August 2016
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From the Colorado Bar Association
Business Law Section
Ed Naylor, Editor
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Business Law
NEWSLETTER
September 2016
From the Colorado Bar Association Business Law Section
Ed Naylor, Editor
In This Issue:
- Escrows vs. Representations and Warranties Insurance: How the Choice Can Alter Deal Dynamics
- NASDAQ-Listed Companies: Director Compensation Disclosure Rule Change
- All Public Companies: U.S. Business Leaders Release New Corporate Governance “Commonsense Principles”
- Business Law Section Activities
- Antitrust and Consumer Protection Subsection
- Financial Institutions Subsection
- International Transactions Subsection
- M&A Subsection
- Securities Subsection
- Upcoming CBA-CLE Programs
- Business Law CLE Homestudies
- CBA-CLE Books
Escrows vs. Representations and Warranties Insurance: How the Choice Can Alter Deal Dynamics
By Paul Koenig, Co-CEO and Travis Bell, Associate Director, Corporate Development & M&A Transactional Group, SRS Acquiom
[TEASER: Thinking of using rep and warranty insurance on your M&A transaction? It could alter--perhaps adversely--the deal dynamics.]
Background
The allocation of risk shapes every merger and acquisition, and the backbone of risk allocation is the right of the acquiring company (the “Buyer”) to be indemnified for breaches of the selling company’s representations and warranties (such selling company, the “Seller”). In a standard acquisition of a non-public Seller, the selling securityholders (the “sellers”) bear the indemnification risk. This risk has traditionally been managed using a two-tiered structure: (i) an escrow funded from proceeds due to the sellers[1], and (ii) in the event of a claim beyond the escrow, the right of the Buyer to claw back proceeds from the sellers directly. However, Representations and Warranties Insurance (“RWI”) is emerging as a tool to modify or replace this structure. RWI shifts some or all indemnification risk from the sellers to an insurer, and a policy can be either buy-side or sell-side. When the Buyer is the insured (a buy-side policy), RWI can reduce or eliminate the need for an escrow because an insurer, rather than the sellers, indemnifies the Buyer for covered losses.[2] When the sellers are the insured (a sell-side policy), they remain liable to the Buyer for breaches—typically through the two-tiered structure—but RWI compensates the sellers for covered losses. In both cases, the RWI premium is a percentage of the insured amount, generally 2–5%.
Buy-side policies are the dominant form of RWI today, comprising at least 80% of policies issued annually in the U.S. according to major insurers and market data. Sellers often push for buy-side RWI over sell-side RWI because, among other reasons, buy-side RWI allows sellers to receive the funds at closing that would otherwise be at risk in escrow. In principle, the economic protection afforded to the Buyer is largely the same between an escrow and RWI (subject to both the premium and a deductible when using RWI, both of which the Buyer may require the sellers to bear).[3] Deal parties should be aware, however, that using buy-side RWI rather than an escrow can alter traditional deal dynamics in non-economic ways. These include the quality of the Seller's representations and warranties, the likelihood of indemnification claims, the indemnification recovery process, and the ability of serial Buyers to assert claims. These points are discussed in turn below.
Quality of Representations and Warranties
Buyers generally require detailed representations (reps) and warranties from the Seller for two reasons: risk allocation and due diligence. Buyers use reps and warranties to allocate to the Seller as much of the risk as possible regarding information asymmetry about the Seller and potential unknown liabilities, and the Seller naturally wants to avoid as much of this risk as possible. The Buyer can shift more of this risk to the Seller by requiring the Seller to give thorough reps and warranties about its business, with the Buyer having the ability to seek indemnification if it is harmed by inaccuracies. For example, the Buyer may require the Seller to represent that all of the Seller’s patents are valid and free of adverse claims at closing. Even if both parties believe this to be true, the Seller bears the risk for an agreed-upon period following closing that the representation is shown to be inaccurate when made.
In addition, Buyers use reps and warranties to supplement due diligence. That is, Buyers can minimize information asymmetry through a combination of conducting due diligence and requiring thorough reps and warranties. This allows the Buyer to maximize the information it receives about the Seller pre-closing, and the process shakes out disclosures that could trigger additional questions or even result in the renegotiation or termination of the deal. In these ways, a Buyer uses reps and warranties to maximize the probability of a successful deal.
