What the Ashley Madison hack tells us about M&A security risk

The online service Ashley Madison is reeling from a catastrophic data breach that resulted in the public exposure of its customers’ sensitive private information.  Ironically, the Ashley Madison hack was a very conspicuous and public affair. However, not all cyber security breaches are publicly broadcasted. Most hacks are done surreptitiously such that the hacked company would not know (at least not right away) that it has been attacked. Such “private” hacks can go undetected for months or even years after the initial cyber security breach, and the consequences and damages resulting from the breach are therefore very difficult to predict, both in terms of scope (e.g., the company might not know how much of its information has been compromised or what reputational effect this will have) and the quantum, in dollars, of total liability.

How are M&A lawyers supposed to deal with the nebulous phenomenon of cyber security risk in the context of a proposed acquisition of a company? Boilerplate representations in a purchase agreement regarding confidentiality, privacy and the intellectual property may not sufficiently cover and allocate the risk as between the purchaser and seller, especially where the target company is in a more information-sensitive sector (such as technology) or runs a customer-facing business. In those cases, the risk is heightened and all parties need to pay particular attention to how the purchase agreement deals with the risk and allocates it.

Here are some tips on how to manage cyber security risks during the negotiation and due-diligence stages of an M&A transaction, especially where the target is in a more information-sensitive business:

  • Dig into the representations. Buyers should carefully understand what it means for a seller to represent that the cyber security systems and protocols the target uses are within “industry standards”. The Ashley Madison hack certainly makes the case that industry standards may not be robust enough to prevent a serious attack. Buyers should therefore think twice before taking too much comfort in such representations in purchase agreements and sellers might be able to take a bit more comfort in offering them up. It would instead be more appropriate for the buyer to ask the seller to give a representation that it has not been made aware of any (material) security breaches and has no reason to think that any such breaches have occurred.
  • Re-calibrate the indemnity provisions. Indemnity provisions in the purchase agreement should bear a meaningful relationship to the magnitude of the risk that the buyer is taking on (and that the seller is trying to get rid of). The parties should think about when it would be appropriate to uncap, raise the cap or extend the time-frame of indemnity provisions that are triggered upon the breach of security of information representations. If the issue of security of information is particularly important in the context of the deal, then the representations relating to them should be “fundamental” and should be associated with the appropriate indemnity baskets. Where the risk is highest, buyers should ask for a separate indemnity (outside of that resulting from any breach of representation) and sellers should be very careful before agreeing to give this.
  • Define the exposure. In order to allocate the risk of cyber breaches, the purchase agreement needs to provide the parties with a clear way to identify when a breach has occurred so that damages can be allocated contractually as between the parties (rather than decided by a court). If the purchase agreement cannot tell the parties exactly when a hack has occurred or when the damages have arisen, the parties will be left to litigate how the agreement should be interpreted rather than just being able to enforce the indemnity contractually. The formulation depends on the type of breach that is of concern. If the parties are worried about the leaking of trade secrets integral to the business, they could agree to retain a forensic expert to identify when the trade secret was stolen, and apportion liability based on that date relative to the signing or closing of the deal (when risk generally shifts as between the parties). If the parties are worried about the theft of sensitive customer data such as stolen credit card numbers, consider whether the relevant date would be the date of the fraudulent use of the stolen information, as there would be a transaction record to evidence the date of misuse. In that case, consider allocating the risk to the seller if the fraudulent use occurs within a certain period following closing, after which period the risk would go to the buyer.
  • Do the right diligence. During the due diligence process, buyers should make a serious and thorough inquiry into the security of the target company’s data. Analyze the quality of their security systems and investigate any attempted data breaches. If the target stores its data in a cloud computing database, consider the contractual arrangements it has with its service provider.
  • Consult a tech expert. The parties involved in M&A transactions often fail to consult with cyber security and technology experts. Instead, they rely on boilerplate “industry standard” language as adequate assurances against potential data breaches. Buyers should consider engaging a technology or forensic specialist to assess the data security of a target company to gain meaningful comfort before signing the deal.

