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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
Introduction
1. THE PRESENT MODEL
This model contract is the first of a series of models of international "Merger and Acquisition" (M&A) agreements.
Broadly speaking, M&A agreements refer to the transfer of a company or a business and cover a variety of contracts, such as:
The first model of these ICC M&A Agreements is a Share Purchase Agreement (SPA) in its simplest form, i.e., the acquisition of the entire issued share capital of one company. It does consequently not consider the acquisition of a majority shareholding (where a number of additional issues arise due to the fact that the position of the minority shareholders must be considered), nor the case where a group of companies is acquired (which also gives rise to further issues). It also does not consider the case where there is more than one seller. These situations, which imply a number of further issues, have been left aside in the context of a simplified model, but may be considered in future model contracts.
This model is made to assist parties and lawyers who are not specialized in the field of M&A contracts to draft a simple contract covering the most common issues involved. This means that the model may not be appropriate for complex transactions, nor for acquisitions of public companies.
2. THE DRAFTING TECHNIQUE USED
The structure and contents of SPA's are strongly influenced by the models and forms developed within common law jurisdictions. This has caused the parties to use, independently from the law governing the contract, clauses and concepts which belong to these common law legal systems.
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One example of this is the reference to "Representations & Warranties". It is difficult to imagine a Share Purchase Agreement without "Representations and Warranties". However, these two terms have no precise meaning outside the common law jurisdictions and may be misleading even within these legal systems 1. Parties expect them to be in a Share Purchase Agreement, but it should be clear that these two "magic words" have actually acquired within this type of contract an autonomous meaning, independent of the legal meanings of "representations" and "warranties" within specific national legal systems 2.
In this case the task Force has chosen to make use of these terms, although they may be misleading, because it felt that it could not go against such a well-established usage. But, as a general rule, the Task Force has tried not to use terms which are too specific to any particular legal system, in order to make the model compatible, as far as possible, with all applicable legal systems.
3. THE NEGOTIATION AND CONCLUSION OF SPA’S: ORDER OF EVENTS
Buying a company is a complex deal which almost always requires a number of successive steps, and all the more so in a cross border transaction when the purchaser is not familiar with the legal and business environment of the target company. Although the steps leading up to the conclusion of an SPA may vary substantially from case to case, it is customary to initiate the process with preliminary agreements such as confidentiality agreements, letters of intent, and various descriptions of negotiation agreements such as term sheets or heads of agreement, with or without exclusivity provisions and other advisable provisions such as time schedule, time and scope of due diligence investigations, confidentiality, break fee arrangements, etc.
If the due diligence investigations are satisfactory for the purchaser and the negotiation of the terms of the acquisition breaks through, the parties enter into the Share Purchase Agreement which, in many cases, is organised in two steps, i.e. signature and completion. While it is simpler to wrap up the deal in one step, there may be practical advantages to proceeding in two steps, especially when the jurisdiction of the target company is unfamiliar.
The downside of a lengthy process is to delay the take-over of the target business, but varied transfer of management, risks and responsibility provisions can be inserted in the SPA to provide for the variable concerns of the parties in terms of time and risk.
Once the SPA is signed and completed, a number of post-completion steps may continue to involve both parties, such as on the one hand formalities and on the other hand performance of post-closing obligations, including payment of the price in instalments with or without the involvement of an escrow agent and non-compete provisions with or without performance bonds.
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4. POSSIBLE ADJUSTMENT OF THE PRICE: CLOSING ACCOUNTS AND EARN-OUTS
In some circumstances the buyer and seller may agree that the purchase price should be made subject to an adjustment (either upwards or downwards) after closing. The two most common forms of adjustment are known as closing accounts and earn-outs.
Closing accounts are most commonly used when there is uncertainty about the financial condition of the company at the point in time when closing takes place, for example if there are no-up-to date financial data concerning the company, or the available data are regarded as unreliable. For instance, it may be that closing takes place eleven months after the last audited accounts of the company were prepared, or the company may have undergone a reorganisation, as a consequence of which the proper value of its assets at closing is not precisely known.
Closing accounts will involve an adjustment to the purchase price based on the net assets of the company at closing.
