Preliminary agreements: international acquisitions
Overview of main documents entered into in early stages of an international acquisition: letter of intent, confidentiality agreement, exclusivity, break fee. Country specific information (updated periodically) for Australia, Canada, China, France, Germany, Hong Kong, India, Italy, Japan, Mexico, The Netherlands, Russian Federation, Singapore, South Korea, UK and US (New York).
The phrase "preliminary agreements" is a generic description for a number of documents that are signed in the early stages of a potential acquisition - usually before detailed due diligence and drafting starts.
Preliminary agreements include the following:
Letter of intent (also called heads of terms, memorandum of understanding, term sheet or protocols).
Lock-out agreement (also called exclusivity agreement).
Break fee (also called an inducement fee).
These agreements can be separate or incorporated into one document. They may be concluded simply by exchange of letter or with greater formality where this is required under national law (see below). Commonly, the letter of intent will contain any lock-out provisions and break fee while the confidentiality agreement will be a separate document often entered into before the letter of intent.
Letters of intent
Letters of intent are common in most jurisdictions for significant acquisitions.
There is no standard form. Content will often depend on the purpose for which they are used:
As written confirmation of the main terms agreed in principle and the negotiations to be undertaken.
To outline the timetable and obligations of the parties during the negotiations.
As a framework for certain preliminary binding clauses, for example, lock-out, confidentiality or break fee arrangements (see box Checklist: Letter of intent).
A useful statement of the key terms to help "sell" the deal to the main board of directors, prospective underwriters, lenders or non-management shareholders. If government support is required, the letter of intent may prove useful. This is a common use for the document in Russia.
The basis for a submission for clearance or guidance from the relevant competition, tax or other regulatory authorities. In the US, for example, filings under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 can be based on a letter of intent (which can be non-binding). The initial waiting period is typically 30 days (15 days for cash tender offers or certain bankruptcy-related transactions), during which the transaction cannot be consummated. The waiting period can be extended if the relevant US anti-trust regulator (the Department of Justice or the Federal Trade Commission) issues a second request for additional information.
In the EU, a transaction can be notified before the conclusion of a binding agreement, provided the parties intend in good faith to enter into an agreement. The proposed transaction must have been cleared before it is implemented (subject to very limited derogations). The European Commission has an initial period of 25 working days (Phase I, which can be extended to 35 working days) to review a transaction. In cases raising serious concerns, an in-depth investigation (Phase II) can be launched, taking up to a further 125 working days.
Although a seemingly innocuous document, a letter of intent may have important adverse consequences:
A legally binding commitment may unintentionally be created (see Legally binding?).
There is a risk that inadvertent obligations can be created as a result of the duty to negotiate in good faith recognised in certain circumstances in some jurisdictions (see Duty of good faith). Also, changing a term may constitute a breach of this duty.
Even if the letter only has moral force, a party's negotiating position may be weakened if it seeks to depart from the agreed terms.
If a US listed company (or one of its subsidiaries) enters into a letter of intent, the listed company may, under certain circumstances, be obliged to publicly disclose the agreement. Liability may also arise for third parties that trade in the market after the execution of the letter of intent without knowledge of the terms of the potential transaction.
There may be a number of adverse tax consequences (see Adverse tax consequences).
Descriptions of the proposed transaction should be drafted carefully from an anti-trust and sector regulatory point of view.
The time taken to agree letters of intent may be disproportionate to the benefit. Care needs to be taken to avoid effectively negotiating the contract twice or the letter of intent restricting the scope of subsequent negotiations (particularly if the buyer wants to take into account the results of due diligence).
A letter of intent will commonly contain some provisions that the parties intend to be legally binding (such as confidentiality, lock-out and break fee provisions) and others that are not intended to be legally binding (such as an indication of interest or price, and any further matters which the parties identify as needing to be addressed).
Great care is needed to ensure that non-binding terms do not create contractual obligations:
Unambiguous language must be used. For example, in many jurisdictions, the term "subject to contract" is not recognised.
In some continental European jurisdictions such as France and Italy, a letter of intent may be construed by the courts as a binding pre-agreement if it contains key terms such as the parties, price and conditions precedent. It is therefore essential that the language in the letter of intent is consistent throughout in expressing that the letter is not legally binding.
If the letter contains terms that are intended to be binding, these should be clearly identified and the legal requirements for creation of a valid contract under local law should be satisfied. For example, agreements relating to the sale of shares in a German GmbH must be executed before a notary. Technically this includes letters of intent if they are to create a legally binding obligation to sell the shares in a GmbH.
Duty of good faith
Most continental European jurisdictions impose a duty to negotiate in good faith. The duty extends to all phases of commercial relationships both in the pre-contractual and contractual stages. It will exist at the beginning of negotiations, so care needs to be taken in the period before signing the letter of intent. Entering into a letter of intent may help to crystallise the duty and make it easier to enforce. For example, a letter that sets out detailed terms agreed in principle would be evidence of the closeness of the relationship and of what each party is expecting from the other.