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Acquisition: the key to innovation

It has become increasingly difficult to deny that we live in an age of technological innovation – particularly  entrepreneurial innovation. Many cities across Canada contain the components of an ideal start-up environment: a diverse culture receptive to innovation, top quality educational institutions, and willing investors. According to a 2012 report by Canadian Business, Western Canada has become somewhat of a start-up “hot spot”, with 3.7% of Brutish Columbia’s working population owning a start-up, which the report defines as a business under two years of age. Unsurprisingly, then, start-ups play an important role in Canada’s economy.

But how does this role of start-ups impact M&A? The answer, is seems, is significantly. Last year, PwC published a report indicating that upwards of 63% of owners of emerging companies are actually looking to leave their companies – quickly – as opposed to seeing their businesses grow.  Indeed, M&A is a solid option for entrepreneurs because it enables them to profit from their efforts, and allows their start-up to develop more fully than it would have been able to otherwise, given the entrepreneur’s potentially limited access to resources and business experience.

Similarly, M&A is a good option for buyers of start-ups because it offers them the opportunity to profit from talented individuals with innovative ideas, who may not have sufficient capital to run their businesses on their own. Although buyers are likely to be interested in start-ups that have established products and proven revenue streams, there has nonetheless been a marked shift in the past few years towards acquisitions of start-ups comprised of increasingly smaller teams, i.e, a trend away from pure-play acqui-hires.

Many Canadian start-ups are acquired by international companies (primarily American). This brings to light another trend, in which foreign companies are acquiring Canadian start-ups. From a socio-cultural perspective, it is arguable that this trend is contributing to a less uniquely Canadian, and more global culture. From an economics perspective, this new trend hints towards a more global, fluid economy, rather than one that is limited by jurisdictional boundaries.

M&A has, and will continue to have, an important role to play in facilitating innovation. It is already enabling Canadian entrepreneurs to partake in technological innovation in the form of start-ups, and  interact to a larger degree with the global economy. It will surely be in the near future when their larger impact on the Canadian cultures, societies, and economy will be evident.

The author would like to thank Melanie Simon, summer student, for her assistance in preparing this legal update.

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Private equity investments and common governance rights in investee companies

Private equity investors (PEIs) are often a good source of capital for companies looking to start, maintain, or grow their operations and can also provide significant operational and transactional expertise. Like other investors, PEIs operate with a primary goal in mind; that is, to receive a favourable return on their investment. However, PEIs generally seek to have a greater level of involvement in an investee company than other investors.  Accordingly, PEIs commonly negotiate for certain governance rights in the company via a unanimous shareholder or limited partnership agreement in order to maintain a certain level of oversight over the investee company and protect their investment.

Although governance rights can take various forms, they commonly include: representation rights on the board of directors of the company (Board); the right to veto certain company decisions; and access to certain company information. Notably, these rights are not specific to any type of business organization (e.g., corporations, partnerships).

The optimal degree of control is largely dependent on the PEIs’ concerns and expertise relating to the investee company, the PEIs’ stake in the company (i.e., majority or minority), the strength of such company’s management and that company’s willingness to relinquish any such control.

Board representation rights

PEIs usually negotiate for the right to have at least one representative on the Board. Ancillary to this right, they also negotiate for the right to replace their representative or fill its vacancy should the initial representative cease to be a director. However, PEIs may also seek further rights such as:

  • the quorum for Board meetings require their representative’s presence; and
  • their representative serve on certain Board committees (g., audit committee, compensation committee, or reserves committee).

These rights help ensure that the PEIs have an effective voice in the direction and operation of the company and, therefore, their investment.

Special approval of certain company decisions

In addition to Board representation, PEIs may also negotiate veto rights by requiring that certain company decisions require the approval of the PEIs (e.g., decisions regarding the approval/implementation of the company’s budget for expenses and expenditures, the compensation and benefits of management or employees, and the termination or employment of management). These rights may appear in various forms, such as requiring the approval of (i) the shareholders; (ii) a super majority of the Board; or (iii) the PEIs’ representative.

