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Jake Lowther
KCAB International, Seoul
jake.lowther@kcab.or.kr

 

Report on Arbitration Committee session at the 2019 IBA Annual Conference in Seoul

Thursday 26 September 2019

 

Session chair

Liz Chung Microsoft, Seoul

 

Speakers

Babajimi Ayorinde The New Practice (TNP), Lagos

Carine Dupeyron Darrois Villey Maillot Brochier, Paris

John Vanden Heuvel Pierce Wilmer Cutler Pickering Hale and Dorr, New York

Pallavi Shroff Shardul Amarchand Mangaldas & Co, New Delhi

 

Moderator Liz Chung began the session by briefly introducing the kinds of disputes that can arise from cross-border merger and acquisition (M&A) transactions. From pre- and post-closing adjustments, to claims under indemnification rights or representations and warranties (R&W), to shareholder relations and more, there are clearly a multitude of sources for potential disputes and international arbitration provides a key mechanism to resolve them.

The session was divided into four topics:

• What can go wrong during an M&A transaction?

• Which forum is preferable in an M&A dispute?

• What are the key issues in post-closing M&A disputes?

• What are the key issues in shareholder disputes?

What can go wrong during an M&A transaction?

Babajimi Ayorinde set out the various stages of an M&A transaction and what can go wrong. Generally, M&A transactions take place in three stages:

• negotiation;

• pre-closing; and

• post-closing.

Understanding those stages is crucial to identifying what can go wrong during a transaction.

Negotiation

The negotiation stage involves the signing of documents that outline the proposed terms of the deal structure. Such documents may include term sheets, memoranda of understanding and letters of intent. They are typically non-binding except for the confidentiality clause, exclusivity clause, penalty clause and the dispute resolution clause. Things that can go wrong during the negotiation stage include:

• breaches of confidentiality;

• breaches of exclusivity;

• disputes over the governing law or dispute resolution clause; and

• disputes over which clauses are binding.

Pre-closing

At the pre-closing stage of the transaction, the M&A agreements have been signed but closing has not occurred. Things that can go wrong during the pre-closing stage include:

• a party deciding to back out of the transaction using the force majeure provisions;

• a party not using its best efforts to obtain any necessary government or anti-trust approvals;

• a party challenging the validity of the M&A agreement on grounds such as the signatory lacks the necessary authority; and

• a party exercising its right to withdraw.

Post-closing

At the post-closing stage, all the conditions precedent have either been met or waived and the transaction has been ‘fully consummated’. Ayorinde confirmed that it is at this stage when most disputes arise. Things that can go wrong at the post-closing stage usually include disputes involving:

• R&W;

• earn-out clauses;

• price adjustment clauses;

• multi-step dispute resolution clauses;

• put and call options; and

• ancillary agreements, such as management services agreements, intellectual property licensing agreements and non-compete agreements.

Ayorinde described post-closing disputes in more detail.

R&W

R&W disputes can manifest in several different ways. First, they can arise when there is disagreement over the correctness of the financials at the time of signing the M&A agreement. Second, R&W disputes can arise if any liabilities emerge post-closing other than those that were disclosed at the time of closing. Third, they can arise if there are any defects in title post-closing: that is, if the target company does not own all of the assets listed in in the schedule to the M&A agreement. Lastly, R&W disputes can arise if there has been a misrepresentation as to the state of compliance with the applicable law.

Earn-out clauses

M&A targets are typically going concerns with frequent changes to their balance sheets. This means that the purchase price in an M&A agreement is often provisional. Consequently, the parties may include an earn-out clause, which refers to a pricing structure in which the seller ‘earns’ part of the purchase price, calculated according to the future performance of the target company following the acquisition over an agreed period of time. Given that it can require the buyer to pay additional sums to the seller, it is the source of numerous M&A disputes.

Price adjustment clauses

A price adjustment clause provides a post-closing mechanism for the adjustment of the purchase price. The adjustment is based on changes to key financial indicators of the target company between the date of financial settlement that formed the basis of the negotiations and the closing balance sheet. Disputes often arise as to whether or not there is a significant change that warrants price adjustments and also as to the operation of the price adjustment mechanism.

Multi-step dispute resolution clauses

Ayorinde described disputes involving multi-step dispute resolution clauses as often unintended. They can arise where an M&A agreement provides for expert determination, which requires that an expert, typically an accountant, resolve disputes involving technical questions. Sometimes they also provide that a party dissatisfied with the expert’s determination may proceed to arbitration. Disputes can therefore arise as to whether the necessary steps have been taken before proceeding to arbitration. In addition, overlap disputes can arise when it is uncertain whether the dispute should go to expert determination or straight to arbitration.

