and benchmarks may be warranted – reliance on

–

Specific metrics and benchmarks may be warranted reliance on general MAC provision to terminate will be difficult

–

MAC will be viewed in context of entire agreement, not in isolation

 Buyer’s rationale for deal matters  Buyer s rationale for deal matters  Strategic vs. financial buyer may be important

15 15

Negotiating MAC Clauses Drafting Considerations Drafting Considerations



Case law is fact specific and does not provide uniform benchmarks or

• definitions. However, materiality standard almost certainly higher than

securities law materiality threshold securities law materiality threshold



Exclusions/carve-outs are critical and must be carefully crafted



Buyer typically should insist on appropriate forward-looking component D fi b h k bi l l ll



Define your own benchmarks; ambiguous, general language generally works against buyer



Self-assess: who is the buyer, what is the purpose of the transaction, and what does the buyer know? y



Pay attention to choice of law and choice of forum provisions



Coordinate representations and warranties (and other agreement provisions) with MAC



Language is key! In the world of MACs, one size does not fit all

16 16

MAC Clauses and I d ifi ti P i i i M&A D l Indemnification Provisions in M&A Deals

Negotiating Indemnification Clauses Negotiating Indemnification Clauses

17

Negotiating Indemnification Provisions Materiality Scrapes Materiality Scrapes

 Definition of “Materiality Scrape”

Materiality qualifications in representations and warranties

– Materiality qualifications in representations and warranties

disregarded for all indemnification related purposes or

– Materiality qualifications in representations and warranties

disregarded for calculation of damages/losses, but not to determine whether a breach has occurred or

– Materiality qualifications in representations and warranties

disregarded to determine whether a breach has occurred, g , but not when calculating damages

18

5231036.1

18

Negotiating Indemnification Provisions Materiality Scrapes (cont’d ) Materiality Scrapes (cont d.)

 An increase in materiality scrapes was a product of an

increasingly buyer-friendly environment which is now increasingly buyer friendly environment, which is now becoming friendlier to sellers

–

Between July 2010 and September 2011,materiality scrapes were used in about 81% of deals, up from 69% between July 2007 and July 2010*

–

However, only about 21% of materiality scrapes were used to both determine breach and damages while about 69% were used only to determine damages*

 From 2007 to 2010 about 41% of materiality scrapes were used to both  From 2007 to 2010, about 41% of materiality scrapes were used to both

determine breach and damages; 51% of materiality scrapes were used

• nly to determine damages*



Sellers could use the presence of materiality scrapes to negotiate for th i i i l di hi h b k t d t d d tibl

• ther provisions, including higher baskets and true deductibles



Materiality scrapes provide an incentive for sellers to list all items or include a “catch-all” provision in the disclosure schedules

19

5231036.1

*Source: 2011 SRS Study; 2010 SRS Study 19

Negotiating Indemnification Provisions Materiality Scrapes (cont'd ) Materiality Scrapes (cont d.)

Alternatives to Materiality Scrapes: Use dollar thresholds to determine whether

 Use dollar thresholds to determine whether

immaterial matters constitute a breach

– This provides certainty, but also invites arbitrariness

p y

 Include materiality scrapes only on certain agreed-

upon representations

20

5231036.1

20

Negotiating Indemnification Provisions Survival Periods Survival Periods

Survival periods increased in the recent buyer’s market

 Survival periods increased in the recent buyer s market

–

By 2007, typical survival periods had decreased from 24 months to 18 months*; some only one audit cycle In 2008 the average survival period was 19 months**

–

In 2008, the average survival period was 19 months

 Survival periods may be decreasing as the buyer’s market

softens

B t J l 2010 d S t b 2011 th i l

–

Between July 2010 and September 2011, the average survival period was 17.5 months***

 46% of deals during that period had a survival period of 18

months***

 Only 18% of deals during that period had a survival period of

more than 18 months***

21

5231036.1

* 2010 SRS Study ** 2011 Houlihan Lokey Purchase Agreement Study (“2011 Houlihan Lokey Study”) *** 2011 SRS Study 21

Negotiating Indemnification Provisions Survival Periods (cont'd ) Survival Periods (cont d.)

