The time is right A guide to planning and negotiating a private M&A deal May 2015 Resources sector With commodity prices at rock bottom and share prices depressed, cashed up companies in the energy and resources sector are in a prime position to make strategic acquisitions. The downturn in the resources sector has put pressure on miners, contractors and related service providers and has already brought about the demise of a number of Australian resources companies including the Forge Group and the Allmine Group, with recent rumours that Atlas Iron may follow suit. However, the current lowpoint in the cyclical business of the mining sector is not all doom and gloom. Distressed assets present an opportunity for companies with a healthy balance sheet and access to cash to acquire significant assets at historically low prices. Part 1 Planning your transaction TERMS SHEET Following an approach by a prospective buyer or seller, the first step in any M&A transaction will often be to negotiate a term sheet or memorandum of understanding – a high level outline of the key commercial and legal terms which are to form the basis of the transaction. A term sheet will often be non-binding but certain parameters for the conduct of the transaction may be expressly agreed by the parties as being binding. These will usually include obligations of confidentiality, exclusivity and may include payment of a break fee by the seller in the event the transaction does not proceed. Although a break fee is not common in a private transaction it may be required by a buyer where they perceive the seller to be at high risk of entertaining a competing offer before the transaction becomes binding. The recent Supreme Court of Queensland case of Baldwin & Anor v Icon Energy & Anor  QSC 12 reinforced the position that an obligation to use reasonable endeavours to negotiate transaction documentation in a memorandum of understanding or heads of agreement is generally unenforceable. Parties should be mindful that although a term sheet is an important part of the process of planning a transaction, full legally binding documentation will need to be entered into in order for the agreed terms to be enforceable. Of equal importance is ensuring that the provisions set out in the terms sheet are expressed not to be legally binding if that is the intention of the parties. DUE DILIGENCE The most critical element of the early stages of a transaction is the due diligence process. While the current market offers plenty of opportunities for the acquisition of distressed assets, buyers will need to undertake in-depth due diligence to establish the value of assets and identify any material issues which may have an effect on the valuation. Undertaking a proper due diligence process enables a buyer to make a frank assessment of the value of a target by developing an understanding of the assets, liabilities and potential issues which may arise following completion. The due diligence process should ordinarily assess possible legal risks related to corporate status, title to shares or assets, financial information, contracts, licences or permits required to operate the business, intellectual property, employment, environmental issues, litigation, tax and health and safety. Due diligence also encourages the parties to flush out particular issues which may require specific warranties and indemnities to be given by the seller where a loss is reasonably anticipated to be the consequence of a particular issue uncovered during due diligence. The process may also provide an opportunity for the buyer to require that the seller ‘clean up’ particular administrative issues prior to completion. In this first part we take a look at the key issues to consider when planning a transaction. DEAL STRUCTURE One of the key preliminary issues for the parties to consider in any sale transaction is how the transaction is to be structured. The sale of an asset or business can either be undertaken by the buyer acquiring all of the shares in the company that holds the business or relevant assets, or, by direct acquisition of the specific assets or all of the assets that form the business (as relevant). Asset sale The most commonly used operating structure for a jointly owned mining project in Australia is an unincorporated joint venture, as this allows the participants to take their own share of production from the joint venture, account for their own tax and maintain a consolidated tax group. The sale of a party’s interest in an unincorporated joint venture is therefore normally undertaken by way of an asset sale with the seller’s interest in the mining tenements, mining information, associated equipment and joint venture documents all transferred to the buyer upon completion. One of the advantages of an asset sale is that all liabilities arising prior to completion will usually remain with the seller and the buyer will only be liable for future liabilities arising as a result of its ownership of the assets. An asset sale also provides a buyer with the ability to ‘cherry pick’ certain assets and may in fact be the only deal structure available if the seller holds other assets which will not form part of the sale. An asset sale is generally more onerous in a logistical sense as it requires the transfer of each individual asset to the buyer and necessitates obtaining all third party consents necessary for the transfer of associated contracts, permits and authorisations. Share sale Under a share sale the buyer acquires all of the shares in the company which owns the assets. The buyer therefore indirectly acquires all of the company’s assets and liabilities. The buyer