Private Company Acquisition Agreements: Drafting Reps, Warranties, Covenants and Closing Conditions Leveraging Current Market Trends in Deal Terms When Negotiating Key Contract Provisions

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THURSDAY, FEBRUARY 20, 2014

Presenting a live 90-minute webinar with interactive Q&A

Vincent R. Martorana, Counsel, Reed Smith, New York

Adam R. Schaeffer, Partner, Jones Day, Chicago

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Practice Tips for Drafting Representations and Conditions

February 20, 2014

Adam R. Schaeffer, Jones Day Vincent R. Martorana, Reed Smith

Goals

• Talk about recent experience and trends in negotiating representations and warranties, covenants, conditions and indemnity.

• Highlight most negotiated representations and warranties and conditions.

• Assuming basic understanding of reps, warranties, covenants, conditions and indemnity (i.e., what they generally do / how they work).

• Happy to answer questions, basic or complicated, at the end or offline.

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Representations and Warranties

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Purpose

• Diligence

• Risk Allocation

• Closing Conditions

• Indemnification Claims

• Public vs. Private

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The Lead-In

“Except (i) [as disclosed in any report . . . or other document filed with . . . the SEC and publicly available prior to the date of this Agreement] or (ii) as disclosed [in the disclosure letter delivered by the Company to Parent immediately prior to the execution of this Agreement (it being agreed that disclosure of any item therein shall also be deemed disclosure with respect to any other section of this Agreement to which the relevance of such item is reasonably apparent], [as of the date hereof and as of the Closing,] the Company represents and warrants to Parent and Merger Sub as follows:”

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Qualifiers

• Knowledge • “‘Seller’s Knowledge’ means the [actual] knowledge,

[after reasonable due inquiry], of [named individuals]” • “Constructive” – For which the knowledge group knew or

should have known (much more common) – Reasonable due inquiry requirement (71%)

• Materiality / MAE • “The Company is . . . in compliance [in all material

respects] with all [material] Laws and Orders[ except as would not reasonably be expected to have an MAE]”

• Date qualifiers: looking back / looking ahead

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Compliance with Laws Representation

• “The Company is now, and has been [for the last three years], in compliance [in all material respects] with all [material] Laws and Orders [except to the extent such non-compliance has not, or would not reasonably be expected to, have a material impact on the Business]. [To the Knowledge of the Stockholders,] there is no proposed Law or Order that would be applicable to the Company and that would have a [material impact on the Company/Material Adverse Effect]. The Company has not [in the last three years] received any [written] notice from any Governmental Authority [or any other Person] regarding (a) any actual, alleged[, possible or potential] violation of, or failure to comply with, or liability under any applicable Law, or (b) any actual, alleged, [possible or potential] obligation or liability of the Company.”

• Trends: • Look back becoming less common • Notice of investigation is becoming more common

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No Undisclosed Liabilities • Keys: GAAP, Knowledge, Materiality / MAE • No GAAP Qualifier: “[To the Company’s Knowledge,] [as of the date hereof,] there

are no [material] liabilities or obligations of the Company or any of its Subsidiaries, whether accrued, absolute, determined or contingent, except for (i) liabilities or obligations disclosed and provided for in the balance sheets included in the Company Financial Statements (or in the notes thereto), [(ii) liabilities or obligations incurred in connection with the Transactions,] (iii) liabilities or obligations incurred in the ordinary course of business consistent in the past practice since [the date of the last Balance Sheet], [(iv) liabilities reflected or referred to in the Disclosure Schedules,] and [(v) liabilities or obligations that would not reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect]”

• GAAP-limited: “The Company and its Subsidiaries have no Liabilities of a type required to be reflected on a balance sheet prepared in accordance with GAAP other than (i) Liabilities expressly reflected, reserved against or otherwise disclosed in the Most Recent Balance Sheet (including the notes thereto) . . . ”

• Mini-basket: “The Company and its Subsidiaries have no Liabilities of a type required to be reflected on a balance sheet prepared in accordance with GAAP other than (i) Liabilities that are, in the aggregate, less than $[_____] . . . ”

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Sufficiency

• Asset deals / carve-out deals • “Except for the services and assets contemplated to be performed

or provided to Purchaser pursuant to the TSA, the [Purchased Assets / assets owned, leased or licensed by the Company] constitute all assets, properties and rights necessary or desirable to conduct the Business as currently conducted and, immediately after the Closing, for Purchaser to continue to operate and conduct the Businessin all material respects as currently conducted.”

