Risk Management in M&A Transactions: Key Legal Concepts Every Buyer and Seller Should Understand

When entering into a transaction for the sale or purchase of shares of a corporation or the assets of a business, both buyers and sellers assume significant risks inherent in these transactions. These hazards can be effectively managed through proper risk allocation and mitigation using well-drafted contractual provisions. While the approach may vary based on the nature of the transaction, this article outlines certain legal concepts commonly used to manage risk in such transactions.

Representations and Warranties

In a purchase agreement, the representations and warranties section is often the most extensive part of the agreement. A representation is a statement of fact made by one party that the other party relies upon when entering into the transaction or taking a particular action. A warranty is a promise that the statement of fact is accurate. Representations and warranties include statements of fact covering matters such as the parties’ corporate status and authority, financial statements, ownership of assets, compliance with laws, and legal proceedings, to name a few.

The representations and warranties are typically linked to the parties’ obligation to indemnify (i.e. compensate) the other party if any statement is inaccurate or breached. From the buyer’s perspective, it is essential to include all representations and warranties that are relevant to the transaction to ensure adequate protection. From the seller’s perspective, it is important to carefully review each representation and warranty, provide appropriate disclosures, and include suitable qualifiers to ensure the representations and warranties accurately reflect the facts and minimize potential liability.

Indemnification

An indemnity clause in an agreement creates a contractual obligation for one party to compensate the other for specific losses arising from certain events, most commonly a breach of representations and warranties or the failure to fulfill obligations under the agreement. This clause also typically addresses third-party claims, sets out the procedure to be followed if a claim arises, and specifies the right of the party who is required to indemnify (i.e. the indemnifying party) to assume the defence and control of such claims. Careful drafting of such provisions is essential to ensure that liability is properly allocated to the party responsible for the loss and that the indemnity covers all related costs and expenses.

Limitation of Liability

A limitation of liability clause defines and restricts the extent of the parties’ financial exposure under an agreement. This clause provides certainty by setting clear boundaries around potential post-closing claims.

Some of the ways liability can be limited include, for example, survival periods for representations and warranties, which determine how long related indemnity obligations remain in effect; caps on liability for different types of claims; basket provisions that set a minimum loss threshold before claims can be made; de minimis thresholds that limit the ability of a party to make an indemnity claim for losses below a certain amount; and appropriate exclusions for consequential or indirect damages.

Termination Rights

In certain transactions, there may be a gap between the signing of the purchase agreement and the completion of the transaction during which the parties have ongoing obligations. A termination clause sets out the circumstances under which the parties may end the agreement before completion, such as the failure to satisfy conditions by an agreed date, non-fulfilment of material obligations, a material breach of the agreement, or the emergence of facts that result in a material adverse effect. A properly drafted clause also outlines the procedure for termination and specifies the obligations of each party upon termination, including the allocation of costs, responsibility for losses, and any contractual remedies that may be claimed.

Force Majeure

A force majeure clause is another provision that may be included in transactions where there is a gap between the signing of the purchase agreement and the completion of the transaction. This clause allows a party to be excused from performing its contractual obligations, or to delay performance, in the event of circumstances beyond its reasonable control.

Force majeure clause typically defines the events that qualify as force majeure, set out the obligations of the affected party to provide notice and mitigate the impact, and outline the consequences of such events on performance timelines or termination rights. While this clause is more commonly used in operational contracts, including them in a purchase agreement can provide an extra layer of protection where unforeseen external events may significantly affect the execution of the deal.

Conclusion

While risks are inherent in the sale or purchase of shares or assets, a properly drafted agreement helps to allocate risk, protect the party’s interests, and provide clarity in the event of disputes or unforeseen events. Given the complexity and potential consequences of such transactions, it is essential that the provisions are carefully drafted and thoroughly reviewed by a qualified lawyer. This ensures that the agreement is tailored to the specific transaction and provides effective protections.

The foregoing should not be considered to be legal advice and should not be relied upon as such. Please consult a lawyer to get advice and an opinion on your unique circumstances.