Earn-outs on the other hand involve the possible payment of an additional price based on the results arising out of various indicators over a given period. Earn-out adjustments are therefore particularly appropriate in the case of businesses with a variable level of profitability, for example a newly established company which is growing quickly, and which is being valued principally for its potential to generate profit in a given period following closing.
If the parties agree that the price should be adjusted as a result of a closing accounts exercise, the sale and purchase agreement will need to provide that either the buyer or the seller prepare a first draft of the closing accounts (it should be clearly stated what this should involve, for example, a full balance sheet prepared in accordance with generally accepted accounting principles on a basis consistent with prior balance sheets, and the time requirements applicable in relation to the production of the first draft closing accounts). The agreement should then provide that the other party review the draft closing accounts (and that it should have access to the necessary accounting information and personnel required for this purpose if necessary).
The agreement should also provide that the parties should seek to agree the closing accounts or seek to resolve any disagreement in relation to them, but should provide that in the absence of agreement, the matter should be settled by an expert (usually an independent accountant appointed jointly by the parties, but in the absence of agreement as to the identity of the expert, the agreement should provide that an independent party, for example the president for the time being of the relevant country's professional association representing accountants appoint the expert).
Once the closing accounts are agreed or resolved by expert determination, the agreement should provide for a formula pursuant to which a portion of the purchase [Page10:]price be repaid to the buyer or an additional amount paid by the buyer to the seller. For example, if the net assets exceed a pre-agreed target, then an additional sum equal to the excess should be payable by the buyer. If a repayment of the purchase price from the seller to the buyer is likely, then the buyer should consider whether it requires a retention (of part of the price) to be made or payment of a portion of the purchase price to be made into a jointly held (or jointly held solicitors') account until the adjustment to the purchase price has been determined.
Earn-out mechanisms operate on a similar basis, but the agreement should instead require a profit and loss account to be prepared in respect of certain pre-agreed periods following Closing. A formula should require the repayment of a portion of the purchase price or the payment of additional consideration by the buyer in the event of target earn-out values being exceeded or not.
Closing accounts and perhaps even more so, earn-out mechanisms, are areas where very careful drafting is required as there is a serious risk of dispute after closing.
The agreement should provide in detail which accounting policies and principles will apply to the closing accounts or earn-outs. Although this is a matter for agreement between the buyer and seller, the most commonly adopted formula is that the usual accounting policies and principles of the company (for example as adopted in its last audited accounts) will apply, except to the extent that such policies and principles are not in accordance with generally accepted accounting principles, and that if a certain policy or principle is not expressly provided for in the company's last audited accounts, then the matter will be determined by reference to generally accepted accounting principles.
In relation to earn-outs, there is an obvious risk that in the absence of any restrictions being expressly stated in the agreement, the buyer, who has control of the company after closing, may take steps after closing which (deliberately or otherwise) may affect the amount of the earn-out adjustment to be paid. Accordingly, detailed earn-out provisions should be included in the sale and purchase agreement, restricting the ability of the buyer to take any steps which might prejudice the calculation of the earn-out.
5. THE NEGOTIATION OF THE PAYMENT CONDITIONS
The model provides for payment of the purchase price at the time of the closing of the transaction (see article 6). The transfer is mechanically straightforward, but there are some issues which need to be considered when negotiating this clause.
Under the model, the buyer would be unprotected if the seller could not or did not want to honour any subsequent claims based on a breach of the warranties or an adjustment of the purchase price as discussed above in §4. Therefore, a bank guarantee from the seller in an amount and for a term to be agreed should be considered. The duration could be linked to the warranty period, and the amount would take into account the likelihood and probable size of any warranty claims, although no exact [Page11:]calculations are of course possible. In certain countries it is more usual to retain part of the purchase price in an account with an escrow agent. In jurisdictions where this is not standard practice the negotiation of an escrow agreement with a bank is often so time-consuming and expensive that a bank guarantee is the less costly solution. In some countries it is also practice to deposit part of the purchase price in a special bank account under the control of the buyer and the seller whereby the release of any money to the buyer requires the express consent of the seller. If the consent is not granted, the buyer will have to sue the seller. It is crucial for this arrangement to work that any judgement obtained be easily enforceable.
