Buyer Beware: Indemnity Risks May Rise Further

Buyers of public companies, for a variety of reasons, have generally borne more risk with respect to contingent pre-closing liabilities than buyers of privately-held companies.

But of late, private equity funds have expanded their investment portfolios to include public companies, and hedge funds have expanded their investment portfolios to include private companies. As a result, the shareholders of public and private companies are looking increasingly alike. Will this identity shift impact the sharing of risk between buyers and sellers typically associated with the purchase and sale of portfolio investments by these funds? In other words, will sellers of privately-held companies start pressing to have the same kind of lax pre-closing liabilities as sellers of public companies?

The standard model for negotiating the purchase and sale of an asset is based upon an ingrained tradition that has been passed down from generation to generation. The model is used simultaneously in the open-air marketplaces of the third world and the corporate boardrooms of the most industrialized nations of the world. A buyer expresses interest. The seller proposes a somewhat above-market price. The buyer, in turn, proposes a somewhat below-market price, and eventually the parties meet somewhere in between the “bid” and “ask”.

As transactions have become more complex, this traditional give and take has been applied to deal terms other than merely the purchase price. For example, in an auction for the sale of a company where the seller drafts the model sale agreement as part of the bid package, the sale agreement is generally drafted with very few warranties, an extremely limited survival period, and little or no indemnities for breach of the warranties or other key matters such as taxes, in each case, with the thought in mind that the seller wants to limit the exposure it might have if the buyer were to make claims pursuant to the indemnification provision.

On the other hand, when a buyer is offered the opportunity to draft the initial version of an acquisition agreement (for instance, in a “non-auction” context), the agreement is generally drafted with broad indemnities, a survival period of several years, and numerous post-closing covenants and indemnities. Of course, these initial draft agreements do not reflect the seller’s or buyer’s actual expectation of the final terms of the agreement, but like the negotiation in the open-air marketplace, the give and take must begin somewhere. The actual terms that are settled upon by the parties will depend on numerous factors including the relative negotiating leverage of the parties and the scope of the potential liabilities.

At a minimum, most buyers expect warranties and indemnities with respect to certain basic items like title, organization, capitalization, environmental liability, employee benefits and taxes, in each case with reasonable survival periods. Whether the seller gets its way and limits the potential post-closing downward adjustments to the purchase price, or the buyer gets its way and preserves its ability to make claims and decreases the “net” or “actual” purchase price post-closing, the negotiations with respect to such terms can have a direct and often significant effect on where the ultimate purchase price ends up, and, accordingly, can also have or impact on the related investment returns.

One important exception that has developed in practice to the compromise generally reached in acquisitions, is the purchase and sale of a public company. In the public company context, the selling shareholders generally provide substantial warranties but only provide limited survival periods and indemnities predominantly through partial escrow arrangements. Frequently, there is no survival period and such warranties serve as mere “closing conditions.” Thus, buyers of public companies actually expect sellers to provide only limited protection for liabilities that are described pre-closing, and, accordingly, fully expect that liabilities that are discovered post-closing will become their “risk”.

Migration To Private Markets

More recently, many private equity funds have taken a similar position when they have sold privately-held portfolio companies. These funds have argued that they should be treated as public shareholders and provide only the limited protections expected upon the sale of a public company. From a pragmatic standpoint, they do not want to be in a position to distribute sale proceeds to their limited partners only to have to “call” for a portion to be returned should a successful indemnification claim be made against them by a buyer. While this approach may be viewed by some as posturing, private equity funds have increasingly met with success taking this position and such a stance is viewed by many as “market” in today’s very active M&A environment.

This increasingly common stance raises interesting questions for the future. How should the public company exception be properly applied? Moreover, as hedge funds enter the private equity market in increasing numbers and take substantial interests in private companies, the line between private equity and hedge funds becomes increasingly blurred. Is the sale of a portfolio company by a hedge fund similar to the sale of a public company? Arguably, a hedge fund may not have the same exact distribution concerns that a private equity “commitment” fund has (hedge funds continue to manage liquid assets under management and could arguably distribute any payments due under an indemnification without “calling” funds from its LPs). However, hedge funds may rely on other creative arguments. One argument that a hedge fund might make is that it is most similar to a “public company” in that it has many LPs, each of which traditionally owns a very small interest in the fund.

The answer to these questions may lie in the reasons for the special treatment traditionally afforded with respect to the sale of the public company. Many reasons have been suggested for the so-called “public company exception”–the justification for providing scant legal protection to buyers of public companies.

* One possible reason is that most material information with respect to public companies must be disclosed under relevant securities laws, such as the Securities Exchange Act of 1934, as amended. Thus, the securities laws already support the standard representations and, arguably, obviate the need for indemnities. If this is the reason for the public company exception, then the exception is arguably inapplicable to private companies regardless of the identity of the seller.

