“Shop-in-shop” retail: perfecting your security interest

In today’s business world, we continue to see creative interconnection among businesses. These arrangements are often motivated by a desire for companies to attain certain benefits of M&A transactions (such as synergies) without incurring certain costs (such as loss of autonomy and heightened transactional expenses). In the retail sector, a “shop-in-shop” business arrangement has become a common occurrence, where characteristically, a large retailer (herein referred to as a “licensor”) will license physical square footage in its retail store to another retailer (herein referred to as a “licensee”) to sell goods. These types of arrangements enable licensees to operate what would optically appear to be an independent store within a larger host, sharing the facilities and the consumer base of the larger host store.

A common example of a “shop-in-shop” is a cosmetic kiosk positioned on the floor of large department retailer. In 2009, The Wharton School authored an insightful article outlining the economic advantages of such business arrangements, which can be accessed here.

For a “shop-in-shop” business arrangement to take effect, the licensor and the licensee may enter into some type of license agreement that enumerates a license fee payable to the licensor, among other terms. The parties may also agree that title to inventory located on the licensor’s premises is retained by the licensee, while proceeds from the sale of the licensee’s inventory are collected by the licensor. These proceeds may be remitted by the licensor to the licensee, subject to certain terms.

Secured lenders and licensees engaged in a “shop-in-shop” business relationship should take note that the physical location the licensee’s collateral (such as inventory) remains relevant under the Personal Property Security Act (Ontario). This is primarily because a secured lender runs the risk of losing its security interest in collateral being sold or dealt with on the premises of a licensor.

Analysis related to perfecting a security interest should be dealt with on a case-by-case basis, although generally speaking, the following may be considered to advance the interests of a secured lender in a “shop-in-shop” context:

  1. Collateral access-type agreements: Secured lenders should consider whether any existing license agreement enables access to collateral in the event of default. Practically speaking, such agreement may be necessary to make such collateral located at a “shop-in-shop” eligible, despite the licensee retaining title.
  2. Assignment of a license agreement: An assignment of a license agreement may be necessary if the secured lender wishes to step into the shoes of a licensee in an event of default, to effectively continue to operate the licensee’s business. The conditions to assignment of a license agreement should be considered carefully by all parties.
  3. Security interest: A licensee operating a “shop-in-shop” may have an unsecured interest in any proceeds derived from the sale of its inventory that are held by the licensor (until these proceeds are remitted to the licensee). A licensee may wish to consider a segregated trust arrangement that would be recognized in law or obtaining a security interest in the proceeds, granted by the licensor. The advantages of a licensee obtaining a security interest against the licensor include, the licensor’s creditors being put on notice of the licensee’s claim to the proceeds and the licensee’s security interest will be in priority to any unsecured creditors of the licensor.

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Protecting trade secrets in M&A

Trade secrets and confidential information are a cornerstone to most successful intellectual property strategies.  Trade secrets provide important competitive advantages that augment the profitability and value of a business.  The importance and value of trade secrets have been recently confirmed by substantial damage awards, broad enforcement and the introduction of specific legislative protection in the United States.

In the M&A context, particularly during the negotiation and due diligence phases of an M&A transaction, the disclosure of trade secrets and confidential information can expose the disclosing party to various risks. As such, taking measures to protect confidential information must be a priority.

Trade secrets

In Canada trade secrets and confidential information are typically protected by contract, fiduciary obligations and through a breach of confidence action.  The owner of a trade secret must establish that the information was confidential, communicated in confidence and misused by the person to whom it was communicated.  Accordingly, a breach of confidence action will not succeed against someone who used publicly available information to reverse-engineer or independently create the confidential information.  Trade secret protection is perpetual so long as the information remains secret.

Protecting trade secrets 

Trade secret owners should carefully protect the value of their confidential information by documenting, implementing and following procedures to clearly identify the information as confidential and narrowly restricting access to it.  Contracts with employees, suppliers and customers who have access to the confidential information should specifically identify the confidential information and clearly set out the consequences for misuse.  There are numerous examples of former employees trying to misappropriate confidential information to the detriment of their previous employer.