will need to be careful to ensure that the company has good title to all of the assets which the seller represents it owns subject only to known encumbrances. The buyer also inherits all liabilities of the company under a share sale – whether or not those liabilities are actual or contingent or have been identified by the seller. A comprehensive understanding of the liabilities being indirectly assumed is therefore a fundamental part of evaluating the value of any potential target. As a result, under a share sale the seller will generally give more extensive warranties covering the liabilities of the company. All contracts entered into by the target company will remain with the target subject only to any rights which third parties may have to terminate such contracts on a change of control of the company. Buyers should be careful to ensure that any major contracts underpinning a valuation of the target company do not contain such provisions or that a waiver of these provisions by the relevant third party is made a condition precedent to the sale agreement. There may also be certain tax advantages in structuring a transaction as a share sale but these will depend on the nature of the assets of the company and the jurisdiction in which these assets reside. Seller Buyer Target company Business assets Share sale buys shares in company Asset sale buys assets of the business FIRB APPROVAL The parties to a transaction will need to consider whether the buyer is required to obtain Foreign Investment Review Board (FIRB) approval prior to completion of the transaction. A company will be considered a foreign person for the purposes of the Foreign Acquisitions and Takeovers Act 1975 (Cth) where any person not ordinarily resident in Australia or a foreign corporation has a 15% or more interest in such company. In general such foreign persons must notify and obtain prior approval from FIRB before acquiring a substantial interest (15% or more) in, or control of, an Australian business that is valued above $252 million. Foreign persons also generally need to notify FIRB if they wish to acquire a substantial interest in an offshore company whose Australian subsidiaries or gross assets are valued above $242 million. Approval is also required in relation to the acquisition of interests in land (including mining leases) and shares in companies which own Australian land. The Australian Federal Government’s scrutiny of transactions involving foreign persons has recently increased with the lowering of the threshold requiring FIRB approval for the acquisition of interests in land used wholly and exclusively for a business of carrying on primary production. The government has lowered the threshold above which FIRB approval must be obtained from $252 million to just $15 million. This change will not only affect buyers of rural land for the purposes of continuing primary production but will also affect foreign owned mining and resources companies and joint ventures acquiring land for the purposes of access or development. TAX IMPLICATIONS Tax implications have a significant impact on a transaction and should always be considered as early as possible. Unfavourable tax outcomes have the potential to make a deal uneconomic so uncovering these issues as soon as possible prior to or during the due diligence process ensures that costs are not unnecessarily incurred. The transfer of certain assets including property, plant and equipment, goodwill, receivables and trading stock may attract stamp duty depending on the location of these assets. Other than in New South Wales or South Australia, the acquisition of shares in a company does not attract marketable securities duty. However, a share sale may attract landholder duty at the same rate as for a transfer of land if the company has landholdings over a certain threshold (e.g. $2 million in Queensland) with mining tenements included in the definition of land. GST is not payable on the sale of shares if both the buyer and seller are registered for GST. GST will apply to an asset sale unless the ‘going concern’ exemption applies where the buyer acquires all things necessary to conduct the ongoing enterprise. On a share sale, capital gains tax is generally payable if the seller makes a profit or gain when selling their shares. On an asset sale, capital gains tax or income tax will be payable if the seller makes a profit or gain when selling its business assets. THE KEY TO A GOOD DEAL The key to a successful investment is careful planning and appropriate due diligence. Considering all of the issues which might affect the value of an asset or business will go a long way towards ensuring that there are no nasty surprises down the track. The government has lowered the threshold above which FIRB approval must be obtained from $252 million to just $15 million. NEGOTIATIONS Any transaction involving distressed assets or a sell down by a company desperate to shore up their balance sheet will have particular implications for the respective bargaining position of both buyer and seller. In an acquisition of a distressed asset a buyer will generally be in a position of strength in negotiations when it comes to price but the strength of covenant offered by the seller is likely to be weaker than that normally available in a seller’s market, thereby increasing the risk to the buyer in undertaking the transaction. The buyer needs to assess the ability of the seller to stand behind its post-completion obligations, including warranty claims, particularly in an asset sale where the assets being sold form most, if not all, of the assets of the seller. TRANSACTION DOCUMENTS Share purchase