Lockton | Conscious coupling: mergers & acquisitions

Mergers and acquisitions (M&A) is the term used to describe a corporate transaction whereby one company purchases a portion or all of another company's shares or assets (acquisition) or two companies join to form one entity (merger). This article considers the key risks that legal advisers may encounter in advising on such transactions.

M&A activity is often complex, high-value and can involve multiple jurisdictions. Risk is inevitable in M&A transactions. Therefore, at the centre of any deal there will be a solicitor tasked with managing transaction risk.

Prior to the current economic malaise, the volume of M&A deals in Scotland was on the rise and will surely recover again as interest rates and the economy stabilise. As more businesses consciously couple, it’s good news for corporate practitioners, but the risks associated with these transactions cannot be overlooked.

When deciding whether to accept an M&A instruction, it is important to consider the nature of the business of the target company and the sector in which it operates. Every business and transaction is different and advising on a corporate sale or acquisition will rarely be a self-contained exercise. You will often require expertise in areas such as pensions and tax. To ensure that a firm does not expose itself to unnecessary risk you will need to ensure the firm has the requisite expertise and sector knowledge to effectively advise a client on such a transaction. Where gaps in expertise are identified, this should be raised with the client. Specialists may be brought in to bridge those gaps or the work could be carved out of your scope.

All too often, allocation and management of transaction risk is only considered by advisers after the fundamental terms of the deal have been agreed.

A key way to minimise the risk of claims is to enter into an engagement letter with the client, clearly documenting the relationship, including your agreed scope of work, the transaction timetable, your estimated fees (or fees calculation), and who will manage the transaction for the client. This letter should set out assumptions and exclusions relevant to the transaction. Assumptions are points that the client can confirm are correct or incorrect, for example that any property is held in the name of the target company. Exclusions are carved out of your scope of work, such as not advising on tax matters or any law other than Scots law.

Due diligence and disclosure are key features of any M&A transaction.

Due diligence is the process by which a buyer investigates a target company to ensure the buyer is clear what it is buying, and to inform the negotiation and content of the key transaction documents. There are four main types of due diligence: commercial, legal, financial and management (although further specialist due diligence may be required depending on the sector the target operates in).

When carrying out legal due diligence reporting for a client, it is essential to agree the scope of your investigations to limit ambiguity and possible claims. It is advisable to set risk and materiality thresholds and to identify any out-of-scope areas in your report. Practitioners should ensure there is a cap on the firm’s liability and that the report is addressed to the firm’s client only and is not to be shared or relied upon by third parties without consent.

You will need to ensure that all the key risks identified in the legal and other due diligence reports are dealt with appropriately in the transaction documents.

Disclosure is a key protection for a seller in an M&A transaction. The seller discloses to the buyer those matters which, if not disclosed, would potentially make the warranties in the sale and purchase agreement untrue. This gives the buyer full knowledge of the situation before completion and protects the seller from breach of warranty claims. Advisers need to understand what should be disclosed to a buyer and how to frame specific disclosures. If the test of ‘fair disclosure’ is not met, then the disclosures may not protect the seller. Good M&A advisers have a feel for what is and is not ‘fair disclosure’, and are able to guide a seller in making fair disclosures that will give the seller protection from claims.

One of the biggest frustrations in M&A transactions is a failure by certain participants to understand the market position on a particular matter. This generates unnecessary debate and negotiation, and drives up costs. Knowing what is (and is not) market requires regular exposure to the relevant discipline. For example, an M&A adviser will need to know what is market standard in terms of warranty coverage to be given by a seller in a transaction in a particular sector; how long a seller should be at risk under those warranties, how much of the purchase price should be at risk (which is sometimes dependent on the sector), and what limitations to a seller's liability should be accepted.

Understanding what position to take, and whether the counterpart is being reasonable or unreasonable, is crucial for an M&A adviser. Market developments can quickly change the landscape such that failure to keep up with these changes creates a risk of claims. As an example, warranty and indemnity insurance protection for deal participants has become commonplace. The market is a mature one and is a real and valuable option for sellers and buyers looking to manage the risk of claims having to be made under the warranties and tax covenant in the transaction documents. Failing to understand this and advise the client appropriately may well expose a firm to a claim of having provided inadequate advice.

There can be huge pressure from clients to complete an M&A transaction quickly, with changes to the deal often made last-minute, which can expose a firm to stress. This can increase the risk of mistakes being made and expose practitioners to potential claims.

It is therefore important to keep records showing where instructions are received late, or changed at the last minute or that a client has chosen not to follow advice on a particular issue. Practitioners should also recognise that reviewing and reporting on (often significant numbers of) complex documents requires a certain level of resource available on demand. The timescales of an M&A transaction won’t be stretched to accommodate legal advisers, and so a firm needs to be certain it has the necessary internal resource to advise on the transaction at the outset.

M&A transactions are fertile ground for claims where clients feel they have been improperly advised. Whether that is a failure to limit the scope of the engagement, missing key issues in diligence or making a mistake under pressure, the sound of champagne corks popping can be replaced with the sound of writs dropping onto doormats if practitioners stray out of their area of expertise. The key is for solicitors to ensure they have the team and the expertise to provide the required advice before accepting an instruction.

Written by Lindsay Ogunyemi and Iain Franklin from the Professional Indemnity Team and Gary Macdonald and Siobhan McKenna from the Corporate Team at DWF.