• Should the sufficiency rep apply to IP? “. . . the [Purchased Assets / assets of the Company] constitute all tangible and intangible assets, properties and rights necessary to conduct the Business . . . ”

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Financial Statements

• GAAP Qualified: “The Financial Statements fairly present [, in all material respects,] the financial condition and the results of operation, shareholders equity and cash flow of the Company . . . , in each case, in accordance with GAAP.”

• Not GAAP Qualified: “The Financial Statements (i) fairly present the consolidated financial condition . . . Of the Company . . . and (ii) . . . were prepared in accordance with GAAP, [subject to normal year-end adjustments].”

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FCPA / Anti-Bribery

• “No Acquired Company, nor any of their respective managers, directors, officers, agents, brokers, representatives, employees or consultants acting on their behalf, has used any funds to make, directly or indirectly, any unlawful contribution, gift, bribe, forgiveness of all or part of a debt, payoff, kickback or other unlawful payment or any facilitation payment to or at the direction of any Government Official in violation of any Anti-Corruption Laws.”

• DOJ guidance and emphasis on diligence • Every deal?

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10b-5 / Full-Disclosure Representation • 10b-5: “[To Seller’s Knowledge,] neither this Agreement (including

the exhibits and schedules hereto) or the Ancillary Agreements nor any other agreement, document, certificate or written statement furnished to the Buyer by or on behalf of the Company in connection with this Agreement, the Ancillary Agreements or the transactions contemplated hereunder or thereunder contains any untrue statement of a material fact or omits to state a material fact necessary in order to make the statements contained herein or therein not misleading.”

• Full disclosure: “[To Seller’s Knowledge,] the Seller has not withheld from the Buyer any material facts relating to the condition (financial or otherwise), business, assets, properties, liabilities, results of operations, employee or customer relations or prospects of the Company’s business.”

• Generally aggressive, other than in material acquisitions by public companies

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Anti-Sandbagging Representation

• “Buyer has no knowledge of any breach of the Company’s representations or warranties in this Agreement or the Ancillary Agreements and Buyer has no reason to believe that any of the conditions to closing will not be satisfied on or prior to the Termination Date.”

• Can be included as a representation, covenant, in the indemnity provisions or even in the miscellaneous section

• Arguments

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Disclaimers • “Except for the representations and warranties contained in this Article III,

Seller makes no representation or warranty of any kind or nature whatsoever, oral or written, express or implied, with respect to [the Company] or the transactions contemplated hereby, including any relating to the financial condition, results of operations, assets or Liabilities of the Company. Except for the representations and warranties contained in this Article III, Seller disclaims . . . (i) any other representations or warranties, whether made by Seller or any other Person and (ii) all Liability and responsibility for any other representation, warranty, opinion, projection, forecast, advice, statement or information made, communicated or furnished (orally or in writing) to Buyer or its Affiliates or their respective Representatives (including any opinion, projection, forecast, advice, statement or information that may have been or may be provided to Buyer or its Affiliates or Representatives by any Seller or any Representative of Seller or any of their respective Affiliates). For the avoidance of doubt, neither Seller nor any of its Affiliates makes any representations or warranties to Buyer or any other Person regarding the probable success, future performance or profitability of the Company or the Business (whether before or after the Closing).”

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Ring-Fencing • “The representations set forth in this Section 3.17 are the only representations given

by the Seller with respect to matters related to intellectual property matters.” • Can you rely solely on practice area-specific reps?