 A 2008 case has illustrated the importance of clear survival

period provisions period provisions



A survival period must be explicit and is to be construed against the party invoking the provision (Western Filter (9th Cir. 2008))

The 9th Cir found the provision to be ambiguous and to only limit the time

–

The 9

• Cir. found the provision to be ambiguous and to only limit the time

period for which a breach could occur or be discovered

–

The court found that the provision did not serve as a contractual statute of limitations

–

Practice point, make clear that the survival period is meant to cut short the statute of limitations

 However, a 2011 case provides more support for enforcing

survival periods and declined to extend the strict construction principle applied in Western Filter



The court held that agreements to shorten the statute of limitations do not

22

5231036.1

g violate public policy and are enforced if reasonable (Zalkind v. Ceradyne, Inc. (App. Ct. 2011))

22

Negotiating Indemnification Provisions “Sandbagging” Sandbagging

 “Anti-sandbagging” provision limits the

Seller’s liability for losses resulting from breaches of representations or warranties if the Buyer had knowledge of the breach before the closing

 “Pro-sandbagging” provisions (knowledge

savings clauses) expressly provide that g ) p y p remedy is not affected by any knowledge of the Buyer

23

5231036.1

y

23

Negotiating Indemnification Provisions “Sandbagging” Sandbagging

 The 2011 SRS Study showed pro-sandbagging in 63% of

deals * deals.

–

About the same as 2010 (66%), and still up from 2009 (54%)*

 35% of deals had anti-sandbagging language*  The compromise position is to remain silent; note that in

some jurisdictions, silence can be interpreted to result in an imputed anti-sandbag. p g

–

Between July 2010 and September 2011, only about 3% and 2% of deals, respectively, were silent*

–

This is down from 8% in 2009 and 5% in 2008* This is down from 8% in 2009 and 5% in 2008

*2011 SRS Study 24 24

Negotiating Indemnification Provisions B k t Baskets



Basket amounts have been stable

–

For the years 2008 through 2010, the mean basket was approximately 0.8% f th P h P i *

• f the Purchase Price*



Expected studies would show more first-dollar baskets instead of deductible baskets, but studies have some conflicting information

–

2011 Houlihan Lokey Study - 81% deductible baskets y y

–

2011 SRS Study - only 33% deductible baskets



Buyers may also request:

–

Baskets that only relate to breaches of reps and warranties, and not to specific indemnit pro isions specific indemnity provisions

–

Materiality scrapes related to the basket

–

The inclusion of carve-outs in the basket, in addition to capitalization, due

• rganization, due authority, and ownership of shares/assets

g y p

 About 93% of deals in the 2011 SRS Study had carve-outs; these deals

had an average of 6 carve-outs**

*Source: 2011 Houlihan Lokey Study 25

5231036.1

Source: 2011 Houlihan Lokey Study ** Source: 2011 SRS Study 25

Negotiating Indemnification Provisions Caps Caps

 Caps increased with the emergence of a buyers’

market and seemed to soften after an initial surge market and seemed to soften after an initial surge

–

The 2011 Houlihan Lokey study found the average cap was 17% in 2007, 14% in 2008, and 10% in 2009* Th SRS S d fl d f 13 68% f 200 2010**

–

The SRS Study reflected an average cap of 13.68% from 2007-2010**

 However, caps appear to be rising again

The 2011 Houlihan Lokey Study found that the average cap was 12%

–

The 2011 Houlihan Lokey Study found that the average cap was 12% in 2010*

–

The 2011 SRS Study reflected an average cap of 17% between July 2010 and September 2011** 2010 and September 2011

*Source: 2011 Houlihan Lokey Study ** Source: 2011 SRS Study 26

5231036.1

26

Negotiating Indemnification Provisions Caps (cont’d ) Caps (cont d.)