Alternatively the purchase price could be paid in instalments whereby the unpaid portion serves as collateral for any claims of the buyer, but then the seller might want to receive protection for its payment claims by way of a bank guaranty given on behalf of the buyer.
6. WARRANTIES AND DISCLOSURE LETTER
One of the main issues of the Share Purchase Agreement is the exact definition of the warranties 3 given by the seller.
This issue is of particular importance in this type of agreement: by purchasing the shares the buyer acquires the company, but the nominal value of the shares as such does not reflect the actual value of the company, which depends on a number of factors such as the value of its assets, goodwill, etc. 4. The purpose of warranties is therefore to define the critical factors in relation to the business upon which the buyer is prepared to offer the purchase price. Any breach of a warranty will therefore be related to a reduction of the value of the target business and may in short financially result in a reduction of the Purchase Price.
The buyer will of course obtain information about all relevant aspects of the company (see §7 below). However, the buyer has no certainty that the information received is true and accurate and this is why the seller will be asked to give a number of warranties as to the truth and completeness of certain information received by the buyer for the purpose of valuing the Company.
In this context a contractual technique has been developed over the years whereby each warranty states a positive guarantee (e.g., all the taxes have been paid, all assets belong to the company) and then possible exceptions are disclosed by the seller to the buyer (e.g., there is a problem with the taxes of the year 2000, or certain equipment belongs to a third party).
These exceptions to the warranties can be contained in a separate document, the "disclosure letter" or in a document more strictly connected to the representations and warranties.
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In order to facilitate a comprehensive view of these aspects the Task Force has preferred to put the exceptions to the warranties (contained in Schedule A) in a parallel document (Schedule B) which follows the same order and numbering.
Furthermore, the two schedules have been placed for the convenience of the reader in parallel on the same page, so that the warranties and their exceptions can be seen together. Of course, this does not prevent the parties from drafting the actual schedules separately.
7. KNOWLEDGE OF THE BUYER AND BREACHES OF WARRANTIES
It is obvious that the buyer will need information about the main aspects of the Company before purchasing it and negotiating the price. This information can be gathered in different ways.
Particularly where a due diligence investigation has been made, a problem may arise as to how and to what extent the information available to the buyer can affect the buyer's right to be compensated for breach of warranty. It is recommended to expressly deal with this problem in the contract.
The two extreme solutions are the following:
The model contract proposes a solution along the lines of the first alternative: in principle all information that is relevant for limiting a warranty must be disclosed in the contract (in Schedule B, which is made for the purpose of containing such information). The seller bears in principle the risk for not having disclosed within the contract certain facts as a consequence of which the buyer will be entitled to seek damages for breach of warranty, even if the seller can prove that the buyer knew of[Page13:]such facts already by some other means (but he can avoid this by accurately drafting the contract and in truly extreme cases he might be protected by the principle of good faith).
Relevant date for correctness of warranties 5
The next issue to be addressed in transactions where signing and closing take place at different dates is the definition of the relevant date on which the warranties must be true and correct to avoid any claims for breach. This issue is normally discussed intensively in negotiations in such transactions. As mentioned above, the warranties are to define the factors critical to determine the purchase price and the value of the underlying business. If the parties agree on the date of signing as the relevant date, any deterioration of the business after the signing will not have an effect on, and not result in a reduction of, the purchase price. As a consequence, because the full purchase price remains payable even if the condition of the business deteriorates, the risks associated with the business will pass to the buyer before the transfer of both title to the shares and control over the business. This may appear unfair to the buyer, and laws in certain jurisdictions would even give the buyer the right to withhold the purchase price or, in case of a drastic change, to walk away from the contract. The seller, however, will often argue that it was willing to close at signing and that any delay in the transfer of title was exclusively caused by the buyer, perhaps because of some outstanding permission or finance. With this argument, if successful, the seller would justify the premature transfer of the risk to the buyer.
