Managing risk in M&A: Key transaction risks

October 2020
By Dr. Gregory Bournet, Partner and Corporate Finance Leader, PwC Malaysia

During the earlier part of this blog series, we shared that a key element of the board’s oversight role is the evaluation of M&A activity to ensure that an individual transaction is consistent with the strategic plan. Increasingly, a critical part of that oversight is the assessment of legal and commercial risks associated with a specific transaction. Even the most strategic transactions may fall short and fail to deliver, resulting in disputes and ultimately litigation.

In this post, we cover the common themes in M&A litigation and the board’s role in minimising related threats as a follow-on from our recent blog on the board’s active involvement throughout the M&A journey.

Breach of representations and warranties

In an M&A transaction, the seller provides the buyer with an assertion of facts as they are being presented in terms of the contract. These are known as representations and warranties. Commonly, a breach of representations and warranties occurs when the buyer claims the seller’s guarantees are false or inaccurate, hence overpaying for the company. Other common disputes arise from undisclosed pending litigation or material liability, omissions or mistakes within financial statements, and illegal activity such as non-compliance with the Malaysian Anti-Corruption Commission (Amendment) Act 2018.

A breach can provide the other party with the right to terminate or refuse to close the transaction - if such a breach has been discovered before the completion of a transaction. Alternatively, and if the parties are unable to resolve the issue, the matter is likely to be taken to court. To avoid the serious repercussions of a breach, the board can establish a special committee of independent directors to evaluate, negotiate and recommend proposals to the board. This ensures that the board can effectively play its oversight role within the transaction. The audit committee also needs to assess and form a view of key areas of focus during the due diligence process. Read more in our recent blog on the audit committee’s involvement in an M&A transaction.

Working capital adjustments

Working capital is defined as the operating liquidity available to a company, and can be calculated as the difference between current assets and current liabilities. The buyer and seller would agree upon a working capital target that the acquired company should have at closing. The components of working capital to be finalised within the deal would be addressed in the M&A purchase agreements. The most appropriate method for determining working capital (and the respective targets) can vary between industries and businesses and is typically a point for thorough negotiations. During the due diligence process or the review of the completion accounts, the buyer may identify issues that would require adjustments related to the set working capital target. This results in an adjustment to the purchase price, a process often referred to as a ‘true-up’.

At times, disputes may arise regarding the working capital calculation. Provisions that favour the buyer may be unfavourable to the seller, which makes negotiations difficult. These claims are typically financially driven. Ultimately, if the seller disagrees with the buyer’s true-up calculations and a deal cannot be reached, the parties may employ the dispute resolution process set forth in the agreement. To minimise this risk, divergent viewpoints should be considered and reflected within the purchase agreement, and any post-closing purchase price adjustments should be drafted with specificity, particularly if they are related to certain accounting treatments. Therefore, it is critical for the board to engage an experienced M&A advisor to negotiate strategically within the deal and eliminate working capital disputes. The board needs to also fully understand the negotiated mechanisms for such adjustments and the potential impact on the ultimate purchase consideration.

Earnout

As with working capital adjustments, earnout is another aspect which the board should engage actively in. The basic idea of an earnout involves the seller being paid a cash amount for the business upfront and then getting paid specified amounts in the future when certain goals agreed with the buyer are reached.

Earnouts can be beneficial in breaking purchase price negotiation deadlocks, however they naturally come with several challenges in their implementation. The greatest of these is the potential for litigation in the period between transaction-close and the earnout’s expiration. Risks arise when earnout provisions are too simplistic or too complex. Again, the board should fully appreciate the maximum exposure from an earnout, specifically if it’s a tail-end event.

To minimise the risks associated with an earnout, both parties should lay out explicit terms, determine highly specific milestones and ensure incentives are in place. In the case of disagreements, the board should appoint accounting and legal teams in an arbitration process, before disputes escalate to litigation.

Shareholders’ lawsuits alleging breach of fiduciary duty by the board

A common form of lawsuit arising from M&A transactions allege a breach of fiduciary duty by one or more directors. The volume of litigation by shareholders has raised concerns in recent years. Plaintiffs typically allege a breach of fiduciary duty by the target’s board of directors from conducting a flawed sales process that fails to maximise shareholder value. Therefore, it is highly likely that a board’s decisions and decision-making processes related to M&A will be subject to intense scrutiny in a lawsuit.

Common allegations in these lawsuits include:

Alleged failure of the board to conduct a fair sales process designed to obtain the highest price
Alleged coercive deal terms
Disparity of treatment between majority/minority investors
Inadequate disclosures
Potential conflicts of interests among directors, major shareholders or financial advisers

A vital step for the board to take would be to engage outside litigation counsel at the outset of the M&A process to analyse any potential conflicts and litigation risks.

Other litigations on the increase

There have also been other litigations on an increasing trend, such as failure of the buyer to proceed with a particular transaction due to inability to obtain financing, as well as strategic litigation by competing bidders. As such, it is important to ensure a proper agreement with appropriately defined terms, and to monitor the timely resolution and risks identified during the due diligence process. This is where the board and audit committee roles come in, to respond to present M&A threats and cultivate trust within the deal. Alignment between parties early on contributes to building a solid foundation of trust. This form of trust is not based on emotion, but rather the implementation of a thorough, well-managed process that reflects the steps taken to maximise value and evaluate alternatives. In a volatile market, trust can be a key determining factor in a sustainable and successful transaction.

Conclusion

M&A transactions involve significant risks and many uncertainties, creating far-reaching impact to stakeholders at every level, including directors, shareholders, employees, and customers. These issues may lead to complex and costly disputes and litigation risks. The goal for companies is to shift from reactive troubleshooting to proactive measures through a detailed understanding of the board’s role, involving the audit committee, and investing in a comprehensive risk assessment and management plan from the get-go. In the long run, these measures will help companies enhance stakeholder trust and enable better observance of corporate governance.