A. Introduction
M&A deal terms originating from Europe are increasingly found in the United States, particularly in the context of cross-border deals. Transactions featuring these deal terms are not yet common, but with the current deal environment, including the prevalence of auctions and increased sell-side private equity activity (both primary and secondary exits), some of these deal terms may eventually become commonplace in the United States. This article focuses on two emerging trends in the United States: the use of Vendor Due Diligence Reports (VDD) and the locked-box mechanism.
B. Vendor Due Diligence Reports
A VDD is typically found in a competitive auction process or a dual-track process (which involves preparing a company for an initial public offering while simultaneously pursuing a third-party sale). The VDD is not a marketing document and differs from a confidential information memorandum in that it objectively and comprehensively describes the target company’s financial and legal situation and discloses issues and risks. This is particularly useful in complex transactions because it helps accelerate the process by providing prospective buyers with more information at an earlier stage.
Of course, the VDD is not without its drawbacks. First, the exercise of producing a VDD can potentially be a source of tension between the client and its advisors, not unlike the auditors and their client in the context of audited financial statements. Second, although the VDD provides several benefits to the seller, including accelerating the bid timeline and helping foster detailed and high-quality indicative bids, one of the significant drawbacks is that it identifies issues that may result in lower bids. In this regard, VDD proponents argue that by disclosing the issues up front, the seller reduces the likelihood of a bid being lowered at a later stage of the negotiations (the rationale being that a sophisticated buyer would likely identify these issues as part of its due diligence and could then attempt to lower its initial bid). Third, the time saved during the accelerated bid timeline is simply shifted to the preparation phase, and the costs associated with a VDD can be significant. In Europe, the VDD can be provided to the prospective buyer and its lenders on a reliance basis, with the accounting or law firm preparing the VDD capping its liability vis-à-vis these third parties. VDDs are increasingly offered by accounting firms in the United States, but they are issued on a nonreliance basis. U.S. law firms generally would not provide any due diligence materials on a reliance basis, and it is unclear whether a law firm would be able to limit its liability, which is permitted in several European jurisdictions. However, European law firms and clients sometimes ask American law firms to provide a due diligence report on a reliance basis, and it may be helpful for the parties to clarify early in the process what the expectation is on this particular point. Please refer to the Report of the ABA Business Law Section Task Force on Delivery of Document Review Reports to Third Parties (67 Bus. Law. 99 (2011)) for an in-depth discussion on this particular issue.
C. Locked-Box Mechanism
The locked-box mechanism originated from the United Kingdom and has been used for years in M&A transactions across Europe, but many American sellers and buyers are still unfamiliar with it. In a nutshell, the locked-box approach removes price uncertainty associated with a post-closing working capital or other similar post-closing adjustment in that the seller and buyer negotiate a fixed price when signing the purchase agreement based on the agreed upon locked-box balance sheet. The locked-box mechanism forces the parties to focus on items such as normalized working capital before signing. Given that the economic interest passes to the buyer as at the locked-box date, the seller will often charge a per diem or (alternatively) interest on the equity value from the locked-box date until the closing to reflect the fact that the seller did not receive the proceeds from the buyer when the economic interest was passed to the buyer. Although concepts such as normalized working capital also apply to closing accounts, the parties sometimes do not focus on it as much as they should before signing and procrastinate until it is time to prepare the closing balance sheet, only to realize that they had not focused on (or agreed to) specific adjustments or normalizations. This lack of focus often results in disputes between the parties, and any claims resulting therefrom would not be covered by representations and warranties (R&W) insurance. The paradox is that the parties secure R&W insurance to avoid post-closing claims, but according to escrow claim studies, claims relating to purchase price adjustments are among the most frequent claims under a purchase agreement. As a result, one of the most “common” risk is one that is not covered by R&W insurance. Although the locked-box mechanism virtually eliminates purchase price adjustment disputes, it can introduce other issues. For one thing, the parties must agree on what constitutes permitted leakage between the locked-box date and the date of closing. An example of such permitted leakage would be arm’s-length, intra-group payments in the ordinary course. The locked box may not be appropriate in all circumstances: a carve-out transaction where assets from different divisions are sold and where there are no financial statements for the carved-out business would be problematic. Finally, agreeing on the locked-box balance sheet may prove to be more difficult in the context of a highly cyclical business, such as a toy business.
D. Conclusion
Although the deal terms described above remain uncommon in America, they are increasingly seen particularly in the context of cross-border deals with Europe. Some of these trends have already migrated to other parts of the world. Given the predictability of the locked-box mechanism and the fact that it virtually eliminates purchase price adjustment disputes, it seems to be the logical complement to R&W insurance, and it is surprising that this approach is not more common in the United States, especially in transactions involving a private equity seller.