 If cap is less than 100% of purchase price, buyer

h t i l d t may push to include carve-outs:

– For Seller’s breach of covenant or fraud

Last year about 90% of deals included a carve out for fraud; 65%

 Last year, about 90% of deals included a carve-out for fraud; 65%

for non-willful breach of covenant; 58% for intentional breach of rep*

– For specific indemnity provisions

 Capitalization, taxes, due authority, and share ownership are

popular carve-outs p p

– For certain reps and warranties

 The most common carve-outs are for the following

t ti it li ti (71%) d th it (66%) h

27

5231036.1

representations: capitalization (71%); due authority (66%); share

• wnership (64%) and taxes (59%)*

* Source: 2011 SRS Study 27

Negotiating Indemnification Provisions Escrow Escrow

 Importance of Escrow or Set-off Rights

– Buyer’s indemnification claims are unsecured claims

 This has heightened relevance if seller files for bankruptcy post

closing closing

– Escrow

 Portion of purchase price may be placed in escrow  Procedures for drawing escrow funds are critical

– Escrow provide funds for all indemnification amounts? First or final

amounts?

– Escrow limited to certain types of claims, e.g. environmental – Term of escrow account

28

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28

Negotiating Indemnification Provisions Escrow (cont’d) Escrow (cont d)

– Set-off Rights

All b t d d t i d ifi ti t i t f t

 Allow buyer to deduct indemnification amounts against future

transaction payments or earn-out payments

 Procedures for identifying setoff payments are critical

– Time period of payments v. time of allowable indemnification claims – Limited to certain types of claims, e.g. environmental – Thresholds / materiality qualifiers

y q

 Joint and Several Liability

– Impact on buyer

Impact among sellers

– Impact among sellers

29

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29

Negotiating Indemnification Provisions Escrow (cont’d) Escrow (cont d)



Escrow periods continue to increase

–

For 2010, the average period was 20 months according to the 2011 Houlihan

19 20

months according to the 2011 Houlihan Lokey Study*

–

The SRS Study also saw an increase in escrow periods, up to 18.3 months in 2011 from 15.9 months in 2009**

16 17 18 19 Escrow Period (months)*



Escrow amounts remain high, but sellers have been pushing back with some success since 2009

15 16 2007 2008 2009 2010

success since 2009

–

In 2010, the average amount was 7.5%, reflecting a slight increase from 2009, but remaining lower than 2007 and 2008*

–

For July 2010 through July 2011 the SRS

4 00% 6.00% 8.00% 10.00% Escrow as percentage of

y g y Study indicated an average escrow of 12.94%**

*Source: 2011 Houlihan Lokey Study ** Source: 2011 SRS Study

0.00% 2.00% 4.00% 2007 2008 2009 2010 percentage of purchase price* 30

Source: 2011 SRS Study

Negotiating Indemnification Provisions Closing Deals Without Credit Closing Deals Without Credit

 Important to understand how indemnification

provisions are affected by new terms and structures used to get deals done in tight credit markets

 Some currently used terms and structures

y include:

– Post-Closing purchase price payments; Earnouts; – Post Closing purchase price payments; Earnouts;

Simultaneous Acquisitions; Seller Financing; Equity Rollover; Payments in Kind

31

5231036.1

y y

31

Negotiating Indemnification Provisions

Closing Deals Without Credit (cont’d ) Closing Deals Without Credit (cont d.)

 Post-Closing Purchase Price Payments

How does the delay affect the survival clause?

–

How does the delay affect the survival clause?

 Earnouts

–

Increased risk of litigation or arbitration

–

In the 2010 SRS Study, 25% of deals had earnouts (1/3 of which extended beyond 5 years), and the Buyer was entitled to offset indemnity payments in 59% In the 2011 Houlihan Lokey Study 21% of deals in 2010 had

–

In the 2011 Houlihan Lokey Study, 21% of deals in 2010 had earnouts, the same as 2009 and higher than the 16% in 2008

 Simultaneous Acquisitions

St t d b k t fi t fi t t b d

–

Structure cap and baskets as first-come, first-serve or pro-rata based

• n purchase price?