The exact scope of the duty of good faith varies from country to country. Broadly, it creates an obligation:
To inform the other party, where reasonable, of all important points that it could not discover on its own.
To apply reasonable diligence in the performance of pre-contractual and contractual obligations.
To observe moral and ethical standards of behaviour where they are not already implied by local law.
Not to break off negotiations without reasonable cause in circumstances where the other party reasonably anticipates that an agreement will be signed.
The duty may be breached if, for example:
A seller secretly negotiates with two potential buyers either or both of which think that they are the sole potential buyer.
A seller states that a non-existent party has made an offer for the company in order to stimulate interest or obtain a higher price.
Either party knows that the other does not have a critical piece of information that would alter its opinion or approach to the negotiations.
Either party introduces a significant modification to a term that was agreed in the letter of intent or withdraws without reasonable justification.
In most countries, the remedy for breach of good faith is limited to so-called 'negative interest' damages (damages that would put the other party in the position that it would have been in had the negotiations not taken place). A buyer may, for example, be able to recover damages for professional fees and the costs of due diligence.
Greater damages for lost opportunity may be available in some jurisdictions. For example, in The Netherlands the amount of damages recoverable depends on the stage reached in negotiations.
It is rarely possible to exclude liability for the duty to negotiate in good faith. So if, for example, a seller wants to reserve the right to negotiate with more than one prospective buyer, it should expressly say so in the letter of intent.
Another approach might be to specify that negotiations are subject to the laws of a jurisdiction that does not recognise the duty of good faith. But regard must be had to Article 3(3) of the Rome Convention (for contracts entered into before 17 December 2009) and to Article 3(3) of the Rome I Regulation (for contracts entered into on and after 17 December 2009) which provide that if the parties have chosen a governing law where all other elements relevant to the situation are located in a different country, a choice of foreign law shall not prejudice the application of that country's "mandatory rules". "Mandatory rules" are those rules that cannot be derogated from by contract (under the Rome Convention) or agreement (under the Rome I Regulation).
In France, for example, the courts may apply the duty of good faith even where French law is not the law applicable to the parties' relationship. The duty is felt by the French courts to be an important element of contract and tort law as a matter of public policy. The French courts may decide that there are enough elements linking the contract with France to justify the application of French legal principles, especially if one of the parties to the negotiation is French and the object of the envisaged contract (the target company) is located in France.
Adverse tax consequences
Parties must give proper thought to the tax implications of the agreed deal and of the letter of intent before signing it. There are several reasons for this:
Where substantial deviations from the terms set out in the letter are agreed for tax reasons, there is a risk that the letter of intent might provide grounds for the tax authorities to argue that the final structure is a device for tax avoidance.
In some cases, changes to the principal terms contained in the letter of intent may of themselves have such material tax consequences as to be tantamount to altering the price and the other side may view the changes in that light.
If the letter of intent is considered to reflect "arrangements" for the disposal of the target, the benefit of tax grouping rules may be lost.
The purpose of a lock-out (or exclusivity) agreement is to give a prospective buyer exclusive negotiating rights, usually for a fixed period. The lock-out may be a stand alone agreement, form part of a confidentiality agreement or be contained in a letter of intent (in which case the lock-out provisions must clearly be stated to be legally binding).
The agreement is generally worded in negative terms (for example "the seller shall not negotiate with other parties...").
A positive obligation to negotiate is not generally enforceable in certain jurisdictions, such as the UK, but may be enforceable in others. From 19 September 2011, the use of lock out agreements in UK public M&A transactions is generally prohibited under the UK Takeover Code (subject to certain limited exceptions).
A lock-out agreement should include the following terms:
The duration of the exclusivity period. This should be for a fixed period. If not, the agreement may be unenforceable.
The seller must not provide information about the target or negotiate with another prospective buyer during the lock-out period. It should also ensure that its employees and representatives do not do this.
The potential remedies for breach of a lock-out agreement are:
An injunction to prevent the seller from negotiating with another party during the lock-out period.
Damages. These are usually limited to wasted costs, rather than loss resulting from a failure to conclude a legally binding agreement (as there is no way of knowing whether the negotiations would have been successful or what would have been agreed if they continued).
In jurisdictions that recognise a duty to negotiate in good faith, signing a lock-out agreement and then, on its expiry, failing to proceed properly with negotiations could be a breach of good faith. This potentially exposes the guilty party to damages.
A break fee is a payment from the buyer or seller to the other (or possibly payable by the target itself) if the deal does not proceed to signing or completion. Common situations that trigger a break fee payment are that the relevant party does not recommend that its shareholders vote in favour of the transaction; or there is a failure to obtain shareholder or regulatory approval.