The impact on business value

For those businesses that depend on trade secrets for the their competitive advantage, the unauthorized disclosure of a trade secret can have disasterous effects on a company’s bottom line.  Consequently, it is important to pro-actively identify, document and implement measures to protect trade secrets to anticipate and avoid that risk.  Trade secret owners should also formulate plans to take swift action upon discovery of an actual or potential breach of confidence.  Given its importance, the value of trade secret protection is a critical consideration in any company’s strategic plan.

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From renegotiation to reticence: how changing NAFTA may slow the PE market

Renegotiating or withdrawing altogether from the North American Free Trade Agreement (NAFTA) has been a focal point of both President Trump’s presidential campaign and his administration. This threat of renegotiation or withdrawal has also been the source of immense speculation from lawyers, economists, politicians and the like regarding the expected implications for the economy, key Canadian industries and business generally. Now, with preliminary negotiations underway, these months of speculation may finally be put to the test.

NAFTA: a brief overview

In 1994, the United States, Canada and Mexico entered into NAFTA – a free-trade agreement that expanded upon an earlier free-trade agreement between Canada and the United States. In addition to facilitating trade among the three participating countries, some other objectives of the agreement included economic integration and economic growth. In fact, Canada is currently one of the largest exporters of American goods and the second largest goods trading partner of the United States. Given these relations, the significance of NAFTA and its renegotiation for Canada, and the Canadian economy more specifically, is palpable.

Renegotiating NAFTA: the impact on Canadian private equity

As mentioned above, renegotiation of this agreement may affect multiple aspects of the Canadian economy, the private investment market in particular. Data from Pitchbook, a data and technology provider, reveal reductions in private equity (PE) deals in the first two quarters of 2017 , both in terms of the size and value of deals. Pitchbook attributes this trend to the impending renegotiation of NAFTA and suggests that the spectre of renegotiation or withdrawal may have caused PE investors to take, what it calls, a “wait-and-see approach” to investing. In the long-term, Pitchbook predicts that such an approach could be detrimental to the Canadian economy. However, the data also reveals that despite the apparent waning of the PE market in response to the NAFTA renegotiation or withdrawal, the industry as a whole has evidenced some growth. A probable factor contributing to this growth is Canada’s increasingly robust technology sector, which Pitchbook notes, is a rather attractive source for PE investment activity. Nonetheless, given the private investor reticence instilled by these looming negotiations, further growth is unlikely and the implications for the PE market in Canada could be consequential. As the negotiations unfold, only time will tell.

For further reading on this topic, please see this post.

The author would like to thank Samantha Sarkozi, Articling Student, for her assistance in preparing this legal update.

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Additional interest: M&A activity following the Bank of Canada’s interest rate increase

For a second time this year, the Bank of Canada (the Bank) has raised interest rates. As of September 6, 2017, the overnight lending rate is 1 per cent, up from 0.75 per cent.

Two increases in a single quarter certainly bucks the trend that the Bank had been setting since 2010. Before July 12, 2017, there hadn’t been any upwards movement in interest rates for 7 years. That being said, the interest rate increase is not surprising given the current strength of the Canadian economy. In its press release, the Bank presented an optimistic view: growth in Canada is becoming more broadly-based and self-sustaining.

Increases in interest rates are typically associated with dampened investment activity. In particular, the cost of an acquisition financed by a loan increases when rates are hiked. Saving becomes attractive in a high interest environment.

However this is not a hard and fast rule, particularly in the M&A context. Gradual interest rate increases which occur in times of healthy economic growth can be a sign of corporate confidence. Higher confidence levels could actually encourage dealmakers to engage in transactions.

Plus there are other factors that may affect the pace of dealmaking more significantly than modest changes to interest rates. Currency values, equity valuations and geopolitics all play chief roles in M&A discussions in 2017.

Notably, interest rate increases affect private equity acquirers more than strategic buyers (i.e., buyers who are looking to acquire to take advantage of synergies and operational efficiencies). For the latter type of buyer, the interest rate news is unlikely to be a determinant in an acquisition decision. As well, acquirers using a high ratio of capital over debt to finance acquisitions are impacted less by interest rate increases.

