Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions.
Deferred consideration and earn-outs are commonplace in today’s M&A market, helping bridge valuation gaps and smooth cash demands on buyers (see also our previous articles in April 2017 and June 2018). But when the day comes to make the deferred or earn-out payment, no buyer wants to pay further purchase price if a warranty or indemnity claim is pending against the sellers.
Set-off rights provide the answer, but are not as simple as many may think. In this article we flag five factors to consider when adding a set-off clause into your sale and purchase agreement.
Those in the know will point out that English law already provides set-off rights, and ask why extra drafting is required.
The two most relevant categories of set-off rights, legal set-off and equitable set-off, operate (each in slightly different circumstances) to allow a party to withhold a payment due to the other to the extent that the intended recipient owes a debt to the payor. That may seem adequate, but note the words “due” and “debt”. Both categories of set-off rights are only available if the two parties owe each other an outstanding (i.e. proven or agreed) debt; in the case of a warranty or indemnity claim, the amount claimed will not usually become a debt due until a court has found in the claimant’s favour or the parties have agreed a settlement.
By contrast, a buyer will want to be able to withhold further purchase price payments while a warranty or indemnity claim is ongoing, i.e. before a final court judgment/settlement has been obtained.
Having concluded that a bespoke set-off right is required in your sale and purchase agreement, what events should give rise to a right to withhold payment?
From a seller’s perspective, the later a withholding right accrues, the better. The common law position (i.e. no right to withhold purchase price until the warranty claim is settled or determined by a court) would be ideal, but would beg the question why bespoke wording in the SPA is required at all.
From a buyer’s perspective, an ability to set-off deferred/contingent purchase price against a warranty claim amount would ideally trigger as soon as the buyer suspects a breach of warranty. However a mere ‘suspicion’ could be seen as too subjective by the seller, granting the buyer significant leverage to push for a settlement of the warranty claim whether it is meritorious or not.
A typical compromise position is to allow the buyer only to withhold an amount equal to its good faith/reasonable estimate of the loss suffered as a result of the breach. The question that follows is who ultimately determines what amount constitutes a good faith/reasonable estimate?
The Buyer (as the owner and controller of the target business) may consider itself the best placed expert to assess the impact of a breach of warranty, but a seller is unlikely to agree.
The selection criteria for the expert, and the process to appoint them, will be a matter for agreement between the parties. It is open to the parties to decide what sort of expert is most appropriate to judge the amount (if any) to set-off against a potential warranty claim.
It may appear logical to involve an accountant for a breach of accounts warranty, a tax adviser for breach of tax warranties, or an actuary for breach of pensions warranties. However the typical choice is a senior barrister, being well placed to assess how a court may view the quantum of the potential claim. The barrister may either be chosen by the parties or, if they can’t agree, appointed on application to the Law Society.
This is no easy assessment to make, in particular if the claim is at an early stage and the full impact of the alleged breach, and the quantum of likely legal costs, is unknown. But if the parties agree the barrister could, in turn, consult with other experts (accountants, tax advisers, actuaries etc) to help inform their assessment of the potential claim.
If the parties are minded to haggle on the issue, there is plenty of scope for negotiation and variation.
Examples could include placing the disputed payment amount into an escrow account pending either the barrister’s assessment or final determination of the claim, including a threshold to set-off such as the claim having a reasonable prospect of success, and allocating the barrister’s costs to one side or other if the decision to set-off or resist set-off lacked merit.
Finally, if a bespoke set-off has been agreed, watch out for ‘standard’ exclusions in either the SPA or any ancillary agreements that may be relevant to the rights or liabilities being set off.
It is common for contracts to contain a clause (often hidden in the general or ‘boilerplate’ clauses at the end) that excludes a party’s right to apply any withholding or set-off right to payments. The effect of this is to prevent a party making use of common law or equitable set-off rights, but it could also frustrate contractual set-off if it clearly conflicts with the intended operation of a carefully negotiated set-off clause.
Is this brief too brief? Do you need any help with your next acquisition or sale? Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
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