Unlike traditional private-company acquisitions, public M&A transactions lack purchase price adjustment and indemnity provisions as it is considered virtually impossible to claw back deal proceeds from a large group of public shareholders once a public-company acquisition has closed. However, amid the recent frothy sellers’ market, some sellers of private companies are taking a page from the handbook of public M&A dealmaking, attempting to sell their privately held companies “public-company style”—that is, without offering a post-closing indemnity.
This phenomenon first started to appear in particularly hot auctions, especially those conducted in parallel with the target prepping for an IPO. Those “dual-track” processes give sellers an upper hand in insisting on no-indemnity deals as they can argue that the alternative to a private sale—the IPO route—allows them to eschew any post-closing indemnification obligations. As the sell-side cycle continues, the “public-company style” phenomenon is increasing in frequency, including, on occasion, outside of the auction context.
The leverage (or perceived leverage) sellers have in many recent private-company transactions is only one explanation for this trend. The other is the advent and increasingly widespread use of representation and warranty insurance. Buyers, the sell-side theory goes, can acquire their own bespoke indemnity package from an outside party—the insurer—and, in so doing, no longer need to depend on the seller offering an indemnity. At times, buyers have gone behind the scenes to obtain representation and warranty insurance on their own in an effort to gain a competing edge in a hot auction.
While some private-company auctions have featured a public-company style auction draft of the acquisition agreement, the overall number of private-company acquisitions completed without at least some form of post-closing recourse to the seller or a seller escrow still remains small.
Indeed, buyers are well advised to remain very cautious about the use of this approach. Evidently, doing deals without any indemnity protection carries significant risks from a buyer’s perspective. Even where a buyer’s due diligence review suggests that a target is “squeaky clean,” buyers (and in particular, public-company buyers required to disclose the acquisition agreement) may want to consider carefully whether they wish to set such a precedent.
R&W insurance: an indemnity substitute?
Buyers should also be aware that representation and warranty insurance (R&W insurance) is not a perfect substitute for a seller indemnity:
- R&W insurance usually comes with a higher retention (or deductible) than a seller would typically require in the context of an indemnity. It is for that reason that many deals in which buyers rely on R&W insurance also include indemnification provisions and a small seller escrow.
- R&W insurance policies carve out certain matters from the scope of coverage. One universally applicable exclusion relates to matters known to the buyer’s deal team at inception of the policy—meaning that in private-company deals with known post-closing exposures, a seller indemnity is the only viable option for a buyer wanting to protect against these exposures.
- Purchasing insurance in an amount up to the full purchase price is often prohibitively expensive, meaning that insurance is unlikely to replicate the protection a buyer would enjoy in respect of fundamental representations under a private M&A purchase agreement.
- The jury is still out as to whether R&W insurance policies reliably pay out on claims. While insurers face an increasingly crowded marketplace and thus are incentivized to act in a competitive manner, the number of litigated claims under these policies is still too small to yield reliable data on the question of payouts.
Wherever possible, sellers will continue to use their leverage to extract the best deal terms. The current market environment has made it possible for some sellers to insist on doing deals public-company style. We expect this trend will continue in 2016. However, buyers should remain cautious about if, and how, they embrace the trend.
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