As the last interest rate increase occurred quite recently, the jury is still out about the actual effects of the the Bank’s July increase. However observers have predicted that increasing interest rates are unlikely to stifle M&A activity in Canada. In any case, it will be fascinating to see how the September increase (and the signals the second increase gives about the Canadian economy) will play into M&A activity numbers for 2017.

The Bank’s next announcement regarding interest rates is scheduled for October 25, 2017. The October announcement will be accompanied by a full update regarding the Bank’s outlook for the economy and inflation.

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Your data room matters

I have yet to meet a client that enjoys populating a data room with its documents. Record-keeping is not fun at the best of times, and exposing all of one’s records for someone else to dissect and question can be an unpleasant exercise. So, it’s never particularly surprising when data rooms are populated with piles of information and minimal effort is put into organizational principles or even basic numbering. But data rooms matter, and with the shifting landscape for M&A, they matter an increasing amount.

Data rooms and sand-bagging

One of the major negotiation points that I have seen recently relates to something the industry calls “sand-bagging”. As someone from a place where sand-bags are primarily used to stop floodwaters, this terminology was originally confusing to me, but it works like this:

If you and I are entering into a transaction in which I sell you my company, I will have to make a bunch of statements about what you are getting and you will be able to hold me to those statements. If I get something wrong, you can typically sue me for damages from that error. These are your standard representations and warranties and the accompanying indemnification. Now what happens if you knew my representation or warranty was incorrect prior to agreeing to the terms with me? Specifically, should you be able to sue me for the breach even though you knew about it before signing? To do so is called sand-bagging. A clause that specifically allows you to do that is a pro-sand-bagging clause. A clause prohibiting it is an anti-sand-bagging clause. To this day, I do not know why it is represented by a sand-bag.

So why do data rooms matter?

But enough of Deal Mechanics 101. What does this have to do with your data room? Well, the way that purchasers typically find out about breaches of representations and warranties ahead of time is through diligence, including a thorough review of what is contained in the data room. Data room disclosures may reveal that the target is offside labour laws, has an environmental issue or has mistakes in its shareholder ledger. Typically, as well, the argument goes that the purchaser is supposed to know everything in the data room.

So, when we get to the point in the negotiation where the seller is asking my purchaser client not to claim for breaches of representations and warranties because the information was already disclosed in the data room, if the data room is a mess, my response, which is quite often persuasive, is that the data room has been populated so sporadically, haphazardly or generally unhelpfully that the notion that my client knows everything in it is inaccurate through no fault of my client. At that point, the seller is either left defending the merits of a data room that was quickly thrown together, or the seller is conceding the point, neither of which are helpful to the seller.

Contrast that with a well-maintained data room. In that situation, a seller could come to me and say “You’ve had all of this information from day one, it has been organized for your ease of reference, and we have promptly answered any further inquiries from you. How can you say you don’t know what is in there?” Granted, if the seller lacks bargaining power, the seller may lose the point anyway. But in this situation, I’d have to tell my purchaser client that the seller has made a good point.

Do the work up-front

Sometimes the steps we take to complete a transaction feel like they are just moving a bunch of paper around, and consequently it can be easy to do the minimum required to get the deal done. Setting up and maintaining a data room with foresight and attention to detail, however, can help you get better terms for your deal and ultimately leave you with a better outcome. Sometimes it’s just a matter of putting in work at the beginning to reap the rewards later on.

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Private equity investments in healthcare: a look into the future

Last year was a record-breaking year for private equity investments in the healthcare industry, with a total disclosed deal value reaching $36.4 billion by the end of 2016. Mid-year reviews of 2017 indicate a downward trend in the number of private equity investments but a significant increase in the value of investments compared to 2016. According to the Global Healthcare Private Equity and Corporate M&A Report 2017 by Bain & Company, investors will want to increase the weight of healthcare in their portfolios given the growing population and increase in demand for healthcare.

