U.S. M&A standards continue to influence the Canadian market, but despite the general trend of convergence in the cross-border legal market, deal terms in the Canadian M&A market still tend to offer more protection to the buyer, particularly with respect to indemnification.
And while the closing dinner may be the best place to discuss whether Canadian M&A culture is more influenced by principles of fairness than of caveat emptor, deal-makers in Canada can profit by keeping abreast of the latest developments and tactically applying the prevailing norms.
Based on the results of the most recent American Bar Association deal studies, which analyze publicly available acquisition agreements for transactions involving U.S. and Canadian private companies, here are our top five cross-border indemnification tips, plus two other points for deal-makers to consider.
Our key takeaway: all else being equal, a seller should prefer U.S. norms, and a buyer should favour Canadian ones.
Should your deal be a U.S. or Canadian deal?
Contractual indemnification provisions in private M&A deals are common on both sides of the border and set out the mechanism by which the seller will indemnify the buyer, typically for losses arising from a breach of the seller’s representations and warranties (R&W). Naturally, the seller will want to limit the duration, scope and dollar amount of its indemnification obligations.
This is an area where the differences between Canadian and U.S. M&A norms loom largest; as studies indicate, sellers in Canada are willing to provide more generous indemnification terms than sellers in the United States.
In particular, and stated from the buyer’s perspective, the Canadian M&A market offers the opportunity to obtain larger indemnification caps, longer survival periods, and fewer limitations on the dollar value of recovery than the U.S. market.
Armed with this knowledge, Canadian sellers would be advised to consider proposing a “U.S. deal,” especially where at least some of the prospective buyers are from the United States, as opposed to a “Canadian deal.” And by contrast, U.S. companies looking at targets in Canada should prefer Canadian-style deal terms, which will be more likely to provide greater protection than a buyer in the United States would ordinarily expect to obtain.
When deciding whether to present a U.S. or Canadian deal during negotiations to achieve a favourable indemnification package, consider the following components vis-à-vis your position as a buyer or a seller:
Indemnity packages tend to be more buyer-friendly in Canada
- Survival periods: Longer in Canada
Survival periods set forth the time during which a party can bring a claim for indemnification. Claims for breaches of most R&Ws are generally available for a longer period in Canada than in the United States, with deals in Canada being more likely to offer between 12-24 months of protection, as opposed to 12-18 months in the United States.
But buyers in Canada should note a convergence trend and expect some resistance: while 47 percent of deals in Canada had 24-month survival periods in a 2012 Canadian study, only 25 percent of the deals in a 2016 study had a similar period.
- Caps: Higher in Canada
Canadian M&A indemnification provisions tend to cap indemnification obligations at a much higher amount than what is typical in the United States, reinforcing the “rule” that deal-makers should sell under U.S. norms, but buy under Canadian ones.
- Baskets: Canada favours a tipping basket over a straight deductible
Another important data point is the use of indemnification baskets, which establish a threshold that must be met before a party is entitled to receive indemnification. While indemnification baskets are common in both legal markets, U.S. deals tend to have deductibles rather than tipping baskets, which permit indemnification of all losses after an agreed threshold has been exceeded.
Specifically, 65 percent of U.S. deals had deductibles, as compared to only 41 percent of Canadian deals. Nevertheless, the Canadian market is also moving quickly toward adoption of the U.S. approach, with the percentage of deals in Canada with deductibles growing from 14 percent in a 2012 study, to 36 percent in a 2014 study and to 41 percent in a 2016 study.
- Materiality scrape: Less common in Canada
In an exception to the general rule that Canada is a more buyer-friendly jurisdiction for indemnification than the United States, the materiality scrape, which favours buyers by making it easier to establish an entitlement to an indemnity, is much less common in Canada than in the United States.
A materiality scrape eliminates any materiality qualifiers in R&Ws, and can impact a buyer’s indemnification rights in two ways. The pro-seller application of the scrape only disregards materiality qualifiers for the limited purpose of calculating a party’s losses, while the pro-buyer application adopts that position but also disregards materiality qualifiers for the purpose of determining whether a breach of any R&W has occurred, which as noted above makes it easier to establish a claim that a representation or warranty has been breached.
The materiality scrape is much more common in the United States, where it is more often applied to favour the buyer.