32

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32

Negotiating Indemnification Provisions Closing Deals Without Credit (cont’d ) Closing Deals Without Credit (cont d.)

 Equity Rollover

Used in 25% of deals in 2010 up from 18% in 2009 and

– Used in 25% of deals in 2010, up from 18% in 2009 and

2008*

 Seller Financing

– Used in only 2% of deals in 2010, down from 6% in 2009

and 2008*

 Payments in Kind  Payments in Kind

– Two-party indemnification for swapped assets or stock

* 2011 Houlihan Lokey Study 33

MAC Clauses and Indemnification Provisions in M&A Deals Indemnification Provisions in M&A Deals

Reassessing Provisions Regarded Reassessing Provisions Regarded as Seller-Friendly

34

Reassessing Common Provisions Consequential Damages Consequential Damages

 Boilerplate provisions commonly exclude

more than consequential damages

– Often exclude: Consequential, Incidental, Indirect,

Special, Punitive Damages, Loss of Revenue/Income/Profits

35

5231036.1

35

Reassessing Common Provisions Consequential Damages (cont'd ) Consequential Damages (cont d.)

 Consequential damages:

– Compensate the buyer for real losses resulting

from seller’s breach of a representation or warranty

 Incidental damages:

g

– Include expenses incurred by non-breaching

party to avoid other losses caused by the breach p y y

36

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36

Reassessing Common Provisions Consequential Damages (cont'd ) Consequential Damages (cont d.)

 Incidental damages likely include out-of-

pocket expenses incurred by buyers to remedy problems resulting from seller’s breach

 Thus, buyers should seek to exclude

, y incidental damages from waiver provisions, although they are commonly excluded in g y y boilerplate provisions

37

5231036.1

37

Reassessing Common Provisions Fraud Exclusion Fraud Exclusion

 Contractual survival periods of

representations and warranties generally apply only to contractual rights

 Fraud & Misrepresentation claims are based

in tort law – thus often not subject to survival j period

38

5231036.1

38

Reassessing Common Provisions Fraud Exclusion (cont'd ) Fraud Exclusion (cont d.)

 Not all states allow parties to limit their liability for tort-based

claims such as fraud and misrepresentation (CERAbio LLC v claims such as fraud and misrepresentation (CERAbio LLC v.

Wright Med. Tech Inc. (7th Cir. 2005))

 If gross negligence indicates intentional wrongdoing, a

provision limiting liability may be ineffective

(Food

provision limiting liability may be ineffective (Food

Holdings Ltd. v. Bank of America Corp. (S.D.N.Y. 2010))

 Certain types of tort claims may not be excluded (DynCorp v.

GTE Corp (S D N Y 2002); Solutia Inc v FMC Corp (S D N Y 2006)) GTE Corp. (S.D.N.Y. 2002); Solutia Inc. v. FMC Corp. (S.D.N.Y. 2006))

–

When a seller has “peculiar” knowledge that could not be discovered by buyer Wh ll d i i t f i f ti t d b b

–

When a seller denies existence of information requested by buyer

–

However, when a sophisticated party knows that it is not receiving full information, it may be barred from relying on the peculiar knowledge

• f its counterparty

39

5231036.1

• f its counterparty

39

MAC Clauses and Indemnification Provisions in M&A Deals Indemnification Provisions in M&A Deals

The Role of the CPA in Proving The Role of the CPA in Proving Material Adverse Change and Benefit of the Bargain Claims

40

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl Standard Material Adverse Change Clause Purchase and Sale Agreements typically include a Material Ad Ch (“MAC”) l t i i l Adverse Change (“MAC”) clause containing language similar to the following: Definition

– Material Adverse Change – any event, development, circumstance, change or

effect that is or would reasonably be expected to be materially adverse to the effect that is or would reasonably be expected to be materially adverse to the business, financial condition or results of the operations of the Acquired Company.