agreement Completion accounts Share purchase agreements commonly provide for a purchase price agreed between a buyer and a seller based on either accounts of the target at a specific point in time (either the latest audited accounts or management accounts of the target company) or a pro-forma balance sheet agreed by the parties and included in the sale agreement. A set of completion accounts as at the date of completion will then be drawn up following completion with an adjustment made reflecting movements in net assets or working capital of the target company. It is important that the parties agree on detailed accounting policies and procedures to be applied in drawing up the completion accounts so that lengthy and costly disputes are avoided. These policies and procedures should reflect the policies and procedures applied in preparing the base or pro-forma balance sheet as relevant. Locked box An alternative and increasingly common method of agreeing the purchase price payable under a sale agreement is known as the ‘locked box’ mechanism. Under this mechanism the buyer and seller agree on a fixed price for acquisition of the target company by reference to accounts dated prior to the signing of the sale agreement, commonly called the ‘effective date’ or the ‘locked box date’. Under this mechanism, the economic benefit of the target transfers to the buyer at the effective date rather than at the completion date. The buyer will need to ensure that appropriate restrictions on leakage or outflows from the target during the period from the effective date until completion are negotiated. The buyer should also undertake thorough financial due diligence on the locked box accounts and negotiate a strong set of warranties relating to the locked box accounts and the target’s operations and performance since the effective date. The locked box method generally favours the seller as it provides certainty of purchase price and shifts the risk of movements in assets, liabilities and working capital onto the buyer during the pre-completion period. It also means that the seller has control over the preparation of the locked box accounts, unlike under a sale with purchase price adjustments where the buyer generally prepares the completion accounts, putting them in a stronger position to put forward a view on the appropriate value of balance sheet items. One of the main benefits of the locked box method for both parties is that they avoid lengthy negotiations over completion account mechanisms and application of accounting policies and procedures and avoid the costs of preparing the completion accounts themselves. Whether completion accounts or a locked box method of agreeing a final purchase price under a sale agreement is utilised by the parties will depend on the individual circumstances of the transaction and the relative bargaining strength of the parties. In this part we take a look at the key issues which arise in preparing sale and purchase agreements in M&A transactions. Part 2 Negotiating your transaction TRANSACTION DOCUMENTS continued Asset sale agreement An asset sale agreement is, as a general rule, not as complex as a share sale agreement because the parties avoid having to negotiate and apply complicated completion account mechanisms. The most critical aspect of an asset sale agreement is clearly defining the assets to be acquired, and the liabilities to be assumed, by the buyer. The physical transfer of assets is also significantly more complex than a simple transfer of shares. Care must be taken therefore to ensure that approval for the transfer of all permits and authorisations necessary to carry on the business, and third party consent to the novation of all keys contracts, are conditions precedent to completion of the transaction. WARRANTIES A seller will usually offer only very limited warranties on a sale of a distressed asset. This recognises that the seller is not willing to stand by the value or the commercial viability of the assets being sold. It also reflects the fact that the seller is likely to resist putting the purchase price at risk given that the funds may be required to pay down debt or inject much needed working capital into a struggling business. The warranties required by a buyer will also depend on the nature of the assets, the structure of the transaction and the quality of information made available by the seller during the due diligence process. LIABILITY CAPS AND LIMITATION PERIODS A seller will always want to limit their liability for claims by a buyer as a result of breach of warranty or another term of the sale agreement. In the event of a distressed sale, sellers are likely to seek higher than normal de minimis thresholds and basket thresholds which must be exceeded before a buyer may make a claim against the seller for breach of warranty. This means that the monetary value for any claim and claims in aggregate must exceed a certain level before the seller becomes liable to the buyer. The overall liability of the seller also needs to be considered in the context of the financial strength of the seller. This is particularly relevant where the sale of assets or shares will leave the seller with limited capacity to fund warranty claims. In these circumstances it may be appropriate for the buyer to seek a parent company or personal guarantee from the seller. Sale agreements will also provide for a limited period of time during which a buyer may make a claim under warranties or an indemnity. Seller friendly limitation periods have begun to emerge with sellers resisting long limitation periods (e.g. 24 months), with most preferring limitation periods of between