By contrast, if the closing date is the relevant date, the seller might find himself in a situation of breach because of an unexpected event that happened between signing and closing. In order to avoid a reduction of the purchase price, the seller might wish to have the right to amend any disclosures against the warranties. This appears to be fair only at first glance, and the buyer would be totally unprotected because it would still have to close at the terms of the purchase agreement. Taking into account the function of the warranties in the purchase agreement, it would only be fair that any negative impact on the value of the business after the signing and before closing should trigger a reduction in the purchase price. If the parties agree therefore on the closing date as the relevant date, a compromise may be found in permitting the seller to refuse closing if as a consequence of any breaches the effective purchase price is reduced below a certain threshold.
In certain situations, the seller might also have to accept a material adverse change clause entitling the buyer to walk away even if there has been no breach of warranty before Closing, due to a dramatically negative development affecting the target business or the market it operates in. (See Article 5)[Page14:]
“Best knowledge” and similar expressions
In the current practice certain warranties are preceded by the words "So far as the seller is aware" or "To the best knowledge of the seller". Since these clauses seek to limit the liability of the seller through the reference to a vague concept like the knowledge of certain facts, it has been decided to limit their use to circumstances where, for example, certain actions are threatened against the seller as the seller should not be asked to warrant that there are no threatened actions which it does not know about. The use of these expressions is limited because the function of the warranty clauses is to define the factors relevant for the value of the business, and it is obvious that there can be no link to subjective facts like knowledge or potential knowledge of a seller. This does not prevent the seller from limiting its liability within Schedule B, by stating why and to what extent he is unable to assume a certain responsibility.
However, there are situations where the parties would sometimes use such expressions of this type more frequently, for example in the areas of environmental matters, compliance with laws, validity and renewals of permits and authorizations, intellectual property. If used, they reflect the understanding of the parties that they are not fully aware of the facts covered by the warranty and that the parties share the resulting risk in some way, which will most likely also have had an effect on, and be reflected in, the agreed purchase price.
8. APPLICABLE LAW
When deciding about the applicable law, parties should consider several circumstances.
In the first place, it is certain that a number of issues strictly connected to the target company are necessarily governed by the law of the country where the target company is incorporated: see, for example, the questions relating to the formalities of the transfer of shares.
Considering that the law governing the company may be relevant for many aspects of the share purchase agreement, parties may choose to submit also such contract to the law of the country of the target company. This is actually the most commonly used solution and has therefore been expressly foreseen in Article 18A.
It should however be considered that, since this model has been drafted independently of any particular national law, with the purpose of establishing a truly international standard, parties will first need to check if and to what extent this model contract conforms to the domestic law they wish to apply.
If it appears impossible (or too onerous) to determine the content of the rules which would apply under the domestic law of the target company, or if such rules prove to be inappropriate, parties may decide to choose one of the following alternatives.
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If parties choose the first solution, they will indicate the country chosen in Article 18A. In such case they should check carefully whether any provisions of this model violate mandatory provisions of the national law they have chosen 6.
The second solution has the advantage of being more appropriate for a contract like this model, which reflects international contract practice without being based on a particular domestic law. This solution makes it possible to apply the rules of the model form in a uniform way to sellers and buyers of different countries, without giving one party the advantage, and the other party the disadvantage, of applying one party 's national law.
At the same time this solution, while avoiding the particularities of national laws, gives a wider discretionary power to the arbitrators, since it is based (at least for matters not expressly governed by the contract clauses) on very general principles. It should also be considered that a reference to general principles instead of a national law may not be effective if the dispute is brought before a national court: such a solution almost necessarily implies that possible disputes be submitted to arbitration, by choosing Article 17.2A (Arbitration).
The Task Force is of the opinion that the possible disadvantage resulting from the application of rather flexible and general rules can be overcome by the use of a sufficiently detailed contract (which expressly addresses most of the critical problems that might arise) together with a set of general rules on contracts, like the Unidroit Principles of International Commercial Contracts 7, which offer a reasonably foreseeable legal framework for most issues of a more general nature, normally not envisaged in the contract itself.