Representation of Seller

– Since date XX, there has not been any Material Adverse Change in the

business operations properties prospects assets or condition of any Acquired

41

business, operations, properties, prospects, assets, or condition of any Acquired Company, and no event has occurred or circumstance exits that may result in such Material Adverse Change.

41

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

• IBP, Inc. v. Tyson Foods, Inc.
• Based on VC Strine’s ruling in this case, a MAC may have

been sustained if:

• Dramatic downturn in earnings from the date of the signing of the SPA and

before the closing.

• There is a downturn in the business that is disproportionate to the industry,

There is a downturn in the business that is disproportionate to the industry,

• The downturn is durationally-significant (or over a commercially reasonable

period), meaning years and not months (is the downturn a blip or a trend?), and and

• The change in the business in unknown to the Buyer.

42 42

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)



Another point of contention, assuming a MAC has occurred is whether it was known to the Buyer prior to signing the whether it was known to the Buyer prior to signing the Agreement?



An assessment of the Buyer’s valuation process will often



An assessment of the Buyer s valuation process will often reveal the facts contemplated by the Buyer at the time and whether or not the causes of the MAC were known.



As a related issue in assessing if damages have occurred, did the Buyer receive the benefit of its bargain or did the Seller materially mislead the Buyer as to the quality of its earnings?

43 43

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)



Valassis and ADVO are in the direct mail advertising b i E h h d l i f $1B Th

• business. Each company had sales in excess of $1B. The

combined entity will exceed $2.65B in sales.



Late in 2005 Valassis commenced merger discussions with ADVO.



On July 7, 2006, Valassis and ADVO signed the SPA, whereby, Valassis would pay $37/share in cash.

44 44

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 Prior to the signing of the SPA, ADVO represented:

– Forecasted operating income for FY2006 of $68 million; – The integration of their SDR computer system was progressing as

planned; planned;

– That the April & May 2006 financial statements were materially correct;

 The SPA is signed on July 5, 2006.

45 45

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)



AFTER the signing of the SPA: g g

– ADVO disclosed that April and May’s 2006 financial statements were

misstated by $2.6M;

– August 10, 2006, ADVO adjusted its $68 million forecasted operating

income to $54.8 million, nearly identical to an internal April 2006 f t f $54 5 illi forecast of $54.5 million;

– Actual FY results ending 9/30/06 were $37.9 million, some $30 million

below expectations below expectations.



Negotiations stalemated. On October 31, 2006 Valassis filed suit to rescind the merger.

46

g

46

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)



Investigate the following allegations:

– Were ADVO’s financial statements and financial forecasts misleading?

Was ADVO’s new computer system operating as represented?

– Was ADVO s new computer system operating as represented? – Financially speaking, did ADVO’s business suffer a financial downturn?

More specifically:



Did ADVO suffer a MAC?



Was ADVO performing disproportionately below its peers in the industry?



Was ADVO’s downturn durationally significant?

– Did Valassis significantly overpay for ADVO? – Critique opposing expert report

47 47

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

48

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

49

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

50

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 The forecasted cash flows and discount rate were

adjusted to reflect the downturn in the business. V l i i d th ti d d

 Valassis revised the revenue assumptions downward

which translated into a revised cash flow analysis.

 A control premium was added to the DCF valuation.

51 51

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

52

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

53

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 A MAC is very difficult to prove, therefore, the buyer

should consider incorporating economic teeth into the MAC clause, for example:

– Downturn defined, in duration and monetary terms – Projected vs. actual results threshold defined – Loss of customer base defined – The combination of these issues would trigger a purchase price

adjustment adjustment

54 54

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 For example:

– If sales decline more than 15% from the previous quarters financial

statements If EBITDA (as defined in the Agreement) declines more that $5 million

– If EBITDA (as defined in the Agreement) declines more that $5 million

from the previous months EBITDA

– If a customer comprising 10% or more of total sales for the previous

p g p twelve months is lost

55 55

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

“The benefit of the bargain measure awards the plaintiff the difference between the gain had the misrepresentations been true and what the p plaintiff actually received.”1

1 Litigation Services Handbook, Fourth Edition, 18.7

g , ,

56 56

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 Did the buyer receive the value represented

b th ll ? by the seller?

