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Risks in Doing M&A in Russia
Anatoly Andriash Head of Moscow, Partner
Norton Rose (Central Europe) LLP 17 April 2013 NES/CEFIR Public Seminar
Risks in Doing M&A in Russia 2
Motivation in M&A transactions
Buyer’s Motivation
- Acquisition of relevant asset (real estate, mining licenses, cash flows, etc.)
- Access to skilled personnel, resources and goodwill of the target
- Technology and intellectual property (including software, trademarks, patents, etc.)
- Expansion of market share – client base
- Reduced number of competitors
- Economy of scale
- Trends in particular sector
- Speculative trading
- Synergy – reduced organizational costs and enhanced benefits from investments
- Diversification
- Management ambitions
Seller’s Motivation
– The selling price exceeds the estimated value of the business
– Uncertainty that positive trend will prevail
– Difficulties with management
– Pressure from monopolists (infrastructure, buyers, sellers)
– Difficulties with liquidity (e.g. forecasted financial stress)
– Structuring of “withdrawal”: e.g. private placement, IPO
– Sale of non-core assets
– Pressure from creditors
– Personal reasons
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Share or asset deal
Pros of a share deal
Simple and fairly rapid
No profits tax, under specific conditions
No VAT charged to Purchaser
No Russian taxes for Target Company
Cons of a share deal
Transfer of legal and tax risks to Buyer: need for detailed due diligence
No step-up in basis of assets for amortization
Pros of an asset deal
No transfer of tax and legal liabilities of Seller to Buyer, save for limited exceptions
Step-up in basis for assets depreciation purposes
Less favorable for the Seller
Cons of an asset deal
Licenses are non-transferable
20% profits tax on capital
No “goodwill” concept for tax purposes
18% VAT on transfer (cash flow issue)
Risk of sale of enterprise as a property asset (lengthy and cumbersome procedure)
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Factors that Impact the Structure of a M&A
Transaction
• If the Seller is a company with no material assets, the Purchaser would
normally request security in respect of the Seller’s liabilities disclosed as
its representations and warranties
• Acquisition of less than 100% of a company’s shares (in this case it is
recommended to have a Shareholders Agreement
• Need for the Purchaser to raise financing for the acquisition of a
company’s shares
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Typical stages in a buy side M&A process
Illustrative timeline
Weeks 1-2
Phase 1
Initial
contact by
Seller
• Review information memorandum (auction)
• Sign confidentiality agreement/ exclusivity agreement
Weeks 3-4
Phase 2
Indicative
bids
• Communicate indication of interest to Seller
• Prepare for due diligence
• Assess financing alternatives
Weeks 5-9
Phase 3
Buyer due
diligence
• Assemble due diligence team
• Review data room
• Site visit
• Preliminary enquiries
• Attend management presentation
• Verify valuation assumptions
• Review SPA
Weeks 10
Phase 4
Binding bids
• Submit bid letter/ determine final bid terms
• Submit marked-up SPA
• Seller assesses bids
• Obtain preliminary Board approvals
Weeks 11-14
Phase 5
Negotiate
contracts
• Sign exclusivity agreement (if not signed previously)
• Negotiate and sign SPA and other transaction documents
• Secure financing
• Obtain final Board approval
Weeks 15-18
Phase 6
Closing
• Satisfy conditions precedent
• Close transaction
• Post-closing price adjustments filings and other matters
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Auction sales vs direct sales
• Auction sales often involve a more formal process
– Established auction process (non-binding for seller)
– Preparation of information memorandum (selling document setting out the business and asset description, financial position and estimates of the target)
– Vendor’s due diligence may be prepared by the seller and shared with the potential buyers
– Buyers several bidding rounds
– Seller drafts SPA and circulates to bidders for comments
• Direct sales – more flexibility
– Buyer and seller are in close contact
– Buyer is less restricted in time for conducting legal and other due diligence
– convention dictates that the buyer prepares the first draft of the SPA according to its requirements
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Confidentiality agreement/NDA
• An early transaction step
• Usually drafted by Seller
• Buyer obliged to keep all “confidential information” strictly confidential and not disclose
• Negotiation points
– Exclusions from the “confidential information”
– Permitted disclosure
– Validity period (on average 6 months to 5 years)
– Obligations after expiration of the validity period
• Top tip: little to be gained from negotiating too hard
– can spend a lot of time and expense negotiating technical points which are low risk for you (some lawyers love to do this)
– can start you off on the wrong foot in a competitive process
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Exclusivity
• Prevents seller from talking/engaging with other parties for a specified
period
• Obligations may be incorporated in NDA or heads of terms
• Negotiation points
– Seller to compensate Buyer for time and expense of due diligence etc in
case Seller breaches exclusivity or withdraws from negotiations
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Buyer’s Due Diligence
Why conduct due diligence?