If risk allocation and information-gathering are key drivers of thorough reps and warranties, then a Buyer may question whether it can expect to get the same quality of reps and warranties if RWI replaces or significantly reduces the use of an escrow. One could hypothesize that a Seller may not negotiate as strongly to ensure accurate reps and warranties where its securityholders bear significantly less economic risk if the reps and warranties are wrong. This is the moral hazard problem. Even where the selling securityholders retain some economic risk before RWI is triggered (if they are liable for the deductible[4]), is it possible that the incentives are such that the Seller will not negotiate as strongly in making its reps and warranties as it would be in the absence of RWI.
While we have no statistical evidence to prove or disprove this hypothesis, a number of leading M&A attorneys have publicly opined on conference panels that, in the attorneys' experience, using RWI rather than an escrow causes sellers to be less vigorous in negotiating reps and warranties. For example, Buyers will often push Sellers to capitulate on issues such as materiality and knowledge qualifiers when RWI is used, with the argument that the insurer rather than the selling securityholders bears the risk. According to these attorneys, this argument often prevails. While this may seem like a win for the Buyer from a risk-allocation perspective, it may be offset by both diminished comfort in the reps and warranties given as well as less thorough information-gathering as discussed above.
Likelihood of Indemnification Claims
The logical extension of the above hypothesis is the question of whether using RWI leads to more indemnification claims compared to using escrows. If RWI causes lower-quality reps and warranties relative to deals with escrows, then more inaccuracies may result in more indemnification claims by the Buyer. Claims can negatively impact the Buyer in three ways. First, they can be costly economically, both in terms of dispute costs and the cost of the breaches incurred. Second, they can distract the Buyer from executing on its post-acquisition strategy, even if the Buyer recovers the economic cost of the claims. Last, the Buyer may be prevented from fully recovering economic costs. For example, if the terms of the RWI policy or acquisition agreement limit the Buyer’s recovery to direct damages, but a breach causes significant indirect damages, then the Buyer may be without recourse for the difference.
Indemnification Recovery Process
A third question is whether the Buyer’s ability to recover for breaches is equivalent between RWI and escrows. The party bearing the risk of loss (whether an insurer or the selling securityholders) may resist paying a claim if a colorable defense is available. Where an escrow is used, the Buyer must show a breach of a rep or warranty and that indemnification is available for such breach under the acquisition agreement. Where RWI is used, the Buyer will need to do the same, but must then also demonstrate that both the type and amount of loss are covered under the insurance policy. RWI policies typically incorporate the indemnification terms of the acquisition agreement, and thus Buyers are usually made whole. However, RWI coverage can include carveouts and exceptions. Further, an insurer may dispute the amount of loss claimed by the Buyer even if the claim subject matter is covered. In these ways, using RWI can add a layer of complexity to disputes compared to escrow-based indemnification.
Ability of Serial Acquirers to Assert Claims
Lastly, serial Buyers may want to consider whether they have the same ability to make claims against RWI as they do against an escrow. The potential exists that a series of material claims by a Buyer against RWI may impact that Buyer's future RWI pricing (i.e., the Buyer's perceived risk profile), similar to the impact of an insured's claims against home or auto insurance. This could have a chilling effect on claims. According to RWI industry professionals, the effect of prior claims on future pricing depends on whether such claims are isolated and justified. A Buyer with a propensity to make claims against RWI without sufficient justification may see higher pricing or have difficulty obtaining RWI going forward.
This chilling effect can similarly apply in an escrow-based deal where parties with whom the Buyer desires to have an ongoing relationship, such as key employees or investors, participate in the escrow. Protecting such relationships by shifting indemnification risk to an insurer is a frequent basis for using buy-side RWI.
Conclusion
Whether an escrow or buy-side RWI is a more appropriate source of indemnification collateral depends on the circumstances of the transaction. In our view, it is not the case that either product is fundamentally better or worse than the other. Rather, it depends on which is a better fit for your transaction. For the reasons above, deal parties should be aware that either option can materially influence the transaction in non-economic ways.