* A second possible reason is that public companies are typically held by numerous, anonymous shareholders, and therefore a post-closing indemnity other than an escrow would be impractical. If this is the reason for the “public company exception,” then it can be argued that the exception should not apply to a portfolio company held by a typical private equity fund or hedge fund. Most private equity funds and hedge funds hold more than one investment and after the sale of a portfolio company will remain as an entity that can support an indemnity. Moreover, hedge funds typically provide for limited distributions and generally recycle investment proceeds and, therefore, retain assets that can support an indemnity. In addition, most private equity funds have a limited number of investors. Thus, even a prorated indemnity obligation imposed on private equity fund investors would not be, altogether, impractical. In fact, many private equity funds have LP clawbacks that impose a similar liability for other types of indemnity claims.

* A third possible reason for the “public company exception” is that the liquidity of the public company investment makes a post-closing indemnity unfair to public company investors. In other words, it would be unfair to impose a post-closing indemnity directly upon a selling shareholder when that selling shareholder may have just recently purchased the shares. There is, arguably, no more reason for the new selling shareholder to bear the risk of pre-closing liabilities than for the buyer to bear that risk. If this is the reason for the “public company exception” then it should not apply to a portfolio company held by a typical private equity fund or hedge fund. Most private equity funds and hedge funds have held the portfolio company being sold for several years before it is sold.

* Finally, one might say that the reason for the “public company exception” is that typically a public company has primarily passive investors. In most cases where the public company exception has been applied the public companies have not had a fifty percent or greater shareholder that manages and controls the company. At best, the company may have been controlled by a management group with limited equity or a relatively large shareholder that does not hold a significant number of shares in absolute terms. The reasoning for the exception might be that the majority of the shareholders have no day-to-day input into the operations of the company and should not be responsible for the liabilities associated with those operations. If this is the reason for the “public company exception,” then whether or not it should apply to private equity and hedge funds may depend upon the nature of the funds as an entity or group of individuals. Under an entity approach, the portfolio company held by a typical private equity fund or hedge fund has been managed and operated by a single shareholder and does not seem similar to a public company. Under a group approach, the funds are managed by general partners that generally have only a limited equity investment (plus the 20-30 percent carry) and, therefore, appear quite similar to a public company for this purpose.

Whether to treat a partnership as an entity or aggregate of individual partners is a difficult question. For US federal income tax purposes, it is treated as an entity for some purposes and an aggregate of the partners for other purposes. There is clearly no “right answer” here. Based upon the foregoing analysis of the “public company exception” it would appear that there are arguments for both applying and not applying the exception to private equity funds and hedge funds. However, private equity funds have a longer history of private company investments. Hedge funds have only recently expanded into the space. This freshness may be a factor in how private company investments are negotiated. As the overall approach of hedge fund professionals is based on the public company market, they will undoubtedly push for the public company model when they sell their portfolio companies (if for no other reason than to protect their returns!).

Assuming the validity of our unsupported prognostication, there are two potential outcomes for the hedge funds: either hedge fund professionals will be successful in asserting the applicability of the “public company exception” to the sale of a private portfolio company or they will be unsuccessful. If successful, then the refusal to provide traditional representations and indemnities, whether or not reasonable, may reduce the price that interested buyers would pay for portfolio companies held by hedge funds. Fortunately, there are many insurance companies underwriting risks associated with M&A representations and indemnities. Thus, a buyer can simply pay the insurer, rather than hedge funds, for the risks that those firms refuse to bear.

Alternatively, if the hedge professionals are unsuccessful, then they will need to change their mindset and accept indemnity liability. A tweak to the hedge fund model for portfolio investments made by such funds is not unprecedented. The hedge fund model, for example, has already been modified to treat portfolio companies separately for valuation purposes. Private equity-type investments by hedge funds are generally disregarded until realization for purposes of determining carry in such funds. However, if a hedge fund agrees to indemnity provisions with respect to dispositions of portfolio companies the fund may need to take the contingent liabilities into account. The hedge fund could treat a portion of the investment as unrealized until the potential liability has expired or establish a reserve under GAAP with respect to the liability.

Clearly, those private equity and hedge funds that have entered the private equity arena have seriously thought about the economic and legal implications of entering that investment arena. However, when these investments mature the hedge funds will need to revisit the implications of exiting these private equity investments with respect to their fund model.

Regardless of the logic associated with the position ultimately taken, it often comes back to the “relative negotiating leverage” present, and that brings us full circle (back to the future?)! So the bottom-line may be that where negotiating leverage exists, private equity and hedge funds will find success, and where it doesn’t exist, they will not.

Isaac Grossman is a partner and tax specialist in the New York office of Morrison Cohen LLP; David Scherl is chairman and managing partner, representing buyout firms in their fund-raising and deal-making activities.