Put and call options

A call option in a contract gives the buyer the right to buy the underlying asset at a specific price on or before a certain date. By contrast, a put option gives the owner the right to sell the underlying asset at a specific price on or before a certain date.  Disputes in respect to put and call options can arise when the option is triggered.

Ancillary agreements

Ayorinde concluded his presentation by referring to the disputes that can rise out of ancillary agreements for breaches of those agreements, such as the seller being in breach of a non-compete agreement.

Which forum is preferable in an M&A dispute?

Having considered how an M&A transaction can end up in a dispute, Carine Dupeyron offered the audience some guidance on the preferable forum for M&A disputes, specifically considering arbitration, litigation and expert determination, with some perspectives from French law.

Arbitration versus litigation

Arbitration is the most common dispute resolution mechanism for international M&A transactions due to its inherent advantages, such as:

• confidentiality;

• finality;

• the expertise and experience of the arbitrators;

• neutrality; and

• its hybrid legal nature as a bridge between the common law and the civil law traditions.

In particular, party autonomy and the ability to choose the language, extent of any document production, the use of cross-examination of experts and witnesses as well as the general flexibility of the tribunal to take innovative approaches are considered beneficial. The ability to enforce an award in so many jurisdictions is also key to arbitration’s success.

Litigation is much more common in domestic M&A disputes. The publication of decisions and the availability of case law allows for more predictable outcomes. The existence of an appeal mechanism is also a comfort to some parties. Many judges also sit in specialised commercial courts and have attained significant experience. There are some exceptions to this general rule, such as in M&A disputes where there is a nexus with the US. Additionally, domestic M&A disputes in Germany almost systematically go to arbitration. There is no significant benefit in resorting to domestic courts in Germany as there are insufficient M&A court precedents.

Arbitration versus expert determination

Compared to expert determination, arbitration is generally more procedurally complex and expensive. It involves multiple players, including the arbitral institution, the arbitrators, the counsel and any experts or other witnesses. The arbitration is subject to a strict review of the conduct of the procedure and to higher standards in return for the greater procedural powers of the arbitrators. The award has res judicata effect and is enforceable under the New York Convention, which provides limited grounds for challenge under Article V.

Expert determination on the other hand offers an ‘objective’, fast and inexpensive means to resolve technical or factual disputes. The expert is a third party chosen by the parties who has limited procedural powers, but correspondingly fewer constraints. The expert decision has no res judicata effect and is not enforceable but, if the parties agree, it will be final and binding unless there is a lack of independence or impartiality, a breach of due process, a manifest error or the expert exceeded their mandate.

Challenging a binding expert decision

A party seeking to challenge an expert’s binding decision must usually meet a high standard in order to set it aside. This review will be conducted by the dispute resolution body elected by the parties. Dupeyron provided some examples of the legal standards required across a number of jurisdictions. Under Swiss law, the decision must be ‘manifestly unjust, arbitrary, defective, seriously unfair or based on an erroneous state of fact or even vitiated by defects in consent’ (Swiss Federal Tribunal 4 A_ 254 2011). Under French law, the decision must be a ‘gross error’ (Com 4 February 2004 n01-13,516) and in Germany it must be ‘obviously incorrect or inequitable’.

The standard in England & Wales is that the ‘error must be easily detected and so clear as to admit no difference of opinion’ (Veba Oil Supply GmbH v Petronade Inc 2001 EWCA Civ 1832, [33]), while in the US the decision must entail ‘fraud, bad faith or palpable mistake’ (Liberty Fabrics v Corporate Props Associates 5, 636 NYS2d 781 [1st Dept 1996]).

Comparing arbitration and expert determination clauses

Considering the recommended arbitration clause published in the IBA Guidelines for Drafting International Arbitration Clauses, Dupeyron pointed to the broad language used in arbitration clauses so as to encompass all contractual disputes and often tortious disputes. She also referred to the procedural elements of the clause, including references to the language and the number of arbitrators. In an arbitration clause, the level of detail may vary without affecting the existence of the arbitration agreement, nor the scope of the dispute.

By contrast, the key to a good expert determination clause is in the detail. A well-drafted clause will include a detailed definition of the expert’s background and of the technical matters that can be submitted for expert determination. The clause should also include a detailed definition of the mandate of the expert, or roadmap.