NASDAQ-Listed Companies: Director Compensation Disclosure Rule Change
By Elizabeth Karpinski Vonne, Davis Graham & Stubbs LLP
[TEASER: Do your board members or nominees receive compensation from third-parties? If so, NASDAQ-listed companies musts disclose “golden leash” arrangements.]
NASDAQ is adopting a rule applicable to its listed companies that will require those companies to publicly disclose compensation or other payments by third parties to board members or nominees in connection with that person's candidacy or service as a director. Under the new rule, NASDAQ-listed companies must disclose the material terms of all third-party compensatory agreements or arrangements for nominees and directors in proxy statements filed on or after August 1, 2016.
Such compensatory arrangements are also known as "golden leashes," and the arrangements vary, but can include compensating directors based on achieving benchmarks such as an increase in share price over a fixed term. NASDAQ believes that golden leash compensation information is important for investors to know before investing in the company and voting for its directors because the third-party compensation arrangements, "potentially raise several concerns, including that they may lead to conflicts of interest among directors and call into question their ability to satisfy their fiduciary duties. These arrangements also tend to promote a focus on short-term results at the expense of long-term value creation."
Companies may generally disclose the information either on the company's website or in the proxy for the next shareholders' meeting at which directors are elected. There are additional details and certain exceptions about these requirements in the rule, and any company that may be subject to the disclosure requirement should consult with its securities counsel. In addition, "compensation" is intended to be construed broadly and includes non-cash compensation and other payments, such as health insurance premiums and indemnification obligations. All NASDAQ-listed companies should update their D&O questionnaires in order to ensure that the information required by the new rule is elicited.
To date, the NYSE has not indicated whether it will follow NASDAQ and require similar disclosure for NYSE-listed companies.
All Public Companies: U.S. Business Leaders Release New Corporate Governance “Commonsense Principles”
By Elizabeth Karpinski Vonne, Davis Graham & Stubbs LLP
[TEASER: Are you looking for a framework for advising your clients on corporate governance matters? Good news! A group of prominent business leaders have already prepared one.]
Another recent corporate governance development, which, like the new NASDAQ rule, includes in its objectives an attempt to temper the influence of shareholder activists, culminated in the release on July 21, 2016 of a letter authored by prominent heads of large companies that sets forth best-practice corporate governance principles that the authors believe every public company should meet.
The letter is titled "Commonsense Principles of Corporate Governance" and is intended to provide a basic framework for sound, long-term-oriented governance. The letter also points out that there is significant variation among public companies and that their approach to corporate governance will inevitably and appropriately reflect those differences.
However, many of the recommendations apply to public companies of all sizes, and can be a challenge for all companies, including: "The board should have the fortitude to replace ineffective directors."
Recommendations not related to improving the performance of boards include encouraging companies to not provide quarterly earnings guidance.
Whether meeting a certain standard of corporate governance will deter activists is an open question. However, the corporate governance practices set forth in the letter could strengthen and increase the long term success of public companies independently of any activist threat, and public companies should review the list of practices and determine whether they and their shareholders could benefit by endeavoring to follow any of the practices which the companies currently do not meet, and how to accomplish them. Click here to access the letter.
Business Law Section Activities
Antitrust and Consumer Protection Subsection
How Companies Can Work With Federal Law Enforcement When Responding to Cybersecurity Incidents
September 29, 2016; 4:00-5:30 PM
Assistant U.S. Attorneys and computer crime prosecutors Judy Smith and David Tonini will present guidance on how victims of cybersecurity breaches and intellectual property thefts can utilize Federal law enforcement resources to address these crimes. The guidance will include the types of cybercrimes investigated and prosecuted federally, the unique tools available to federal law enforcement to help solve data breaches, how to report and what to expect after reporting a cybercrime, and a description of recent successful prosecutions involving computer intrusions and IP theft. Other Federal law enforcement cyber agents also will be present to answer questions.