Access to information

Perhaps the least invasive right that PEIs commonly seek is the right to access information that is within the company’s control but would otherwise not be provided to its shareholders or limited partners. Independently, this right may not provide PEIs with much control over the company and, therefore, their investment; however, in conjunction with other governance rights, such information can be extremely useful. Such information typically includes an operations and/or capital monthly statement, rights to visit the company, as well as any other information that PEIs may reasonably request.

The author would like to thank Nader Hasan, articling student, for his assistance in preparing this legal update.

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Due diligence mistakes make for expensive deals (Part 1)

Paper and filesDiligence is required to provide the buyer with a validation of purchase price and a clear indication of deal risks – a balancing act between cost and perceived risk. Diligence should be tailored to the deal and vary depending on what is being purchased and the complexity of the transaction. Buyers conduct financial and legal due diligence, evaluate the financial potential of the merger or acquisition and proceed with closing and integration. But for some buyers, love is blind and little attention is paid to proper due diligence. Here are a few common mistakes that may lead to increased closing and post-closing costs.

Mistake #1 – Focusing only on financial due diligence

Due diligence does not stop at the financial side. The buyer may become too focused with financials to the detriment of other areas. A systematic assessment of all aspects of the business is required to ensure value for money. Areas of focus include legal, tax, management, intellectual property, employment and labour and insurance. These areas may expose the buyer to liabilities which question, or change the state of, the financials and general accounting policies.

Mistake #2 – Closing a transaction, without transactional lawyers on both sides

M&A deals can be complex, and require manpower and dedication upfront. If the seller’s counsel is not a transactional lawyer, the purchaser’s requests may be perceived as unreasonable and daunting. There may be loss of deal flow and lack of efficiency on both sides. A party’s due diligence thus starts with finding appropriate counsel. Transactional lawyers are proficient in reading the due diligence and providing the necessary protections in a purchase agreement.

Mistake #3 – Getting too invested

A buyer’s investment into the deal is positively correlated with its commitment. As more time and money is invested, it becomes harder for the buyer to walk away, potentially leaving the door open for sellers to extract concessions during negotiations. Consequently, due diligence should be conducted as a matter of priority early on in a transaction with red flags being raised promptly before the buyer develops a heightened tolerance for risk (and a heftier price tag).

The closing and post-closing costs of certain due diligence mistakes can range from being minor to detrimental for either party. Companies such as Quaker, BMW, Time Warner and Mattel have suffered losses due to rushing a deal at the expense of proper due diligence. Don’t add your client to the list.

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M&A activity in the pharmaceutical sector is driving the commercialization of new drugs

The global pharmaceutical sector has been rocked by several significant mergers and acquisitions in 2015:

  1. Indian generics firm Sun Pharma purchased GSK’s Australian opiates operations, citing the development of analgesics as a key growth opportunity
  2. US-based AbbVie acquired Pharmacyclics, with a central motivation being the acquisition of the blockbuster cancer drug Imbruvica
  3. US giant Pfizer received approval for its $17 billion (USD) takeover of Hospira from the latter company’s shareholders. Pfizer’s portfolio of sterile injectables and biosimilars will be significantly enhanced upon completion of the deal
  4. Irish-American generics firm Endo International purchased Par Pharmaceutical, citing Par’s diverse product portfolio and robust development pipeline with over 200 drug applications awaiting FDA approval
  5. US-based Celgene acquired Receptos in a deal that bolsters its inflammation and immunology portfolio with the acquisition of Ozanimod, a lead candidate for the treatment of multiple sclerosis and ulcerative colitis
  6. Following the sale of its generics business to Teva, US-based Allergan focused on the development of its branded operations with the acquisition of Naurex. Naurex’s lead candidate, Rapastinel, is in clinical trials as a promising therapy for depression
  7. UK-based Hikma Pharmaceuticals acquired Roxane Laboratories, citing Roxane’s existing portfolio and attractive development pipeline as key motivating factors

What do all of these transactions have in common? All were motivated to a significant degree by the commercialization potential of the target’s development pipeline. While the motivations behind such transactions are always multi-faceted, the value of the target company’s research and development (R&D) pipeline is increasingly a central consideration. This trend is being driven by rising R&D costs and the reality that few new drugs will become market blockbusters, defined as $1 billion (USD) worth of annual sales. With the average cost of bringing a new drug to market at $2.5 billion (USD), many companies are turning their attention to M&A as a more cost-effective way to expand their portfolios of lead candidates. Indeed, the value of M&A activity in the pharmaceutical sector thus far in 2015 exceeds the value for the same period last year by over 90%, reaching heights not seen since 2009.