 Were misstatements of the financial statement

known to the buyer?

 If the seller misstated the financial statements  If the seller misstated the financial statements,

the buyer may not have received the benefit of its bargain its bargain.

57 57

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 ADVO was valued based on the financial

performance as represented by Valassis in July performance as represented by Valassis in July 2006 (prior to signing) and in August 2006 (after signing) signing).

 Valassis utilized both the Market and Income

approaches in valuing ADVO approaches in valuing ADVO.

 Valassis paid a significant control premium in its

i iti f ADVO acquisition of ADVO.

58 58

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

 A multiple of EBITDA was utilized based

th bl i

• n the comparable companies.

 Valassis initially priced ADVO:  Valassis initially priced ADVO:

• Bargained for - 11 times EBITDA
• As received - 9 times EBITDA

Th lti l f EBITDA h

 The multiple of EBITDA approach

included a control premium.

59 59

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)

Purchase Price Overpayment Calculation I Milli ( t lti l ) In Millions (except multiples) Pre-Signing Forecasted Fiscal '06 Op. Income - Misrepresentation $68.0 Less: Pre-Signing Forecasted Fiscal '06 Op. Income – Realistic (54.5) Operating Income Misrepresentation $13 5

9.0x Multiple

Operating Income Misrepresentation $13.5 % of Misrepresented Operating Income 19.9% ADVO '06 EBITDA (Valassis/Bear Stearns Projection) $119.0 ( j ) $ Less: Misrepresentation (13.5) Corrected ADVO '06 EBITDA $105.8 EV/EBITDA Purchase Price Multiple 9.0x Adjusted Enterprise Value $950 Less: Actual Enterprise Value Purchase Price 1,291.3 Purchase Price Overpayment $(341.8)

60 60

% of Actual Purchase Price 26.5%

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

61

CPA’s Role in Proving MAC and Benefit of the Bargain Claims Standard Material Adverse Change Clause (cont’d.)

62

CPA’s Role in Proving MAC and Benefit of the Bargain Claims St d d M t i l Ad Ch Cl ( t’d ) Standard Material Adverse Change Clause (cont’d.)



Case settled, as it should have, at about a $150 to $200 illi di t million discount



Material Adverse Change:

– Difficult to rescind a merger – The duration of ADVO’s downturn was a significant debate

Durationally significant is difficult to prove when a new customer could be

– Durationally-significant is difficult to prove when a new customer could be

• btained immediately or take years



Fraud claims were compelling:



Fraud claims were compelling:

– Alleged non-disclosure of Budget – Alleged misrepresentation of success of sales promotion

63

– Alleged misrepresentation of the status of the computer system

63

MAC Clauses and Indemnification Provisions in M&A Deals Indemnification Provisions in M&A Deals

Merger and Acquisition Issues Merger and Acquisition Issues – From Dispute to Resolution

64

M&A Issues – From Dispute to Resolution

65 65

M&A Issues – From Dispute to Resolution The Deal – Earn Outs The Deal Earn Outs

 Amerisource Case:

“Thi f ll i th h t tt f d d t “This case falls in the archetype pattern of doomed corporate romances….after some time, the initial romance fades, the relationship consequently sours, and both parties find themselves before the court loudly disputing what the merger agreement before the court loudly disputing what the merger agreement really meant back in the halcyon days.”