- Escrow: Less common in Canada
In a second exception to the general rule that Canada is a more buyer-friendly jurisdiction for indemnification than the United States, the U.S. market favours the use of escrows, which are designed to avoid seller credit risk by providing assurances to the buyer that there are readily available funds to satisfy potential indemnification claims.
Nearly 80 percent of deals in the United States have an escrow and the mean amount subject to the escrow settles just below 10 percent of the transaction value. In Canada, less than half of the deals include an escrow and the amount subject to the escrow is typically lower than the U.S. norm, at around 8 percent of the value.
Deal dynamics and auctions
Deal dynamics and leverage should be taken into account, and potentially temper certain negotiating positions that might logically follow from an effort to gain a commercial advantage by applying the deal norms discussed above.
For example, a buyer in a competitive auction environment might prejudice its bid by making significant substantive revisions to the indemnification provisions in a U.S.-style auction. Alternatively, a large Canadian buyer engaging in bilateral discussions to purchase a smaller U.S. target may have the leverage to impose more favourable indemnification positions.
Moreover, Canadian deal-makers should be mindful that in the United States, especially in the mid-market, deals are now commonly incorporating R&W insurance, a product that steps into the shoes of the seller to indemnify the buyer against breaches of R&Ws. For example, in a mid-market competitive auction in the U.S., buyers are often expected to obtain such a policy, and a bidder should seriously consider incorporating this concept so as not to prejudice its bid.
Although still less prevalent in Canada, the use of R&W insurance is growing and a bidder in a competitive auction in Canada might set its bid apart from its competition by proposing to purchase a policy and reduce the seller’s exposure to indemnification risk.
Two other points to consider
- No legal opinions in U.S. deals
U.S. deals nearly universally have dispensed with the need for a legal opinion of the target’s counsel as a condition to the buyer’s obligation to close the transaction or as a closing deliverable. Gradually, Canada has been following suit, but an opinion is still required in about a third of transactions.
- Cross-border deal financing terms are also converging
When considering the deal financing terms, there has been some convergence between what is considered market across the border.
For example, “SunGard” or “certain funds” provisions have been a market standard in the U.S. since the SunGard deal in 2005, but the provision has only gained traction in the Canadian market in the past few years. SunGard provisions are intended to align the conditions of lending commitments as closely as possible to those in the acquisition agreement, minimizing the risk of the buyer being required to close in circumstances where the lenders are not required to lend.
Buyers often include this type of provision in order to increase the attractiveness of their bid as sellers prefer minimal financing conditionality in order to minimize execution risk. These provisions represent a significantly narrower scope of conditionality and present a higher risk to lenders.
Canadian banks have traditionally had a lower risk tolerance than specialty finance companies or banks in the United States; however, given the overall uptick in activity of U.S. financial sponsors in the Canadian market, it is likely these types of provisions will become more prevalent in Canadian deal finance.
Leveraging the differences
Cross-border growth continues to drive many growth strategies and astute negotiators, like their operational counterparts, should adjust their strategies to account for geographic differences.
Given the scale and influence of the U.S. market and the robust history of successful cross-border M&A transactions, it is no surprise that there has been convergence in terms used in the Canadian and U.S. legal markets.
But knowing the differences, and using those differences to your benefit, as a buyer or a seller, still matters, especially with respect to indemnification in private M&A deals. While no two deals are ever exactly the same, the market in Canada offers more buyer-friendly indemnification packages than in the United States. Armed with knowledge of the prevailing norms in each jurisdiction, savvy deal-makers can leverage the market differences to their advantage in their negotiations.
This column has been modified from an original published by Osler, Hoskin & Harcourt LLP. To view the original plus graphics, please click here.
Marc Kushner, a partner in Osler, Hoskin & Harcourt LLP‘s corporate practice, wrote this article in collaboration with Michael Budabin McQuown and Jillian Mulroy, both associates in the firm’s corporate practice. Marc’s work is primarily focused on mining, private equity, U.S. and cross-border M&A and other deal representations.
Photo of M&A concept courtesy of BrianAJackson/iStock/Getty Images
Photos of Marc Kushner, Michael Budabin McQuown and Jillian Mulroy courtesy of Osler, Hoskin & Harcourt LLP