• Environmental, IP, labor, benefits, real estate • Cross-reference areas:

• Material contracts • Compliance with laws • Permits • Litigation • Undisclosed liabilities • No changes • Environmental with real estate and benefits with labor

• Make sure specialist teams are involved early and often; highlight ring-fence language

• Look for these everywhere

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Timing / Updates

• When are representations made? • Who bears the post-signing risk? • Updates: mandatory, permissive, effect • All matters: “If prior to the Closing, Seller delivers to Buyer a

supplement or update to the Disclosure Schedules that corrects a misrepresentation made on the date of this Agreement or as a result of any matter arising after the date hereof and before the Closing occurs then the matters contained in such supplement or update shall be deemed to amend this Agreement and the Disclosure Schedules effective as of the date of this Agreement for all purposes hereunder other than determining whether the condition set forth in Section 8.02(b) or Section 8.02(d) has been satisfied.”

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Disclosure Schedule Updates • New matters only: “The Company may supplement any portion of the

Disclosure Schedule prior to the Closing for the purpose of updating disclosures to reflect any facts or matters occurring after the date hereof and on or prior to the Closing Date (“Disclosed Additional Matters”); and, to the extent the Closing occurs, such Disclosed Additional Matters shall be treated as if they had been included in the Disclosure Schedule as of the date hereof for the purpose of determining whether the Buyer is entitled to indemnification for breach of a representation and warranty . . . No Disclosed Additional Matter shall qualify any representations and warranties for the purpose of determining the satisfaction of the conditions to Closing . . .”

• Effect of updates: “no Disclosed Additional Matter shall qualify any representations, warranties, covenants or agreements of the Company for any purpose, affect any remedy available . . . hereunder (including indemnification . . . or the right to specific performance) or affect the determination of whether the conditions to Closing have been satisfied.”

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Disclosure Schedules – Buy-side Pitfalls • Broad general reference to schedules as qualifying all representations:

• “Except as set forth in the disclosure schedules, the Company makes the following representations . . . ”

• Cross-referencing: • “An item disclosed on one schedule is deemed disclosed on all other

schedules.” • “An item disclosed on one schedule is deemed disclosed on another

schedule to the extent the disclosure of such item on such other schedule is readily apparent on its face.”

• Ambiguous disclosure: • “Matters disclosed in the environmental reports provided to Buyer” • “Matters disclosed in the Site Assessment Reports of ABC Environmental

Inc. dated March 1, 2010” • “Remediation obligations disclosed in section 6.3 of the [Environmental

Report]”

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Rep and Warranty Insurance

• Trend • Allow sellers to liquidate proceeds • Management relationships • Buy-side v. sell-side policies • Understand what will be covered and what needs to be provided

• Caps / SRI / time periods • Subrogation clauses

• Consider privilege issues (e.g., diligence report)

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Covenants

• Pre-Closing Covenants • Conduct of the Business

• Affirmative Covenants

• Negative Covenants

• No Solicitation (no-shop, no-talk, no-changing your mind)

• Due Diligence; Access to Information

• Government and Third-party Consents, Filings, and Notices

• Notification (of breaches, inaccuracies, and other “bad events”)

• Satisfaction of Closing Conditions

• Public Announcements

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Covenants

• Post-Closing Covenants • Confidentiality (remember: non-use) • Non-competition • Non-solicitation • Access to Information • Further Assurances

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Closing Conditions

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Closing Conditions – Market Trends • Competitive marketplace: fewer conditions

• In auction process, value maximized if seller can say make “best and final” proposal; if buyers think they have another bite at the apple, they may hold back

• The target business comes under internal and external pressures once deal announced (risk of damaged goods)

• Closing certainty is at the top of the sellers’ list • Conditions contingent on third parties: can change leverage and introduce

uncertainty • Creative alternatives if closing conditions are not satisfied or in lieu of closing

conditions (consent workaround / staggered closings) • Keys are:

• Tightness of closing conditions (the “MAE” standard) • Certainty in financing after 2007-2008 debacles • Measure of other party’s closing commitment (regulatory

requirements and third-party consents)