Break fees are fairly common in large US acquisitions and in recent years have become more popular in large UK transactions (although in both the US and the UK they appear more commonly in the acquisition agreement (for failure to complete) rather than the letter of intent). However, from 19 September 2011, the use of break fees in UK public M&A transactions is generally prohibited under the UK Takeover Code (subject to certain limited exceptions). They are increasingly used in The Netherlands and in German public transactions, but remain less common in most other jurisdictions. A number of legal issues need to be considered:
Directors may be in breach of their duties if the agreement is not in the company's best interests or fetters the directors' discretion.
If the target company agrees to pay a break fee, the agreement may constitute prohibited financial assistance for the acquisition of its shares in some jurisdictions (notably in Europe).
If the break fee is payable for breach of contract (such as breach of a lock-out agreement) it may not be enforceable if it is not a genuine pre-estimate of the loss that the injured party is likely to suffer.
Each of these considerations would apply, for example, in the UK.
Confidentiality agreements or letters are a routine feature of acquisitions in most jurisdictions.
Sometimes, confidentiality undertakings form part of the letter of intent. If so, the provisions must be expressed to be legally binding. More often, the confidentiality agreement is a separate document.
Ideally a confidentiality agreement should be signed before any confidential information is provided to a prospective buyer (and, in particular, to potential competitors), in effect, normally before the parties are in a position to agree a letter of intent. Where this is so, it is sensible for the letter of intent either to make clear that the confidentiality agreement will continue to apply, or to replace it with comparable binding provisions in the letter of intent. Confidentiality undertakings can apply to any exchange of information which predates their agreement.
Key provisions of a confidentiality agreement are:
A definition of confidential information. There will normally be three broad categories of protected information:
the fact that negotiations are taking place;
the existence of any agreement, its terms and conditions; and
the detailed commercial information provided to the recipient to enable it to evaluate the transaction.
The obligation may be two way. The recipient will normally seek carve outs for information already known to it or that is in the public domain.
The central obligation to keep the information secret and to use it only for the permitted purpose. This may be for a fixed period or indefinitely. Courts may not enforce a long period for public policy reasons.
The circumstances in which, and persons to whom, the recipient can disclose the information. These may include employees and advisers who are involved in the acquisition or a court or regulatory authority. The discloser may require notification, consent and/or that the recipient ensures that third parties enter into confidentiality undertakings on agreed terms.
What happens to information and records if the deal falls through (destruction or return of the information)?
Survival of confidentiality in the case of termination of negotiations.
Liability with respect to disclosure of the information.
No guarantee of the accuracy of the information.
Most confidentiality agreements also contain a clause relating to non-solicitation of customers and employees. Again, this may be subject to limits for public policy reasons.
Note that in some jurisdictions (for example, Italy), disclosure to a third party of confidential information provided by the other party may amount to a violation of the duty of good faith, even in the absence of a confidentiality agreement. Also each party has a right to confidentiality based on privacy laws as well as on know-how protection provisions.
If a confidentiality agreement is breached the main course of action will be a claim for damages for breach of confidence. Proof is difficult because of the abstract nature of the information and limited discovery process in many countries.
Robert Cleaver and Aisling Zarraga are partners, and David Welford and Nia Dadson are associates in the London office of Linklaters LLP. Thanks to other lawyers at Linklaters LLP who contributed to the note: Bruno Derieux and Alice Magnan (France), Jochen Laufersweiler (Germany), John Goodwin, Kim Latypov and Ilya Andalashvili (Russia), Yuan Cheng and John Xu (People’s Republic of China), Mas Harntha and Scott Sonnenblick (US), Peter Goes, Andrei Babiy and Bauke Faber (The Netherlands), and to Ottaviano Sanseverino and Domenico Mastrangelo of Gianni Origoni Grippo & Partners.
Checklist: letter of intent
There is no standard form letter of intent. The following is a checklist of potential issues to cover. Note that if the letter contains key terms such as parties, price and conditions precedent, it may be construed in some countries as a binding pre-agreement (see main note).
Clearly state whether the letter or specific clauses are intended to be legally binding.
Description of target (shares or assets).
Indicative price or price formula (and statement of what this is subject to (for example due diligence and/or adjustment), for example by reference to closing accounts).
Timeframe and scope of due diligence and other actions.
Conditions precedent. These may include, for example:
accuracy of warranties and indemnities at closing;
liabilities of target company not exceeding a stated amount at closing;
no change of control clauses/other termination provisions in target company contracts;
no material adverse change; and
buyer raising finance.
Standard warranties to be taken (deemed repeated at closing). This may not amount to more than a non-conclusive statement to the effect that typical warranties for a transaction of this type will be given.
Exclusivity (see main note).
Break fee (see main note).
Confidentiality (see main note).
Termination date and any obligations (such as confidentiality) that survive termination.
Costs and expenses.
Law and jurisdiction.