With the ongoing regulatory reform and the uncertainty surrounding healthcare, Bain & Company suggests that investors are now focusing on areas less exposed to regulatory uncertainty. These include healthcare information technology, retail health providers and outsourced services. According to Global Healthcare Leaders Study: 2017 by Lazard, the industry is also expected to transform through the development of new pricing models (“value-based care”), which will replace the currently used fee-for-service model.

With more volatility in 2017, private equity funds continue to see healthcare as a safe haven – despite the legislative uncertainty in the United States. The report by Bain & Company recommended considering the following aspects when seeking healthcare investments going forward:

  • Consider assets beyond your comfort zone – ones that may be smaller, healthcare-heavy or located in other regions;
  • Develop and test all plausible scenarios;
  • Validate your value-creation plan during the diligence process; and
  • Consider creative approaches to your deal, including partnerships, spin-offs and M&A.

Similar to 2016 where corporate buyers accounted for 85% of healthcare deals, they are expected to offer continued competition to private equity investors. The approach taken by private equity investors tends to differ from that of corporate buyers. A corporate buyer may have wider industry knowledge and may know more about the market than a private equity fund. This is one of the reasons private equity funds go through a more rigorous process of commercial due diligence and corporate buyers tend to rely more heavily on internal analyses.

The more volatile the market gets, the more important it becomes to assess each opportunity before diving into a deal. The report by Bain & Company highlights approaches private equity investors take that could be useful if adopted by corporate buyers. One of approaches includes ensuring every deal meets the ‘four Cs”: The deal is confirmable, which means it articulates measurable goals to be test in the diligence process. It is chronicled, i.e., codified in writing. There is consensus surrounding the deal within the organization and lastly, the deal identifies how it will fill a growth or capability need and close the gap.

The author would like to thank Shreya Tekriwal, Articling Student, for her assistance in preparing this legal update.

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In the new world of protectionism, where will M&A stand in Canada?

Canada’s stance on protectionism

Repeated headlines in the past year related to President Trump and his “America First” strategy and the struggles faced by British Prime Minister Theresa May as she leads Britain post-Brexit have convinced many that protectionism now pervades the new world order. Not only are restrictions on physical borders imposed, the flow of investments and trade are inevitable topics being negotiated vehemently by world leaders.

Despite the protectionist rhetoric expressed throughout the globe, Bank of Canada Governor Stephen Poloz argued that “committing to openness has always been the right choice” because “[Canada’s] history shows that it takes a world to raise a nation, and nation building works best in an environment of openness for trade, people and investment”, during a speech he gave at Durham College.

How might protectionism impact us?

According to forecasts by Financier and Thomson Reuters, protectionism will impact megadeals and make big, transforming deals look difficult but more smaller deals will be expected. While the general sentiment for stakeholders in Canada suggest that protectionism remains a threat to deals in the pipeline and risk to businesses, some have suggested that Canada’s openness to markets will give it the competitive edge it needs to differentiate itself from other countries on a global M&A perspective.

EY’s 2017 Global Capital Confidence Barometer listed Canada as the 5th top investment destinations and indicated that management have and will continue to place a greater focus on North America. This is consistent with the findings from our previous post, M&A trends for 2017: Canada a likely target and according to the Intralinks Deal Flow Predictor Q4 2017, their predictive model is forecasting that the number of announced M&A deals in North America in the full year of 2017 will increase by around 10 percent year-over-year.

The importance of due diligence

From a buyer’s perspective, EY and Financier have emphasized the importance of proper due diligence so management can better understand the assets they are intending to acquire and be better equipped to respond to contingencies if the deal involves strategic assets that are likely to be subject to protectionist controls. In this new protectionist environment, targeting and making sure the right deals are struck is already half the battle.

The author would like to thank Jenny Ng, Articling Student, for her assistance in preparing this legal update.