66 66

M&A Issues – From Dispute to Resolution

67 67

M&A Issues – From Dispute to Resolution

Intersection of Indemnification and Closing Date Adjustments Background:



An Interest Purchase Agreement (“IPA”) provides for a working capital adjustment and indemnification of third party claims Indemnification provisions for financial statements and undisclosed liabilities apply



Indemnification provisions for financial statements and undisclosed liabilities apply



A third party claim for pre-closing unpaid rent is made



Indemnification notice and defense provisions of the IPA actuated



First issue is legal: who defends and does seller have a conflict



Second issue is legal and financial: can there be both a PPD and an indemnification claim for the same issue and if so, how derived?

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5231036.1

68

M&A Issues – From Dispute to Resolution

Intersection of Indemnification and Closing Date Adjustments Illustration:



Indemnification claim is settled for $750k



Indemnification claim is settled for $750k



The purchase price equates to approx. 6X EBITDA from warranted F/S

Buyer contentions:



Buyer gets BOTH its $750K as a PPD and $4.5m of indemnification



The rent expense error will result in recurring additional expense



Buyer primarily based its consideration on an EBITDA multiple



Buyer primarily based its consideration on an EBITDA multiple

Seller contentions:



Buyer does not get indemnification for amounts not paid to third parties



Buyers claim is “Plus One” and therefore duplicative; Buyer will pass on additional costs to its customers; Should be “Minus One” if anything



Seller is not responsible for how Buyer derived its offering price

69 69

M&A Issues – From Dispute to Resolution

Intersection of Indemnification and Closing Date Adjustments Illustration cont’d.:

 What if contentions:

– If issue was unrecorded revenue does Buyer owe 6X? – If Seller paid the claim out of own funds what happens?

If Seller paid the claim out of the funds of the acquired business

– If Seller paid the claim out of the funds of the acquired business

what happens?

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5231036.1

70

M&A Issues – From Dispute to Resolution Th Di t

 What to discuss with the potential

The Dispute

arbitrator

 Details about the process: from dispute to

resolution resolution

71 71

M&A Issues – From Dispute to Resolution Th Di t

What issues routinely arise in a purchase price dispute? Discovery issues

The Dispute

– Discovery issues – Dates through which information is relevant – GAAP vs. consistency – Errors in the benchmark – Materiality

D e diligence

– Due diligence – Additional disputed items – Overlap of PPD issues and Indemnification

p

72

5231036.1

72

M&A Issues – From Dispute to Resolution Th Di t

Accounting issues common to purchase

The Dispute

price disputes

– General Areas – Specific Issues

73

5231036.1

73

M&A Issues – From Dispute to Resolution Th Di t

How to improve your chances of success in a PPD

The Dispute

–

Expect disagreement over closing balances

–

Engage legal and financial resources

–

Enroll support from key employees

• suppo t
• ey e

p oyees

–

Retain/obtain documents

–

Be thorough in picking the neutral No underestimating the opposing position

–

No underestimating the opposing position

–

Avoid overreaching

–

Provide support and proof beyond argument Develop an expected value and min/max probabilistic outcomes

–

Develop an expected value and min/max probabilistic outcomes

–

Respond fully to all arbitrator questions

–

Don’t compromise on strong positions

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5231036.1

74

M&A Issues – From Dispute to Resolution

How to limit the likelihood of PPDs

Set baskets

–

Set baskets

–

Define the closing date adjustment narrowly

–

Avoid late changes to the SPA Double check formulaic adjustments for selected amounts

–

Double check formulaic adjustments for selected amounts

–

Set closing date at month end

–

Set or limit changes to contra asset accounts and reserves T k h i l i t i

–

Take physical inventories

–

Agree on fixed asset existence verification

–

Shorten time from benchmark to closing

–

Perform buy and sell side diligence

–

Document the dispute resolution process specifically

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Presenter Contacts

 Todd B. Pfister

312 832 4579 312.832.4579 tpfister@foley.com

 Kevin Kreb

312.298.2587 kevin.kreb@us.pwc.com kevin.kreb@us.pwc.com

 Jeff Litvak  Jeff Litvak

312.252 9323 jeff.litvak@fticonsulting.com

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