• To understand the asset to be purchased (buy / not buy)
– Financial, tax and strategic performance
– Legal matters
– Specialised matters (environmental, technical, etc)
• Identify issues
– Can problems be rectified before or after acquisition?
– Deal with the issues by amending terms of the deal, etc:
– Reduce price / hold back / walk away right
– Add indemnities
– Fine-tune seller’s warranties
When conduct due diligence?
• After NDA is signed but before the final version of the SPA is agreed
• After SPA is signed – as needed
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Buyer’s Due Diligence
Legal matters (typical)
Corporate matters Due incorporation and registration, group structure, corporate governance, shareholders agreements
Title to the shares History of acquisitions, regulatory approvals, current status, encumbrances
Title to the assets History of acquisitions/creation, current status, registrations and encumbrances
Material contracts Validity and enforceability, liability, term and termination, restrictions on activity
Financing Amounts, maturity, liability, security, creditors’ rights, change of control
Licences and regulatory Existence, validity periods, scope, history of obtaining (if relevant)
Disputes Pending and threatened litigation, arbitration and out-of-court disputes, amounts, status, possibility to challenge
Labour and employment Standard terms of employment, terms of employments of key personnel, labour unions, labour disputes
Intellectual property Own IP, licences to IP (granted and received), lack of rights to the IP in use
Insurance Insurance coverage, insurance claims
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Buyer’s Due Diligence
Typical mistakes and problems
• Poorly organised documents and information
• Lack of necessary documents
• No single point of contact/responsible person
• Poorly organised Q&A process and delivery of additional documents
• Lack of qualified specialists
• Too generic (rather than tailor-made) request list
• Extremely wide scope
• Seller’s unfriendly approach
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Benefits of using English law
• Flexible and convenient deal structure
– Possibility to reflect commercial agreements exactly as agreed
– Conditions precedent and conditions subsequent may depend on the parties
– Price adjustment may be linked to the target’s performance
– Availability of escrow arrangements
– Commonly accepted and well developed structure of transaction documents
• Additional buyer’s protection
– Availability of the seller’s warranties covering the target
– Availability of indemnities
• Predictability of court practice
• Recognition and enforcement of foreign arbitral awards in Russia
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Points to note when English law is to be chosen
• “Foreign element” is required
– E.g., a foreign counterparty
• Specific performance in Russia is not guaranteed
– Preferably to structure the deal as sale of shares in a foreign company
• Controversial practice of Russian courts on arbitrability of corporate
disputes
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Structure of the SPA under English law
Common clauses
Clauses in bold are the key operative clauses. Others are “boilerplate” and less heavily negotiated.
1. Parties 9. Confidentiality
2. Definitions and interpretation 10. Waivers/severance/set-off
3. [Conditions precedent] 11. Notices
4. [Pre-completion undertakings] 12. Assignment
5. Completion 13. Counterparts
6. Warranties and indemnities 14. Amendments
7. Claims limitations 15. Governing law and jurisdiction
8. [Non-compete]
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Conditions precedent
• Typical conditions
– Regulatory consents and approvals
– Corporate approvals
– Financier consents
– Rectification of issues identified through due diligence
– Pre-sale restructuring
– Waivers of the right of first refusal / pre-emptive rights
• Additional risks for the parties
– Circumstances change but the parties are bound to complete
– Ability of a party to withdraw (e.g. no corporate approval is granted)
• Ways to minimise the risks
– Long-stop date
– Pre-completion undertakings
– Repeated warranties
– Buyer’s right to withdraw in case of “material adverse circumstances”
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Pre-completion undertakings
• Seller undertakings to the buyer to restrict the target’s activity in
the period between exchange and completion
• Typical pre-completion undertakings:
– No activity outside the normal course of business
– No major transactions, no disposal of assets
– No transactions with shares
– No dividends
– No termination or amendment of material contracts
– No shareholders’ meetings
– Buyer to have unrestricted access to the target’s documentation
– etc. as the circumstances may dictate
…unless approved by the Buyer in advance in writing.