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Regulatory Approval

• Governmental Approvals: “(i) The waiting period (including any extension thereof) applicable to the consummation of the Merger under the HSR Act shall have expired or been terminated, (ii) all filings with or Permits set forth in Schedule 7.1(b) shall have been obtained or shall have occurred and (iii) all other filings with or permits, clearances, authorizations, consents, orders or approvals of or expirations of waiting periods imposed pursuant to any applicable Antitrust Laws required to consummate the Merger shall have been obtained or filed or shall have occurred. All other filings with or permits, clearances, authorizations, consents, orders or approvals or expirations of waiting periods imposed or required by any Governmental Entity in connection with the consummation of the Merger and the other transactions contemplated by this Agreement, the absence of which would render the consummation of the Merger illegal or could be reasonably likely to have a Material Adverse Effect, shall have expired, terminated or been obtained.”

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No Litigation

• “Since the date of this Agreement, there must not have been commenced . . . any Proceeding (a) involving any challenge to, or seeking damages or other relief in connection with the Transaction or (b) that could reasonably be expected to have the effect of preventing, delaying or making illegal the Transaction.”

• Government vs. all actions • Public vs. private deals

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The Bring Down

• Unqualified: “The representations and warranties of the Company . . . will be true and correct in all respects as of the Closing Date, as if made on the date hereof and the Closing Date . . . ;”

• Materiality qualified: “The representations and warranties of the Company . . . will be true and correct in all material respects as of the Closing Date, as if made on the date hereof and the Closing Date . . . ;”

• MAE Standard: “The representations and warranties of the Company . . . will be true and correct in all respects as of Closing Date, as if made on the date hereof and the Closing Date, except (i) to the extent the failure of such representations and warranties to be true and correct would not reasonably be expected to cause a Material Adverse Effect . . . ;”

30

The Bring Down • Generally even split between MAE and materiality • Most deals today adopt a variable approach – some fundamental

representations are absolute, others MAE-qualified • Double materiality scrape

• “the representations and warranties of the Company . . . will be true and correct in all material respects as of the Closing Date, as if made on the date hereof and the Closing Date (it being understood that, for purposes of determining whether such representations and warranties are true and correct, all Material Adverse Effect, materiality and similar qualifications will be disregarded). . . ;”

• How it works: “Schedule 3.11(b) lists each material Governmental Authorization held by or on behalf of the Business or Seller.”

• Timing of the bring down: signing, closing or both

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MAE • “There shall not have occurred any event, state of facts or circumstances which,

individually or in the aggregate, could reasonably be expected to have a Material Adverse Effect.”

• “‘MAE’” means any fact, circumstance, event, change, effect or occurrence that (i) has had or would reasonably be expected to have a material adverse effect on the business, results of operations or financial condition of the Company and its Subsidiaries taken as a whole, but will not include . . . (A) changes in general economic conditions, (B) changes in conditions generally affecting the [specified industry], (C) regulatory, legislative or political conditions or capital markets conditions in any jurisdiction, (D) failure by the Company to meet any projections . . . (. . . facts or occurrences giving rise to or contributing to such failure may be deemed to constitute . . . a MAE), (E) the execution of this Agreement, (F) performance by the Company of this Agreement, (G) changes in Law or GAAP, (H) outbreak of hostilities . . . , or (I) any hurricane, tornado, flood, earthquake or other natural disaster except in the case of clauses (A), (B), (C), (G), (H) or (I) to the extent such fact . . . has a disproportionate effect . . . or (ii) that would reasonably be expected to prevent or materially delay the Company’s ability to perform hereunder.”

• Real world utility?

