With M&A increasingly global, American trends are finding their way into Canadian deals. Call it the big sister-little sister effect, but trends in deal making in the United States have been creeping up to Canada. Developments in M&A in the U.S. that have made their way northward include materiality scrapes, representation and warranty insurance and sandbagging provisions — in a large part due to more open trade borders.
Call it the big sister-little sister effect, but trends in deal making in the United States have been creeping up to Canada. Developments in M&A in the U.S. that have made their way northward include materiality scrapes, representation and warranty insurance and sandbagging provisions — in a large part due to more open trade borders. But the migration of U.S. practices to Canada hasn’t been wholesale, either; sandbagging, for example, has not picked up anywhere near the steam here as it has south of the border.
“Now, all deals are cross-border in the M&A field,” says Sharon Geraghty, who practises M&A with Torys LLP in Toronto. “It’s rare that you’re not hunting out buyers from other jurisdictions; and so we’re across the table from U.S. parties all the time, and they’re introducing as a result the trends and the concepts that they use to Canada . . . We’re also seeing Canadian players becoming much more active in the U.S.”
The convergence of Canadian deal terms to more closely match American styles has been happening for a number of years, says Geraghty, but it has accelerated greatly in the past few years.
“When I first started practising, most M&A deals were local,” says Alan Litwack, who practises with Dickinson Wright LLP in Toronto. “Most M&A was east-west; now, it’s mostly north-south.” Many buyers are large private equity funds, he says, and businesses in Canada have grown to such an extent that there just aren’t the Canadian buyers out there for them.
Representation and warranty insurance
The increase in the use of representation and warranty insurance in Canadian deals is one example of a U.S. (and U.K.) practice that has become more popular in Canadian deals.
Representation and warranty insurance is used for the most part to protect the insured party from losses and liabilities incurred as a result of breaches of representations and warranties contained in a purchase and sale agreement. If there are breaches, the buyer looks to the insurer and not to the seller, Litwack explains, and it serves two functions, he says: to serve as due diligence and to allocate the risk for something that comes up after the fact for something that no one knew about.
“Rep and warranty insurance is not a brainchild of the U.S. market,” says Stefan Stauder, who practises M&A, largely on the private side, with Torys in New York. “It was kicking around [in Canada] for a long time, but it was too expensive and cumbersome to use.” It finally made inroads to Canada two to three years ago, says Stauder, via Europe, and was first introduced in mid-market deals by funds that wanted to distinguish themselves in auction settings.
“In the last few years, there hasn’t been a high-level deal that didn’t include representation and warranty insurance,” he says. “In the last couple of years, it’s ubiquitous. We have used it in many iterations, and what we’re overseeing right now is the . . . sub-trend toward making it as seller-favourable as possible.”
It used to be that even when it was used in Canada, the parties agreed that the seller would maintain some exposure, Stauder adds, but there are now more deals in which the buyers are willing to release the sellers from indemnity, and rely solely on representation and warranty insurance. “It’s a more sell-friendly trend.”
Prices have also come down on representation and warranty insurance, Geraghty notes, coincident with its increased use. Almost no mid-market deal is done in the U.S. now without this insurance, she says. “That could soon be Canada.”
Mark Adkins, an M&A lawyer and managing partner of the New York office of McCarthy Tétrault LLP, also confirms that most deals in the U.S. and U.K. now carry representation and warranty insurance, including the private equity deals. However, although R&W insurance is expanding in Canada, it is not as common in Canada as in the U.S. because it is a product designed for a financial seller, and there are fewer of those in Canada, as well as less litigation, lowering the post-closing risk. (Indeed, says Litwack, in his 40 years of practice, he “can count on one finger the number of claims” he has seen for breaches of representations and warranties.)
Nor is it a perfect solution, says Adkins, as there are often topics that are excluded from the policy’s coverage, such as tax and environmental items. What does get covered is negotiated between buyer and seller, and then with the insurer.
Sandbagging occurs when a buyer learns there is a breach of representation prior to finalizing a deal, then goes after the seller for the breach afterwards; in figurative terms, the buyer sandbags the seller.
For many years, there was silence on the issue of sandbagging in Canadian deals, says Litwack, meaning that it wasn’t mentioned in deals agreements. He says most agreements he sees are still silent.
Americans “came up with the idea of pro-sandbagging,” says Geraghty. In Canada, it isn’t needed, she says, because the law of contract says that a seller who breaches the representation can be sued for damages. Pro-sandbagging provisions are hard to negotiate, she notes, as they involve trust issues.
U.S. law on sandbagging changes from state to state, Stauder notes. Sometimes, buyers have to show reliance on the representation, but not always. Delaware and New York each have nuanced regimes to the extent there is case law, he says, though it is not exactly the same. In New York, how a sandbagging clause plays out in litigation may depend on how the buyer learned of certain circumstances, for example. And it’s been a hot-button issue in the U.S. for the past five to seven years, he says, raising questions such as what kind of damages to exclude from a buyer’s recovery.
“It used to be that consequential, punitive and special damages couldn’t be recovered” by the buyer, says Stauder, but this is changing. Partly as an outgrowth of the more litigious U.S. market, these clauses have been leaning more toward the buyer’s side, he says.
In the U.S. and in Canada, the prevailing market practice is still to remain silent, says Adkins, “with the theory being, if you get into a dispute, you can go to court, and the court will figure it out. [Otherwise], the buyer puts in their sandbag provision, the seller takes it out and you have a fight. Often, the compromise position is to just to stay silent.”
With the multiplicity of sophisticated, multiple buyers in the U.S., including private equity funds, there are stronger pushes to get the best possible deals and preserve all their rights, Adkins says, which has led to a big push in the U.S. for pro-sandbagging clauses that expressly permit a buyer to bring a claim, even if they’re deemed to know of a breach beforehand.
“That has not been the case in Canada,” he adds. “I think probably 25 to 30 per cent of U.S. deals have [a sandbagging provision] in it, whereas I suspect it’s in the 15-per-cent range in Canada. . . . . The question in Canada is whether that provision would be enforceable.” In Delaware, where the vast majority of U.S. public companies are incorporated, pro-sandbagging clauses have been upheld, but in Canada, there is no case law on sandbagging yet, he says.
A materiality scrape provision “scrapes” or excludes materiality, material adverse effect and other materiality qualifiers in the seller’s representations and warranties for the purposes of post-closing indemnification, and it is far more prevalent now in Canadian deals than it was even two years ago, says Litwack.
“The intention is for sellers to limit their exposure by limiting to what rises to certain levels of materiality,” Stauder explains. The materiality scrape is a counter-trend in an otherwise seller-friendly environment, he says, and a lot of sellers’ exposures are backstopped by R&W insurance.
Other M&A cross-border trends
Litwack notes a U.S. trend to execute deals faster. For example, he says, a quality of earnings report will be made available before the players go to market. “A lot of things are done early on, ahead of going to market, that make the deal/transaction go much quicker.”
And Adkins believes the most relevant developments in the U.S. that affect M&A in Canada aren’t legal ones; rather, he expects the greatest impact to be from the new, pro-energy government in the U.S., which recently approved the Keystone Pipeline project between Canada and the United States. “I think the changing government in the U.S. is having a direct impact on activity in our energy sector and probably will continue to do that.”
Sensitive points in Canada-U.S. trade tend to be softwood lumber and agribusiness, he adds, which will not necessarily affect M&A much. “Under NAFTA, the open border in North America for auto manufacturing is of importance. Canada and the U.S. both have an interest in that continuing; and I think a lot of the focus in the U.S. [on trade] is more southbound than up to Canada.”