Gibson Dunn cybersecurity and privacy attorney Ryan Bergsieker will discuss the steps companies working with law enforcement on such investigations can take to minimize the risk of post-cyber incident regulatory investigations and civil litigation. The guidance will include a discussion of the types of legal proceedings that commonly follow data breaches and how companies can plan for and successfully navigate those proceedings, as well as updates on relevant recent cases.
The target audience includes in-house and outside counsel who advise companies on the development of cybersecurity plans or the response to cybersecurity incidents.
Location: Bureau of Alcohol, Tobacco, Firearms and Explosives
950 17th Street, Suite 1700, Denver, CO 80202
No registration fee.
To Register: https://usaocotraining.org/CriminalLawCybersecurity
Financial Institutions Subsection
Implementing FinCEN’s Customer Due Diligence Rule - Considerations and Challenges – Wednesday, October 19, 2016 – Noon - 1 p.m. (option to purchase lunch)
Robert Goecks, MBA, CPA, CAMS, sought-after advisor to financial institutions, will provide important information to help you better advise your clients on the implementation of FinCEN’s Customer Due Diligence Rule. Financial institutions covered by the Rule, required amendments to bank anti-money laundering (AML) programs, identifying beneficial owners and obtaining and maintaining information from them, monitoring transactions, accountability of management, and the evolving expectations of the regulators will be discussed.
The program will be held at the Colorado CLE Classroom, 1900 Grant Street, Denver. This program is offered for 1 general CLE credit. Click here for more information or to register.
Save the Dates for the November and December Financial Institutions Subsection Luncheon Programs:
Wednesday, November 16, 2016 - Noon - 1 p.m.
Wednesday, December 14, 2016 - Noon - 1 p.m.
International Transactions Subsection
Transnational Insolvency – Harmonizing and Unifying the Law on International Trade When Cross-Border Insolvencies Arise – Tuesday, November 8, 2016 – Noon – 1 p.m.
Topics Include:
- Introduction to Transnational Insolvency — the United Nations Commission on International Trade Law (UNCITRAL), Comity and the Emergence of the Law of Effectively Addressing Cross-Border Insolvency, and Chapter 15 of the United States Bankruptcy Code
- The Purpose, Implementation and Use of Chapter 15 – Inbound
- Today’s Use of Chapter 15
The program will be held at the Colorado CLE Classroom, 1900 Grant Street, Denver. This program is offered for 1 general CLE credit.
Registration information to come!
M&A Subsection
The Private-Target M&A Landscape - Data, Trends and Challenges – Wednesday, October 5, 2016 – 8:00-9:00 a.m.
SRS Acquiom collects data on private company mergers that is not available anywhere else. This presentation by Eric Martin, Managing Director, SRS Acquiom, will cover data and trends in deal terms and claim activity for transactions where SRS Acquiom is involved as shareholder representative or payments administrator. The presentation will also cover trends in M&A payments and challenges facing deal parties when evaluating investment options for M&A escrow deposits.
The program will be held at the Colorado CLE Classroom, 1900 Grant Street, Denver. This program is offered for 1 general CLE credit. Click here for more information or to register.
Save the Date for the November M&A Subsection Program:
Tuesday, November 1, 2016 – 8:00 – 9:00 a.m.
Save the Date for the December M&A Subsection Program:
Broker/Dealer Issues that Arise in M&A Transactions – Tuesday, December 6, 2016 – 8:00-9:00 a.m. The program will be held at the Colorado CLE Classroom, 1900 Grant Street, Denver. This program is offered for 1 general CLE credit.
Registration information to come!
Securities Subsection
Dodd-Frank and Investment Adviser Registration: A Look Back and a Look Forward – Monday, November 7, 2016 – Noon to 1:15 p.m.
In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act which, among other things, amended certain provisions of the federal Investment Advisers Act of 1940. One important change was the repeal of the “private adviser exemption” on which many advisers, including those to many hedge funds, private equity funds, and venture capital funds, relied in order to be exempt from registration under the Act.
In its place, the Securities and Exchange Commission (SEC) adopted narrower exemptions for certain advisers – e.g., advisers to venture capital funds, family offices, and certain foreign advisers. These changes caused many other types of advisers which were previously exempt – such as private equity funds, mezzanine debt funds, and certain real estate funds – to register with the SEC.