Articulation issues

Difficulties can arise in multi-step dispute resolution clauses. Jurisdictional and procedural issues commonly arise if the parties’ agreement provides for expert determination on certain questions and arbitration as a dispute resolution mechanism. Ms Dupeyron provided four examples of such ‘articulation issues’.

First, if the technical or factual matters in dispute fall within the scope of the expert’s authority, it may overlap and affect the scope of the arbitration and therefore delay the arbitral tribunal’s constitution and the commencement of the proceedings. Second, if the expert’s decision is not voluntarily complied with or is challenged, will the expert’s decision also bind the tribunal? What should be stated in the agreement? Third, if issues of contractual interpretation are raised during the expert determination proceedings, how can this be coordinated with the expert’s mandate when contractual interpretation belongs exclusively to the arbitral tribunal? Fourth, when the perimeter of the expert determination and the mission of the arbitral tribunal appear to overlap, which prevails and who should make a decision first?

Expert’s power under French law

Ms Dupeyron concluded her presentation with a discussion of Article 1592 of the French Civil Code which states that, absent the parties’ agreement on the selling price, it may be left to a third party to estimate the price. If the third party is unwilling or unable to make the estimate, there is no sale, unless estimation is made by another third party. She then posed the question: what happens if, to determine the price, the expert feels compelled to adopt a reading or interpretation of the contract?

According to the Court of Appeal of Paris, where ‘swiftness’ was the clear aim of the parties, as expressed by an agreement imposing very short deadlines on the expert, and provided that it was necessary to carry out the mandate, the expert was entitled to ‘appreciate,’ but not ‘interpret,’ the meaning of certain clauses, whether they involved legal or accounting principles, to determine the price of the transfer of shares (CA Paris, 17 sept. 2004, no 2003/10700).

This decision could be described as a compromise position. Yet, despite this decision, French experts remain reluctant to interpret or appreciate contractual provisions, thereby creating inextricable situations at odds with the purpose of the expert determination clause.

During the comments it was noted that there is often a need for experts, but that difficulties often arise where an arbitration agreement also refers to expert determination without clear carve-outs to delineate the expert’s jurisdiction. It was also acknowledged that parties should be wary of non-binding expert determination clauses, as there is a risk that the dispute will ultimately end up in arbitration or litigation despite already having gone through a full dispute resolution process.

What are the key issues in post-closing M&A disputes?

John Vanden Heuvel Pierce considered some contractual and non-contractual claims in the context of post-closing M&A disputes. The contractual claims related to breaches of R&W, breaches of covenants and price adjustment claims. The non-contractual claims addressed misrepresentation, fraud and negligence.

R&W

Pierce made the point that representations and warranties are often referred to as a single unit, particularly in the US, but that they are somewhat different in respect to the rights that arise from them. Other jurisdictions define a representation as a ‘fact’ and a warranty as a ‘promise’. Specifically, a representation is a statement of past or present fact, the breach of which gives rise to a claim for misrepresentation or fraud. A warranty, on the hand, is a promise that an existing or future condition is or will become true, the breach of which gives rise to a claim for breach of contract.

Pierce cited American International Group’s latest M&A Claims Intelligence Series, which reports that claims of breach of R&W are most often made in respect to financial statements, especially undisclosed liabilities (18 per cent), tax issues (18 per cent), legal compliance (15 per cent) and material contracts (13 per cent).

Of the claims of breach based on legal compliance warranties, these most commonly occurred in highly regulated sectors such as pharmaceuticals (30 per cent) and financial services (15 per cent). Of the claims of breach based on material contracts warranties, these most commonly occurred in financial services (17 per cent) and manufacturing (16 per cent).

Pierce noted that Europe stands out for having substantially more claims related to tax warranties than either North America or Asia, which he suggested might be driven by more aggressive audit regimes. However, in later questions, Ayorinde made the point that parties should consider the attitude of the seat to the arbitrability of tax disputes. Pallavi Shroff stated that it was a matter of debate and referred to an ongoing tax dispute subject to investment arbitration, Vodafone v India (PCA Case No. 2016-35).

Pierce stated that a key issue in arbitrating claims of breach of R&W is the extent to which the representation or warranty is qualified. The sellers will often push for ‘materiality’ qualifiers, such as ‘in all material respects’, and qualifiers as to their knowledge, such as ‘the sellers warrant and represent that, to the best of their knowledge…’ Such qualifiers then often become the subject of disputes as to their meaning and significance.