The consolidation of drug portfolios and development pipelines driven by commercialization potential is contributing to a pyramidal reshaping of the industry’s landscape. While one company may have shepherded a new drug through development to market entry in the past, the current trend of small and niche players being acquired by the industry leaders means fewer companies are responsible for a greater share of new drug commercialization activity.

The root cause of this trend is likely a reshaping of the pharmaceutical market itself, driven by advances in biotechnology and the loss of market exclusivity by some leading drugs. Instead of focusing on finding novel therapeutic compounds, modern drug development is increasingly focused on the commercialization of new dosage forms and uses of existing compounds. Advances in computerized molecular modeling techniques and laboratory tools have made drug discovery more accessible to smaller developers. Moreover, the development of biologics, a new frontier in drug discovery whereby therapeutic substances are synthesized by living cells, has dramatically altered the traditional chemical synthesis paradigm that has historically underpinned the industry. The result is the compression of traditional R&D timelines as developers strive to commercialize more new drugs in less time to stay competitive. From a health care perspective, a potential benefit of this trend for patients is quicker access to a larger selection of new drugs.

The author would like to thank Mark Vanderveken, summer student, for his assistance in preparing this legal update.

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Early-stage deal activity points to a healthy global climate for M&A

Earlier this month, Intralinks published the latest edition of its Deal Flow Predictor report (the Report), which tracks global, early-stage M&A activity in order to predict M&A deal volume in the coming quarters.

According to the Report, early-stage M&A activity points to a healthy climate for global M&A through Q4 2015. The Report’s midpoint forecast for 2015 is 14% growth year-over-year in announced global M&A deals, with a lower bound of 9% and an upper bound of 14%.

The fastest growing area was the Asia Pacific region, which posted 15.8% growth in early-stage M&A activity during the first six months of 2015 compared to the same period in 2014. China and South Korea were bright spots in the region and are expected to continue being significant drivers of M&A activity.

Early-stage M&A activity in North America was also solid, growing 10% during the first six months of 2015 compared to the same period in 2014. The Report further notes that in the first six months of 2015, almost 50% of global deal value involved North American targets. These recently completed mega-mergers may push regional M&A activity higher in the coming months, as other companies seek out deals of their own in response to industry consolidation and a shifting competitive landscape.

Latin America was the slowest growing region, with just 0.5% growth in early stage M&A activity during the first six months of 2015 when compared to the same period in 2014. Though this growth was meager, the Report observes that Q2 2015 was the first quarter since Q4 2013 that Latin American early-stage deal activity has increased based on a six-month period, perhaps signaling a tentative rebound in a region that has been hampered by weakened commodities and oil prices.

As for global M&A sentiment, the Report found that in a survey of dealmakers, optimism amongst respondents decreased in Q2 2015 compared to the previous quarter, but remained generally positive. 59% of respondents expect deal volume to increase over the next six months, compared to 65% in the survey for the previous quarter. Given increased early-stage deal activity across all regions, the continued optimism of dealmakers appears to be well-justified.

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When and how to use fiduciary out clauses

Almost every acquisition agreement involving the acquisition of a public company will include a provision whereby the board of directors of the target company agrees to stop soliciting competing bids or stop having any discussions with any other party who might be interested in a making a competing bid. This is generally known as the “no-shop” clause. However, the directors of the target company have certain fiduciary duties that they must comply with. Directors must act honestly, in good faith, and with a view to the best interests of the company, which in the context of an acquisition includes getting the company’s shareholders the most favourable deal. Hence, the “fiduciary out” clause was born.