This event will analyze the evolving contours of these exemptions and the practical experiences of and lessons learned by some of the advisers which became subject to the SEC’s regulatory regime.
The program will be held at The Brown Palace Hotel, 321 17th Street, Denver. This program is offered for 1 general CLE credit.
The cost for CBA Securities Law Subsection members is $34.00 and $54.00 for non-members. You are also eligible for the lower Subsection Member rate if you are a CBA Business Law Section Member, and request to be added to the Securities Subsection membership roster. If you are not sure if you are a CBA Business Law Section Member, please ask when you RSVP.
Please RSVP to the Colorado Bar Association at [email protected], or call 303-860-1115 x727, or click here for more information or to register. The deadline to register is November 4, 2016.
Upcoming Colorado CLE Programs
From the Colorado Bar Association
Advertising Law 2016: What Advertisers and the Lawyers Who Advise Them Need to Know – Wednesday, October 26, 2016
Compelling reasons for you, your advertising clients, and all marketers to attend this one-day program on the state of advertising law in 2016 include distinguished faculty sharing their expertise concerning: (1) the enforcement activities and consumer protection priorities of the Federal Trade Commission and the Colorado Attorney General; (2) updates on native advertising compliance; (3) the basics of copyrights and trademarks in advertising (4) the use of big data and (5) various topics in advertising compliance.
Attend and you will be better able to navigate the maze of laws, regulations, and court cases at both the state and national level affecting marketers. You will gain insights on the legal risks for advertisers, hear best practices for complying with the law, and receive practical tips for steering clear of lawsuits.
Join us in October for a day of learning and networking, and stay for a Networking Reception at the conclusion of the program sponsored by Gibson, Dunn & Crutcher!
The program will be held at the Colorado CLE Classroom, 1900 Grant Street, Suite 300, Denver. This program is offered for 7 general CLE credits. Click here for more information or to register.
Secrets of Bulletproof Contract Drafting: Better Documents; Less Stress; More Satisfied Clients – Friday, December 9, 2016
In “Secrets of Bulletproof Contract Drafting,” you will learn:
- The 3 types of ambiguity and their likely sources;
- 5 linguistic improvements that eliminate semantic ambiguity;
- 6 strategies for structuring sentences to prevent syntactic ambiguity;
- 3 methods of avoiding contextual ambiguity;
- Tried and true methods for identifying and eliminating unnecessary language
The program will be held at the Colorado CLE Classroom, 1900 Grant Street, Suite 300, Denver. This program is offered for 7 general CLE credits. Click here for more information or to register.
Business Law CLE Homestudies
2016 Business Law Institute
Bankruptcy Case Law Update
Business Contracts – The Fundamentals
Check out the complete catalog of CLE Homestudies – search by practice area or credits!
Colorado CLE Books
Business Contracts: A Guide for Lawyers and Business Owners, 2016 Edition
Author: Edward White, Moye White LLP
Encompassing a wide range of business topics, this book provides the practitioner with all the tools needed to prepare business documents used in the formation and operation of businesses. Read more.
Securities Law Deskbook: For Business Lawyers, Public Accountants, and Corporate Management
Author: Herrick K. Lidstone, Jr., Burns Figa & Will PC
This is a practical reference guide to securities law, in one convenient volume. With 17 chapters and hundreds of citations to securities rules, statutes, and cases, it is an essential tool for researching securities regulation, litigation, compliance issues, and much more. Read more.
Review our complete catalog of business law books.
Contributions for future newsletters are welcome.
Contact Ed Naylor at [email protected] 303-292-2900.
This newsletter is for information only and does not provide legal advice.
[1] Escrows are typically funded with 10–20% of closing proceeds and set aside for one to three years.
[2] Whether the sellers remain liable for excluded matters or for clawbacks above the buy-side RWI limit is negotiated deal-by-deal. Buy-side RWI is often used as a tool to eliminate the post-closing liability of sellers entirely (except for Seller fraud), with the Seller's representations and warranties not surviving past closing.
[3] For additional information on RWI and why parties opt to use it in M&A deals, please see [insert link to RWI on our website]
[4] Also known as a "retention".