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MAC clauses
• Allows Buyer to walk away if there is a material adverse change
(MAC) in the business between exchange and completion:
– company/business MAC
– general MAC
• Negotiation points
– how to measure/what is “material”?
– distribution of risks in case MAC is not under control of either party
• Rights under MAC clauses are rarely exercised in practice
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Price adjustment (1)
• Completion accounts
• “Locked box”
• Earn-outs
• Anti-embarrassment
• Retentions and escrow accounts
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Price adjustment (2)
Completion Accounts Locked Box
● Price calculation is based on assumption
that the target has:
- agreed net assets on cash free debt
free basis; and
- agreed working capital
● Upon completion the actual net assets and
working capital are ascertained and
completion accounts are prepared
● Price is adjusted in accordance with the
completion accounts
● Completion accounts are prepared by an
independent accountant, sometimes the
buyer, rarely the seller
● Completion accounts rules and
procedures are set out in SPA – involve
accountants early
● Purchase price fixed by reference to
accounts at agreed date in advance of
signing
● Seller prevented from extracting value
(“Leakage”) from target from the date of
the “Locked Box” accounts to completion
● No price adjustment, but the seller
undertakes to indemnify the buyer if there
was a Leakage
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Price adjustment (3)
Earn-out Anti-embarassment
● The parties may not agree the price
● Purchase price is split in two parts: – one part equals to the agreed
(conservative) valuation
– second part is calculated by reference to
future performance
● Second part is payable only if specified
targets are satisfied within specified
periods after completion
● Performance is ascertained by review of
the accounts under agreed procedures
● Performance may be ascertained by an
independent accountant
● Purchase price is increased if the buyer
on-sells the assets at a higher price (i.e.
the seller is protected against being
“embarrassed” by selling cheap)
● Used in case of emergency sales (e.g.
pre-bankruptcy) or where the seller is a
public or state owned company
● Rarely used in Russia
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Pros and cons of Completion Accounts
Pros for the buyer
Ability to true-up. Only pays for what it gets: price will be adjusted if business has deteriorated before completion
Reduces the risks of unidentified issues
Ability to check completion accounts when in full control of business
Cons for the buyer
Extra costs and potential for dispute
Seller can manipulate accounts
Takes economic risk of the business right up to completion
Price may turn to be higher
Pros for the seller
Speed of execution as Buyer may need less comfort on balance sheet before completion. May speed up negotiations
Economic benefit in the business. Gets credit for running the business and receives profits right up until completion
Cons for the seller
Extra costs and potential for dispute
Less control over the completion accounts/adjustment process
Takes economic risk of the business right up to completion
Price may turn to be lower
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Pros and cons of Locked Box
Pros for the buyer
Predictability – price is not adjusted (especially relevant when acquisition is financed)
Cost – no completion mechanism so cost savings
Simplicity – no management time spent debating completion accounts post completion
Cons for the buyer
No completion mechanism to exploit – need to rely on warranties and DD
Risk of business deteriorating between locked box date and completion
Need to debate debt and working capital earlier, with less detailed knowledge
Need a well defined transaction perimeter
Pros for the seller
Gives certainty of price resulting in ability to distribute proceeds quickly
Increases control over process
Hard-wires consistency with previous accounting policies – there is no debate over completion accounts policies pre completion
Simplicity and cost – no management time spent debating completion accounts
Cons for the seller
Price is based on the last accounts and may differ from the current value
Economic benefits are transferred from the accounts date rather than completion date
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Pros and cons of Earn-out
Pros for the buyer
Values target more accurately and protection against overpaying
Defers payment of part of purchase price
Where sellers continue to be involved in business, ties them into business and incentivizes them to maximise profit
Can be used to offset claims under the SPA against the seller
Cons for the buyer
May restrict its control of target – restrictions on Buyer’s ability to make significant changes to Target’s business
Can be detrimental to target in the long term (if seller is managing Target in earn-out period and manipulates business solely to achieve earn-out targets)
Pros for the seller
Possibility of getting higher purchase price than would otherwise have received