A “fiduciary out” clause is the exception to a “no-shop” clause.  A “fiduciary out” clause allows the board of directors of a target company to take certain actions, which includes terminating the incumbent transaction, if the failure to do so would be inconsistent with its fiduciary duties to the company and its shareholders.  A typical “fiduciary out” clause gives the board of directors of a target company the ability to consider, and if applicable accept, an unsolicited competing bid that the board has determined is more favourable than the incumbent transaction.  This type of competing bid is known as a “superior proposal”.

The “fiduciary out” clause is typically limited to specific circumstances, and its terms and conditions are generally tied to the negotiations regarding the terms and conditions of the “no-shop” clause and support agreements.

Given the limited nature of the “fiduciary out” clause, what constitutes a “superior proposal” is often also a highly negotiated matter. Generally, a “superior proposal” will require the board of directors of a target company to conclude certain matters regarding the competing bid including that the competing bid (i) is reasonably capable of being completed without undue delay (taking into account financial, legal, regulatory and other relevant factors), and (ii) is not subject to any financing condition or any due diligence condition. The board of directors of the target company must conclude, in its good faith judgment and after consulting with external legal and financial advisors, that the competing bid is more favourable, from a financial point of view, to its shareholders when compared to the originally proposed transaction.

Before the board of directors of the target company can exercise its “fiduciary out”, the acquisition agreement will generally require that it give the incumbent buyer a right to match the competing bid or amend its offer to provide for terms more favourable than the competing bid.  If the competing bid is not matched or exceeded, and the board of directors of a target company determines that the competing bid is, in fact, a “superior proposal”, it may exercise its rights under the “fiduciary out” clause and terminate the incumbent transaction.  Such termination is usually linked to a break fee or termination fee payable to the incumbent buyer.

While a buyer wants certainty that the transaction it has proposed and negotiated with the target company will be completed even if a competing bid is proposed to the target company by another buyer, the board of directors of a target company wants to ensure that it can appropriately execute its fiduciary duties. A “fiduciary out” clause is one of the items in the arsenal available to the board of directors of a target company to permit an exercise of its fiduciary duties and to maximize shareholder value.

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A closer look at exit strategies for privately held companies

For every privately held corporation, one of the most difficult, yet unavoidable decisions, will be implementing an exit strategy. In a recent five-part series titled Realizing shareholder value: Private company exit strategies, PwC identifies and explores the principal stages of developing a successful exit strategy: (1) making the decision to sell; (2) finding the right buyer; (3) preparing the business for sale; (4) the deal process; and (5) preparing for life after the deal.

  1. Making the decision to sell. Every ownership group can have different reasons to plan an exit, be it retirement, financial pressures or the desire to transfer the business to an heir. Whatever the motivation, defining objectives of the sale are key to developing the right strategy. Is liquidity more important than succession planning? Are you more concerned with the sale price or the future of current employees? Once these objectives are determined, the transaction can be structured to achieve your goals. Regardless of your objectives, the planning needs to start early so that all the relevant stakeholders are considered.
  2. Finding the right buyer. To find the right buyer, you need to decide how to structure the transaction to achieve your goals. This can be done through a (1) sale to a third party; (2) corporate partnership or joint venture; (3) employee stock ownership plan; (4) an IPO; or (5) selling to family. Each of these methods has advantages and disadvantages that may or may not align with your strategy. As previously stated, knowing what you want to achieve in the sale will make this decision easier.
  3. Preparing the business for sale. Early preparation is important at this stage. Continuing to run the business successfully and negotiating a sale can be difficult and there is a potential that competing interests can arise. Ensuring that the financial and human resources are not depleted throughout this period will create value for both the seller and the purchaser. Creating a dedicated internal team with strong external advisors will alleviate some of the pressures.
  4. The deal process. Before committing to a sale, it is advisable to consider: (1) if your objectives are still being met; and (2) whether market conditions have changed substantially. As long as these two issues are still manageable, issues concerning taxes, timeline of the sale, confidentiality agreements and negotiating key terms will be paramount. The services of an experienced legal professional cannot be understated at this stage.
  5. Preparing for life after the deal. Upon a successful closing, the issues that need to be addressed will be of a more personal nature. Personal income tax planning, financial planning, family issues, wealth transfer planning and planning for retirement will need to be faced head on. These issues can be dealt with by reassessing your objectives from a personal perspective and moving forward. Once these objectives are realized, future planning becomes manageable and achievable.