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The Quantitative MAE • An innovation that everyone says should be widespread, but still is not • Some examples of quantitative MAEs / standalone financial metric tests • “‘Material Adverse Effect’ means any change . . . reasonably expected

to result in . . . any damage, destruction or casualty loss with respect to the Acquired Assets or the Business that require capital expenditures of $25,000,000 or more to conduct the Business in the Ordinary Course of Business”

• Consider stand-alone closing condition as an alternative

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Quantitative / Qualitative Condition • Quantitative conditions

• Minimum income statement performance metrics • Minimum balance sheet performance metrics • Minimum production metrics: “The Facility shall have been

operating in the Ordinary Course of Business for each of the four days immediately preceding the Closing Date, producing widgets at a rate of 220,000 widgets per day for each full day of operation during such period.”

• Qualitative conditions: “Seller shall be able to transport widgets from, and other Inventory to, the Facility on the Rail Line in the Ordinary Course of Business.”

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Definitional Provisions Negotiated • Inclusion of “prospects” in definition (“MAE means any fact . . . that has a

materially adverse effect on the business . . . or prospects of the Company”) • Forward looking? (“has had or would reasonably be expected to have”) • Seller’s ability to consummate (“that would reasonably be expected to prevent or

materially delay or impair the ability of the Company to perform its obligations under this Agreement or to consummate the Transactions”)

• Specific dollar threshold / mini-MAC • Specific, non-exclusive financial or operational milestones • Carve-outs • Subsidiary MACs taken as a whole (“a material adverse effect on . . . the

Company and its Subsidiaries taken as a whole”) • Opportunity to cure before closing • Short-term / long-term effects (“the near-term or long-term results of operations

or financial condition of the Business”) (default rule is long-term only) • Anti-sandbag

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Definitional Provisions Negotiated – Carve-outs • Top carve-outs*

• Economic conditions • War or terrorism • Changes in law • Industry conditions • Announcement of the transaction • Changes in accounting • Financial market downturn • Actions required by agreement

• Most deals have at least one carve-out qualified by disproportionate effect

36 *Source: ABA’s 2013 Private Target Mergers & Acquisitions Deal Points Study.

Financing Conditions • Prevalence of stand-alone financing out has declined significantly

after Financial Crisis • Stand-alone financing condition: condition without

accompanying break fee • Example: “Buyer shall be permitted to terminate this Agreement

if the Financing has not been consummated on or prior to [a date certain]”

• Many big deals are financed • In the PE world, nearly every big deal is financed with debt

• Current approach is to require equity commitment, fully committed debt financing and a reverse break fee

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Anatomy of the Modern Financing Condition • Termination right by the seller if the proposed financing is terminated or other events occur

that make the financing unlikely: • “Agreement may be terminated . . . if (i) the Commitment Letter is terminated without a

closing . . . , (ii) the Lenders have given notice (A) of breach thereunder by Parent or Merger Sub or (B) of their intent to terminate the Commitment Letter or not consummate the transactions . . . , (iii) the conditions to the Lenders’ obligations . . . have been satisfied, but the Lenders do not consummate such transactions . . . or (iv) Parent or Merger Sub breach any of their obligations [with respect to the financing covenant] . . .”

• Payment of termination fee (or “reverse break fee”) by buyer if buyer doesn’t close: • “If (i) the conditions to Purchaser’s obligations . . . have been satisfied or duly waived and

(ii) this Agreement is validly terminated by the Seller pursuant to [financing termination provision or drop dead], then Purchaser will pay to Seller . . . the Termination Fee. Company may not obtain both the specific performance . . . and receive the Termination Fee.”

• Termination Fee as liquidated damages • Covenants • Guarantee / equity commitment

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Financing Condition: Reverse Breakup Fee • Because reverse termination fees do not have the effect of chilling

bidding (i.e., no negative effect to the target’s stockholders), they are not held to the same scrutiny, and may be enforceable at levels in excess of traditional breakup fees

• In 2012, the median reverse breakup fee of deals within the study was approximately 5% of transaction value, and 4.7% of enterprise value*

• Reverse breakup fees have generally increased*

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2008 2009 2010 2011 2012

Break Fee as % of Trans. Val.

Break Fee as % of Ent. Val.

Rev. Break Fee as % of Trans. Val.