This is actually the solution proposed in Article 18.1.B, which states that any questions not expressly or implicitly settled by the provisions contained in the agreement shall be governed, in the following order:
It should be taken into account that under the above clause, which puts the various sources incorporated by reference in a hierarchical order (contract clauses, general principles, trade usages, Unidroit Principles), the Unidroit Principles will apply only to the extent they do not conflict with general principles and trade usages 8.
This also implies that, even when the Unidroit Principles provide that certain of its rules are mandatory, such rules will not prevail over the contractual clauses, general principles or trade usages.
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FOOTNOTES
1 So, for example, while the two terms “representations” and “warranties” have almost an equivalent meaning in the United States, under English law there is a substantial difference between a representation and a warranty. The measure of damages for a misrepresentation is different to those available for breach of warranty. Damages for misrepresentation are based on a tortious measure and can be substantially different to those available for breach of warranty. (Note: recession is also an available remedy for Misrepresentation). A representation also has to “induce” the contract and is usually thought to be confined to pre-contractual statements rather than terms actually in the contract (because it has to induce the contract). An aggressive buyer with a strong negotiating position may attempt to keep available both an action for misrepresentation and breach of warranty so both types of remedy are available. However it is usual that misrepresentation is excluded through the “entire agreement clause” (clause 15.2) and “non-reliance clause” (clause 15.3), i.e., by stating that both parties have not relied on any pre-contractual statements and that the agreement represents all the terms between them. It is also usual for the entire agreement clause to say that the only claim under the agreement will be for “breach of contract”, thereby denying any remedy available under misrepresentation. These extra words should be considered if the contract is subject to English law and the terms representation and warranty are used interchangeably throughout the document.
2 This result is obtained mainly by expressly providing in the contract what the legal consequences of a breach of representations and warranties are, so that it becomes less important to know how the representations and warranties should be qualified under the applicable law and which would consequently be, under such law, the consequences of a breach.
3 The term “warranties” has been chosen for sake of simplicity. In some jurisdictions one would discuss “representations and warranties”, and in still other jurisdictions “guarantees” or the like. It is essential to note that each of these terms might have a slightly different meaning. The legal consequences of a breach should be carefully checked under applicable law.
4 The legal principles which would apply in the absence of specific contractual clauses may be very different from one domestic law to the other and are far from being foreseeable. It should be considered that most national laws have no specific rules for this particular type of contract, which means that the courts will need to apply general rules regarding the sales contract. However, the application of the rules on the seller’s responsibility for non-conformity (or defects or “vices”) of the goods sold may give rise to surprising results if applied to an SPA, considering that the goods sold are in principle the shares (and not the Company). In some countries the courts have worked out solutions which take into account the particularities of a share purchase agreement, but such solutions are often unpredictable and may be very different from country to country. This is one of the main reasons why it is essential to solve these problems (warranties and consequences of their breach) at a contractual level. Of course the contractual solution of these problems will be effective only to the extent it is in accordance with mandatory rules of the applicable law (see paragraph 9 of the Introduction). However, it is much better to have workable contractual rules (and then to check if such rules conform to the applicable law) than to leave these problems to the domestic law.
5 This is only relevant where there is a split signing and completion.
6 In any case (even if no choice of a national law has been made) according to Article 15.2 the arbitrators may consider domestic mandatory rules which would be applicable independently from the applicable law (the “lois de police”).
7 The text of the Unidroit Principles can be found in Appendix (page 57).
8 This solution takes into account that a limited number of provisions of the Unidroit Principles may not actually reflect the expectations of international trade. This may be the case with respect to certain rules which protect the disadvantaged party to an extent which goes beyond the standards which are usual in the business to business relations: see for instance, Article 3.10 on gross disparity (particularly as concerns the end of the sentence in para 1(a), where reference is made to “the improvidence, ignorance, inexperience or lack of bargaining skill” of a party in order to justify contract avoidance) and the rules on hardship contained in Articles 6.2.1-6.2.3 (particularly with regard to the rule authorising courts to modify the contract terms). In such cases general principles of law and trade usages will prevail over the Unidroit Principles in case of conflict. Of course, parties may also expressly exclude the application of specific provisions of the Unidtroit Principles they consider inappropriate.