six and 12 months. Where a buyer obtains W&I insurance (addressed overleaf) then limitation periods will usually reflect a normal commercial arrangement. SECURITY FOR WARRANTY CLAIMS Retention amounts and escrow accounts remain the most commonly used form of security for warranty claims. A trend towards a higher proportion of the purchase price being retained to fund warranty claims reflects the increased risk in acquiring assets in a time of economic uncertainty. Again, the level of security required by a buyer will depend on the covenant strength of the seller and whether a parent company guarantee, bank guarantee, charge over assets or some other form of security can be negotiated by the parties. WARRANTY AND INDEMNITY (W&I) INSURANCE An alternative protection available to a buyer where a seller is either unwilling or incapable of providing commercial warranties and indemnities in a transaction is for the buyer to obtain warranty and indemnity insurance. Buyer-side warranty and indemnity insurance allows a buyer to claim losses arising from a breach of contractual warranties by the seller directly from the insurer. Sell-side W&I insurance is also available but these policies will not provide the same level of cover to the buyer as they do not cover fraud and do not allow the buyer to claim directly under the policy. W&I insurance is particularly attractive to financial sellers in controlled auction processes or more generally where a clean exit is required by a seller (including the sale of distressed assets). The premium payable to a W&I insurer will depend on the risk factors associated with the transaction but usually falls in the range of between 1% and 1.5% of the insured amount. The premium is usually applied to reduce the price paid as the buyer is effectively ‘pricing the risk’ of undertaking the transaction. The parties will need to agree on the deductible or excess above which the policy responds and the liability of the seller. In some transactions the seller’s liability can be as low as $1. However, ensuring the seller has some liability or ‘skin in the game’ will give comfort to the insurer that appropriate warranties have been negotiated and helps keep the seller honest. MAC CLAUSES Material adverse change clauses are commonly included in sale documents for major transactions. Although more commonly associated with public company deals, during times of volatile market conditions they have been increasingly utilised in private transactions. A material adverse change provision or ‘MAC’ clause gives the buyer the ability to walk away from the deal if there is a material adverse change to the target company’s business between signing and completion or following the release of the target company’s most recent financial statements. MAC clauses are usually heavily negotiated as the seller will want to narrow the scope of events which will trigger the right to terminate the sale agreement. Broadly drafted MAC clauses are also unlikely to be enforceable so the parties need to take care to agree on the specific triggers for the operation of the clause. PPSA The Personal Property and Securities Act 2009 (Cth) (PPSA) regime has become a critical aspect of all commercial transactions with the first wave of cases in relation to this relatively new legislation now hitting the courts. In the context of an acquisition, buyers should undertake searches of the PPS register in respect of all entities in a target group and all material serial numbered equipment which is being acquired, in order to establish whether any third parties have registered security interests over these assets. The buyer and seller will then need to negotiate the release of any such securities to the extent necessary to complete the transaction. A buyer should also make enquiries with the seller regarding any assets of the seller which are possessed or controlled by a third party, as the seller (or buyer, once the deal completes) may need to put registrations in place to protect its interest in those assets. Specific warranties in relation to these matters should also be sought from the seller. Where a buyer is paying any form of deposit under a sale agreement, consideration will also need to be given to how the payment is structured to enable the buyer to register a security interest over the seller in respect of the assets that are the subject of the sale. This will help ensure that the deposit is not lost in the event the seller becomes insolvent prior to completion. Depending on the individual circumstances of the transaction it may also be possible to register a security interest in respect of escrow monies to ensure these are not lost to receivers in the event of insolvency of a party. BE ONE STEP AHEAD Sale and purchase agreements can be complicated documents and negotiations can become arduous when the interests of the parties are not aligned. Having an understanding of the key aspects of a sale and purchase agreement will ensure that you come to the table a step in front of the other side. [email protected] www.mccullough.com.au BRISBANE Level 11, 66 Eagle Street Brisbane QLD 4000 GPO Box 1855, Brisbane QLD 4001 Phone +61 7 3233 8888 Fax +61 7 3229 9949 SYDNEY Level 16, 55 Hunter Street Sydney NSW 2000 GPO Box 462, Sydney NSW 2001 Phone +61 2 9270 8600 Fax +61 2 9270 8699 NEWCASTLE Level 4, 251 Wharf Road Newcastle NSW 2300 PO Box 394, Newcastle NSW 2300 Phone +61 2 4924 8900 Fax +61 2 4924 8999 Peter Williams Senior Associate T +61 7 3233 8825 E [email protected] Kristen Podagiel Partner T +61 7 3233 8757+61 M +61 402 825 042 E [email protected] This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.