Rev. Break Fee as % of Ent. Val.

*Source: Houlihan Lokey 2012 Transaction Termination Fee Study 39

Indemnification

• General points • Effective upon closing

• Joint and several liability

• “Indemnify, defend, and hold harmless”

• Applicable “indemnified parties”

• Survival • Reps and warranties

• Generally

• Exceptions (fundamental reps, other exceptions)

• Obligations 40

Indemnification

• Definition of “Losses” • “Nexus phrases” – “arising out of or relating to” • Bases for indemnification

• Inaccuracy of reps

• Breach of obligation

• Specific “dollar one” indemnities

• Brokers; pre-closing taxes

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Indemnification

• Limitations on Indemnification • Deductibles and caps

• Types of deductibles

• True deductible vs. “tipping basket”

• “mini” deductibles

• What types of claims do deductibles and caps apply to?

• Exceptions

• Insurance proceeds

• Tax benefits of loss

• Duty to mitigate

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Indemnification

• Other factors • Materiality and knowledge “scrapes”

• Multiple bases for recovery

• Interaction with purchase price

• Sandbagging provisions • What does silence mean?

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Indemnification

• Procedures for bringing claims • Claim notice • Direct claims

• Objection notice • Right to investigate

• Third-party claims • Third-party claim notice • Right of Indemnifying Party to defend/control third-party

claim

44

Indemnification

• Payment

• Tax treatment of Losses

• Third-party beneficiary status

• Exclusive remedy

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Adam Schaeffer concentrates his practice in the areas of mergers and acquisitions, leasing transactions, and general corporate matters. He represents buyers, sellers, and management teams in public and private acquisitions and divestitures, restructurings, joint ventures, and other strategic alliances, including those in distressed and non-distressed settings. He regularly advises clients regarding general corporate matters, including corporate governance, fiduciary issues, and strategic planning, and in connection with the negotiation of commercial contracts. Adam has represented clients in a wide range of industries, including manufacturing, mining, aerospace, agriculture, health care, pharmaceuticals, logistics, and software. Adam regularly speaks on issues and trends in mergers and acquisitions.

Adam R. Schaeffer Partner, Mergers & Acquisitions Telephone: 312.269.1565 Facsimile: 312.782.8585 Email: aschaeffer@jonesday.com

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Vincent R. Martorana is Counsel in the Corporate & Securities Group with Reed Smith’s New York office. His practice includes the representation of clients in domestic and cross-border mergers, stock and asset acquisitions and divestitures, joint ventures, strategic alliances, licensing arrangements, corporate restructurings, private equity investments, and securities offerings. He also regularly provides advice on corporate governance and state laws governing business entities (including Delaware and New York corporate, partnership, and limited liability company law). Vincent has represented a wide range of clients—from start-up and early-stage companies to well-established enterprises—in various industries, including technology, healthcare, pharmaceutical products, and consumer products. Vincent has extensive experience providing advice on contract drafting, analysis, and interpretation relating to disputes, settlements, and negotiated transactions. He has presented his continuing legal education contract-drafting courses for in-house legal departments and at various other venues, including Practising Law Institute, Strafford Webinars, The Business Development Academy, the National Academy of Continuing Legal Education, the American Bar Association, the New York State Bar Association, the New York City Bar Association, the New York County Lawyers Association, the Brooklyn Bar Association, the Suffolk County Bar Association, and the Westchester County Bar Association. He is also the author of Drafting Points (www.draftingpoints.com), a blog that is dedicated to contract-drafting issues, and is the co-author of the Reed Smith white paper, A Guide to Contract Interpretation (October 2013). Vincent received a J.D. from the University of Chicago Law School and a B.S. in Economics (with concentrations in Finance and Operations & Information Management), magna cum laude, from the Wharton School at the University of Pennsylvania.

Vincent R. Martorana, Counsel Tel: +1 212 549 0418 Email: vmartorana@reedsmith.com

To receive regular updates on contract-drafting issues, subscribe to Drafting Points at www.draftingpoints.com.

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