Opportunity to benefit from synergies achieved by the Target being integrated with the Buyer’s business
Cons for the seller
Prevents clean break
Potential impact of unforeseen external “shocks”
Makes seller vulnerable to buyer’s actions
Might be used by buyer to offset claims it has under the SPA
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Use of escrow accounts
Purpose
• Reduce risks if the transfer of shares and payment of purchase price are not simultaneous
• Security for the performance of obligations
– by the buyer to pay deferred part of the purchase price
– by the seller to satisfy buyer’s warranty claims
Use in Russia
• Analogous Russian law concepts do not allow to utilise the full potential of the escrow accounts
• In practice, parties open escrow account with a foreign bank (or foreign escrow agent) and settle payments through that account
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Buyer and seller’s protections
• Buyer’s protections
– Warranties
– Representations
– Indemnities
• Seller’s protections
– Limitation of liability
– Disclosure
Risks in Doing M&A in Russia 26
Warranties (1)
• Purpose
– Disclosure by the Seller of outstanding tax and other liabilities,
defects, disputes and other tax and legal risks
– Make the Seller financially liable before the Buyer for breach of
warranties
• Structure
– General warranties
– Tax warranties
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Warranties (2)
• Practical issues
– A tax warranty from a Russian seller is usually only a confirmation
that tax returns have been made in a true and accurate manner
and that tax has been fully paid under these tax returns, rather
than a declaration accepting full responsibility for tax relating to
the pre-completion period
– Tax for the pre-completion period may arise as a result of a post-
completion event i.e. as a result of allocation of revenue under a
multi-period contract
– Tax assessment can be initiated directly by the tax office rather
than by the taxpayer through a tax return, in which case there will
be no technical breach of warranty
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Questionable Legal Force of Warranties and
Indemnities under Russian Law
• Many Russian sellers are not familiar with the practice of
representation, warranties and indemnities
• Substantial effort required to educate and convince them
• Many Russian sellers are unfamiliar with such concepts which may take
them by surprise at the negotiation stage
• As a result, the SPA discussions will usually take longer than planned
and the position of the buyers on these clauses will be weaker than
initially expected
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Indemnities
Purpose
To oblige the Seller to indemnify the Buyer, by reimbursing for
a) Tax and other liabilities related to the periods and instances
covered by the SPA prior to the Completion Date (with limited
exceptions), and
b) Associated expenses, including legal fees incurred by the Target
to settle all tax disputes and rectify revealed deficiencies in
connection with additional tax assessments and inspections by
governmental agencies
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The Changing Face of M&As
• Rationale
– Rationalization of business
– Improvement of liquidities
• Trends
– Disposal of non-core assets & “fast cash” considerations
– Rapidity is key to successful distressed M&A deals
– More non-cash & “hybrid” transactions
– New approach to KPIs (Key Performance Indicators)
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Financing of a M&A Deal
• Lack of financing for small and medium companies
• Swaps are an alternative to cash in a M&A deal
• Russian M&A market demonstrated increasing interest in non-cash
acquisitions
• Conversion of debt into equity is permitted under Russian law
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Holdback Amount
The purchase price can be paid / retained in installments (“hold-back”)
– Holdback is normally equal to a percentage of the price
– The price percentage could be paid before the limitation period
expires (i.e. 3 years in Russia)
– In practice, such arrangements are rare and commercially
inconvenient for the Seller
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Contact Details
Anatoly Andriash
Head of Moscow, Partner
Norton Rose (Central Europe) LLP
White Square Office Center
Ulitsa Butyrsky Val.10, Bldg.A Moscow 125047
Russian Federation
Tel +7 499 924 5101
Fax +7 499 924 5102
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Disclaimer
The purpose of this presentation is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Norton Rose (Central Europe) LLP on the points of law discussed. No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any constituent part of Norton Rose Group (whether or not such individual is described as a “partner”) accepts or assumes responsibility, or has any liability, to any person in respect of this presentation. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of, as the case may be, Norton Rose LLP or Norton Rose Australia or Norton Rose Canada LLP or Norton Rose South Africa (incorporated as Deneys Reitz Inc) or of one of their respective affiliates.