Indemnification

Moving on to claims for indemnification, Pierce discussed applicable limitations that can all be the subject of disputes, including:

• caps on maximum exposure (caps may not apply to certain types of claims, such as fraud);

• time limits under specific R&W; and

• minimum ‘basket’ thresholds and deductibles (a threshold amount of losses that a party must incur before it can make a claim).

Price adjustment

Price adjustment clauses provide for an adjustment of the purchase price of the target company after the signing of the share purchase agreement based on specific performance metrics, such as changes in net working capital. The rationale for using such clauses is that they ensure that the price reflects the true value of the target company at closing and protect the parties from working capital fluctuations.

In the case of short-term adjustment mechanisms, the adjustment to the purchase price between signing and closing is determined on the basis of a ‘true-up’ of financial factors such as working capital. Long-term adjustment mechanisms, on the other hand, entail the payment of additional consideration calculated on the future performance of the acquired entity, also known as ‘earn-out’. These mechanisms are frequently the subject of disputes but will more typically be resolved through expert determination than arbitration.

Misrepresentation

In common law jurisdictions, claims for misrepresentation typically arise where the defendant makes a false representation that induces the claimant to enter into the contract and suffer a loss. Damages is typically the primary remedy but claims for misrepresentation may give rise to the remedy of rescission where a misrepresentation induced a party to enter into a contract.

Fraud

According to Pierce, claims for fraud are becoming increasingly common in M&A arbitration. Fraud generally requires evidence that a party intentionally or recklessly made a false representation, express or implied, to another party, inducing that party to act in reliance on the representation and suffers a loss as a result. In many jurisdictions such as the US, England and Wales, France and Mexico, contractual caps on liability will not apply to claims of fraud as a matter of public policy.

Fraud claims are often challenging for claimants because of the burden of establishing intentional wrongdoing on the part of the defendant. Issues can also arise where the language of the contract provides for limitations on liability for extra-contractual representations. For example, the law in the US states of New York and Delaware provides that language in a contract specifically disclaiming any reliance on extrinsic representations will defeat a claim for fraud in most cases.

Negligence

Buyers occasionally claim that sellers have breached their duty of care when making representations to the buyers. In common law jurisdictions, a claim for negligence generally requires the existence of a duty of care owed by the respondent to the claimant, a breach of that duty and that the claimant has suffered a loss as a result of that breach. The defendant in a claim for negligence in M&A arbitration may challenge the existence of a duty of care. It can then be difficult for a party to establish a duty of care, given that a transaction will typically take place at arm’s length between sophisticated commercial entities.

What are the key issues in shareholder disputes?

Shroff presented the M&A disputes that can arise from exit mechanisms and post-closing issues, providing shared insights from the Indian perspective.

Put and call options

Historically such options were prohibited for listed companies in India, but there is confusion about public unlisted companies. There are no such restrictions on private companies. In 2013–2014, amendments were made to liberalise the Indian legal framework, including the Companies Act 2013 (India), the Securities and Exchange Board of India (SEBI) Regulations (India) and the Reserve Bank of India Regulations (India). As a result, put and call options are now valid as long as there is no assured price or return. However, only mandatorily and fully convertible instruments can be issued to non-residents. Debt instruments such as partially and optionally convertible instruments cannot validly be issued to non-residents.

Pre-emption rights

A pre-emption right is commonly a contractual right to acquire shares newly coming into existence before they can be offered to a third party. Pre-emption clauses create restrictions or obligations on a shareholder’s freedom to sell its shares to third parties. Pre-emption rights include:

• rights of first offer (ROFO), which obliges the owner to undergo exclusive good faith negotiations with the rights holder before negotiating with other parties;

• rights of first refusal (ROFR), which give the rights holder the option to enter a business transaction with the owner, according to specified terms, before the owner is entitled to enter into that transaction with a third party;

• ‘drag along’ rights, which give the rights holder who is buying a majority shareholding the right to force the minority shareholders to join the deal, usually on the same terms and conditions; and

• ‘tag along’ rights, which give the rights holder who is a minority shareholder the right to sell to the buyer of a majority shareholder on the same terms and conditions.

