United States: Recent Trends In Private M&A Deal Terms

During the past several years, the private-target mergers and acquisitions (M&A) market experienced robust growth and valuations, generally strengthening through 2017 from its most recent trough in 2009. The period from 2015 to 2017 in particular witnessed a stronger M&A market relative to prior periods within the last decade. (For more information on the general state of the market, please see the U.S. Deal Flow chart below.)

Consistent with a strong M&A market, sellers have enjoyed an expansion of pro-seller deal terms. For example, pro-sandbagging clauses are in decline, as are buyer-required legal opinions from seller's counsel, while deductible baskets, representations and warranties insurance² coupled with firm indemnification limitations, buyer termination fees, no-other-representations clauses and non-reliance clauses have all increased in frequency. In addition, fundamental representations and warranties are less likely to survive indefinitely and a seller's representations and warranties at closing are more often qualified by a "material adverse effect" standard of accuracy. This article examines trends in certain seller-friendly deal terms over the prior three calendar years.

Pro-Sandbagging Clauses

Pro-sandbagging clauses (sometimes referred to as a "benefit of the bargain" or "investigations" clause) explicitly enable a buyer to recover under a claim for breach of representations and warranties even if the buyer knew of the breach before closing. Market data indicates that pro-sandbagging clauses are in decline and in 2017 reached their lowest point in recent years. Of the deals surveyed, pro-sandbagging clauses appeared in 48% of deals in 2017 compared with 57% in 2016 and 51% in 2015. Although sellers more successfully eliminated pro-sandbagging clauses, particularly in 2017 compared to 2016, anti-sandbagging clauses, which expressly limit liability for losses resulting from a breach known by the buyer prior to closing, do not exhibit such a definitive trend. Of the deals surveyed, anti-sandbagging clauses were included in 4% of deals in 2017, none in 2016 and 4% in 2015.

Despite the general decline in pro-sandbagging clauses and the slight increase in anti-sandbagging clauses in 2017 compared to 2016, many deals remain silent on the issue. Of the deals surveyed, sandbagging clauses were entirely omitted from 47% of deals in 2017, compared with 42% in 2016 and 44% in 2015. In the absence of an explicit provision addressing sandbagging, the issue defaults to applicable state law. Many states, including Delaware, default to a pro-sandbagging position, while others, such as California, default to an anti-sandbagging stance. Because a significant number of deals are silent on the issue, this pro-seller trend may nevertheless conceal a pro-buyer undercurrent in which savvy dealmakers elect to remain silent thereby committing both parties by default to pro-sandbagging state law, a probable outcome in many instances given the prevalence of Delaware choice of law.

Deductible Baskets

Baskets limit indemnification obligations, subject to customary exceptions, through two fundamental types: a deductible basket and a first-dollar basket. A deductible basket protects one party from indemnifying the other until the amount of losses exceeds a negotiated dollar threshold. Once losses exceed the dollar threshold, a seller is liable only for the amount of losses exceeding the threshold. A first-dollar basket typically shares the same basic structure as a deductible basket, except that once losses exceed the dollar threshold, the seller is liable for the total amount of all losses, including losses below the threshold.

Of the deals surveyed, deductible baskets appeared in 52% of deals in 2017 compared with 42% in 2016 and 31% in 2015. The increasing frequency of deductible baskets corresponds with a decline in first-dollar baskets. Of the deals surveyed, first-dollar baskets appeared in 43% of deals in 2017 compared with 49% in 2016 and 63% in 2015. Overall basket sizes have remained relatively constant over the past three years, however, with a close plurality of deals containing baskets with dollar thresholds of between 0.5% and 1% of the total transaction value and a nearly equal number of deals containing baskets with dollar thresholds of 0.5% or less.

Sellers are typically able to negotiate higher dollar thresholds for first-dollar baskets than for deductible baskets given the balance of risks faced by the buyer under the two structures.

The increasing use of deductible baskets in recent years also correlates with a rise in popularity of the "materiality scrape". Of the deals surveyed, materiality scrapes were employed in determining breach and damages in 37% of deals in 2017 compared with 33% in 2016 and 19% in 2015. For further information on materiality scrapes, see The Triumph of the Materiality Scrape on pages 6-8 of M&A Perspectives.

Survival of Fundamental Representations and Warranties

Representations and warranties considered as "fundamental" vary from deal to deal, but typically include representations and warranties concerning at least due organization, capitalization and ownership of shares, title to assets, power and authority, and third-party broker fees. These so-called fundamental representations and warranties customarily have longer, or even indefinite, survival periods compared to the typical twelve- to eighteen-month post-closing survival period for other representations and warranties during which the buyer must pursue a claim for breach or be time-barred from pursuing such a claim. The longer or even indefinite survival period for fundamental representations and warranties results from the foundational significance of their terms.

Of the deals surveyed, fundamental representations and warranties are less likely to survive for an indefinite period, with indefinite survival appearing in only 12% of deals in 2017 compared with 19% in 2016, 18% in 2015 and 29% in 2012-2014.

In addition to the general movement toward pro-seller terms resulting from a robust M&A market, this trend also aligns with the Delaware Court of Chancery's decision in Cigna Health and Life Insurance Company v. Audax Health Solutions, Inc., 107 A.3d 1082 (2014). Audax suggests that an indefinite survival period for representations and warranties violates Delaware law when indemnification provisions allow for recovery of the full purchase price from stockholders.

The decline in indefinite survival periods may therefore be a response to Audax, as fewer buyers are willing to negotiate for a provision Delaware courts may deem unenforceable, possibly resulting in an unpredictable outcome that places buyers in a worse position than had they negotiated a definite survival period.

Footnotes

1 Statistics and trends based on data provided by 2016, 2017 and 2018 SRS Acquiom M&A Deal Terms Studies, prepared by SRS Acquiom, Inc. with reference to 2016 and H1 2017 Private Target Mergers & Acquisitions Deal Points Studies prepared by the American Bar Association Subcommittee on M&A Market Trends.

2 For further information on representations and warranties insurance, see Insuring the Deal: Key Trends and Terms in Representation and Warranty Insurance, on pages 9-12 of M&A Perspectives.

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