Planning an exit can seem daunting at the beginning because it is something that business owners typically will only do once in their careers. With proper planning, a strong team of advisors and an appreciation of the stages and issues that will be faced along the way, a successful exit strategy is within reach.

The author would like to thank Robert Corbeil, summer student, for his assistance in preparing this legal update.

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PPSA registrations in asset purchase transactions: when are they necessary?

In asset purchase transactions involving the sale of accounts receivable, questions often arise about whether a registration under the applicable provincial Personal Property Security Act (PPSA) will be necessary. The answer to this questions depends on a number of factors, including where the seller’s accounts receivable are located and whether a party is the purchaser or the seller of the assets.

If the accounts receivable of a seller located in Ontario are being sold, an Ontario PPSA financing statement may need to be filed showing the seller as “debtor” and the purchaser as “secured party.” This is due to section 2(b) of the Ontario PPSA which stipulates that the PPSA applies to a “transfer of an account or chattel paper even though the transfer may not secure payment or performance of an obligation.” On the other hand, section 4(1)(g) of the PPSA excludes the sale of accounts where it is part of a transaction to which the Ontario Bulk Sales Act applies.

Irrespective of these provisions, the best approach may depend on whether a party is purchasing or selling the assets in question. By making a registration, the purchaser may be able to avoid arguments with third parties down the road about who has rights in the accounts receivable. However, sellers may also wish to take a different approach in order to avoid having a PPSA registration “cloud” their title to their remaining assets.

When seeking to buy or sell assets, purchasers and sellers should work closely with legal counsel to make sure that all of the above considerations are being taken into account.

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Limiting tax exposure on an acquisition by share purchase

One characteristic consequence of a share sale is, generally, that the vendor realizes a capital gain. Canadian resident shareholders are generally taxed on half of the amount of the capital gain. If available, the cumulative lifetime capital gains exemption can shelter all or a portion of the capital gain, reducing the overall tax bill of a shareholder.

The cumulative lifetime capital gains exemption entitles every individual who is a resident of Canada throughout the year to a deduction from capital gains realized on the disposition of “qualified small business corporation shares” (QSBC Shares). The deduction allowed is indexed annually. For 2015, the deduction limit is $813,600.

Generally, shares of a corporation will be QSBC Shares of an individual if the following three tests are met:

  • The corporation is a “small business corporation” as defined in the Income Tax Act (Canada);
  • No one other than the individual or a person or partnership related to the individual owned the shares throughout the 24 monthly immediately preceding the sale; and
  • The corporation satisfied criteria requiring the use of at least 50% of its assets in a Canadian active business throughout the 24 months preceding the sale.

Although the name may suggest that a “small business corporation” must be small, this is not in fact the case. A corporation will be a small business corporation where, generally, the corporation is a “Canadian-controlled private corporation” and certain assets tests relating to the use of the assets in a Canadian business are met in a 12 month period.

Where all of the above requirements are met, the shares of the target corporation will be QSBC Shares and any gain realized on the disposition of these shares will be available for the cumulative lifetime capital gains exemption. If the individual has previously used a portion of his or her cumulative lifetime capital gains exemption, the deduction will be reduced by that amount. If an individual has previously used the full $813,600 of his or her cumulative lifetime capital gains exemption, the deduction will no longer be available to that individual.

It is clearly very advantageous to the individual shareholders of a target corporation if the shares disposed of are QSBC Shares. Accordingly, an individual vendor should always consider whether the shares of a the corporation qualify as QSBC Shares. A company that is not currently in compliance with one or more of the above tests may be able to “purify” itself if the proper measures are taken prior to sale. However, certain of the purification techniques can take up to two years depending upon which test the corporation is offside. As a result, use of the cumulative lifetime capital gains exemption to shelter capital gains arising on the disposition of a target corporation’s shares may not always be available.

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