Shroff considered whether pre-emption rights impose restrictions on the free transferability of shares in publicly listed or unlisted companies. In India, the courts have recently held that such arrangements are valid. The shareholders of a public company can enter into consensual agreements in respect to their shares, as the shares of the public company can be subscribed to and there is no prohibition on the public from subscribing to shares of the public company. Shareholders can sell their shares on the terms and conditions as defined by the relevant pre-emption right, so as long as they are consistent with the law.

The rationale is that, because shares in a company are moveable property, they can be dealt with in such manner as the shareholder deems proper, including entering into any contract in the exercise of the shareholder’s property rights. Accordingly, where a shareholder voluntarily enters into an agreement giving pre-emption rights to their shares, such agreement will be valid.

Under the Companies Act 2013 (India), an agreement between two or more persons in respect to securities of a public company is enforceable. Since October 2013, SEBI has also recognised such agreements. Shroff referred to an arbitration between the government of India and a large mining company. In that arbitration, the promoters of the company claimed a pre-emption right when the government expressed a desire to sell its shareholding. A dispute then arose as to the price at which the shares would be sold by the government, and therefore the valuation of the company.

Shroff then turned to post-closing issues, focusing on purchase price adjustments, earn-outs and fraud.

Purchase price adjustments

Typically, post-closing adjustment clauses focus on the liabilities and assets of the target company that fluctuate as a result of business operations between the time the M&A agreements are signed and the closing of the transaction, which can take place months after the initial agreement on price. There are two main types: closing balance sheet adjustments and earn-outs. A closing balance sheet adjustment clause will typically compare the closing balance sheet amount to a reference balance sheet amount and adjust the price by any difference. Disputes as to the calculation of the balance sheet often arise.

Earn-outs

An earn-out compensates the seller for a near-future potential that cannot be calculated into the closing price because it depends on the performance of the business post-closing. An earn-out clause typically provides that if the target meets certain income statement targets after closing, the seller is entitled to additional payment. It captures any failure of the company to perform as represented. Disputes often arise as to the amount of the earn-out. Shroff recounted a recent matter where, prior to the date for determining the earn-out payment, the ‘erstwhile promoter’ raised issues as to the buyer’s policies and approach, which they alleged did not permit them to perform. A dispute arose, but it ultimately settled.

Fraud

Disputes alleging fraud are based on the failure of a party to disclose facts or documents that are critical to the transaction. The question is whether such claims are arbitrable. Claims of fraud, fraudulent inducement and intentional misrepresentation are certainly capable of being settled by arbitration.

Under Indian law, an arbitration agreement does not become inoperative or incapable of being performed in the event of allegations of fraud. In 2016, the Supreme Court of India developed a subjective test: an allegation of fraud simpliciter is arbitrable, however matters involving very serious allegations of fraud of a criminal nature or where complex issues which are to be decided by a civil court arise, then an arbitral tribunal may have no jurisdiction.

In the recent Daiichi Sankyo case, Daiichi acquired 100 per cent of the shares in an Indian pharmaceuticals company. Following the acquisition, Daichii discovered that the sellers had not disclosed a US Food and Drug Administration and Department of Justice investigation into the target company and the existence of certain documents. A dispute arose and the parties proceeded to arbitration administered by the ICC and seated in Singapore. A majority of the arbitral tribunal accepted Daichii’s argument that the seller had engaged in ‘willful misrepresentation’ and awarded damages against the Respondents. The Delhi High Court upheld the award.

Concluding her presentation, Shroff referred to various miscellaneous issues that can cause disputes, such as:

• the interpretation of clauses of shareholder agreements regarding super-majorities;

• veto rights and affirmative voting rights; and

• the funding of capital calls by the company in equity or debt.

In the ensuing discussions, it was noted that it can be difficult where an expert fails to make a determination of price adjustment mechanisms, as this can jeopardise the entire transaction. In light of the Daichii case, the fine line between civil and criminal fraud was also discussed. In German and Korean law, a ‘grossly unfair bargain is void’.

One question from the audience referred to material adverse change (MAC) clauses relating to a change in circumstances that significantly reduces the value of the target, and that disputes arising under MAC clauses might not be suitable for arbitration, with the example of the US travel industry following 9/11. Another comment from the floor referred to the law of Nepal and the remedy of specific performance where damages might not be adequate. Such a remedy is generally more difficult to obtain in other jurisdictions such as India.

Chung wrapped up the discussion by referring to the advantages of the common law discovery procedure in fraud cases. As it is very difficult to prove an allegation of fraud without documentary evidence, document production can be critical in such cases.

 

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