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An update on the use of reverse breakup fees in M&A deals

The 2007-2008 financial crisis saw reverse breakup fees emerge as part of a new structure of private equity in the United States. The use of reverse breakup fees quickly spread thereafter, and by 2010-2011, approximately one-third of M&A deals in Canada included reverse breakup fees. These fees serve to discourage bidders from walking away from deals and helped to determine the risk-sharing between parties involved in M&A transactions.

When reverse break fees are typically paid

In a previous post, we noted that reverse breakup fees are typically paid where there is an unavailability of “committed” financing. Part of the reason these fees have gained prominence is because target companies usually suffer greater consequences when M&A deals fail. These consequences often include: the negative effect of the termination on the target’s reputation, morale and opportunity costs, and the possible loss of the target’s employees.

Reverse break fees are deal-specific

A prior blog post further notes that reverse breakup fees are deal specific. In determining the amount of a reverse breakup fee one should consider the triggers of the fee, which typically include: a buyer’s breach of the agreement, a buyer’s inability to obtain financing, and a buyer’s failure to secure shareholder approval for a deal. In some cases, reverse breakup fees are calculated on a tiered basis, with the total amount of the fee being dependent on the specific termination right which has been triggered. Often however, contracts in M&A deals provide for a fixed sum that is payable in the event of a termination.

Factors impacting value of reverse break fees

Other factors that influence the value assigned to reverse breakup fees include:

  1. the size of the deal; the length of the interim period in between when the contract was signed and when it closed;
  2. the existence of financing conditions;
  3. whether the bidder is strategic (in a similar line of business and buying to hold), or financial;
  4. the extent of regulatory approvals required to close and perceived challenges in obtaining those approvals; and
  5. the relative bargaining power of the parties.

Negotiating deals can be expensive and time consuming for all parties involved. It is important that both sellers and buyers in public and private M&A transactions have knowledge of reverse breakup fees and an understanding of how and when they are used as a deal protection mechanism.

The author would like to thank Brandon Burke, Summer Student, for his assistance in preparing this legal update.

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Director distraction and successful M&A

Members of a board of directors play a crucial role in the decision making processes of a company, which shape the company’s practices, strategies, future goals and overall success. Directors who are not are primarily employed by the subject company or those who sit on multiple boards may be at a risk of neglecting some of their key director responsibilities if they are preoccupied with too many things at once. This is not to say that busy directors will inevitably get distracted and neglect their responsibilities, but that directors ought to be mindful of juggling too many roles at once because of the negative impact it may have on the company.

Impact on effective board governance

In a recent article called “Distracted Directors”, Luke Stein and Hong Zhao of Arizona State University conducted research on the impact of distracted directors on effective board governance. They found that overall, distracted directors were less effective in their advisory and monitoring roles. For those primarily employed at another company, the level of distraction was especially pronounced when the primary employer was going through periods of poor performance.

Impact on M&A

Of particular interest is the impact that distracted directors may have on a company’s acquisition decisions. Directors often take on an advisory role when selecting and negotiating mergers and acquisitions. When directors are not actively engaged in the process as a result of outside obligations, Stein and Zhao found there to be lower returns around the announcement of acquisitions. When directors with M&A experience in particular were distracted during this period – those who the company would presumably turn to for valuable advice – the returns were significantly lower.

Board diversity can help

Since it is commonplace for directors to have outside obligations, it is advisable that companies structure their boards so as to mitigate the negative impact of distraction. Stein and Zhao suggest having larger boards with directors from a diverse range of industries. This is due to the fact that poor performance typically affects the same or related industries at once. Board diversity can help ensure that all directors are not distracted at the same time, thus having a lesser impact on effective board governance. A larger board of directors also has its benefits, as a greater number of directors on the board is more likely to absorb the negative impact that the distraction of a few directors may cause.

The author would like to thank Sadaf Samim, Summer Student, for her assistance in preparing this legal update.

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Smart contracts: how computer programs and blockchain could affect M&A

Smart contracts, which replace traditional paper documents with a computer program that automatically verifies and executes an agreement, are poised to fundamentally alter the way M&A and contract-based legal work is performed. Think of a smart contract as a small army of robot lawyers and accountants: once the parties agree to terms, these robots automatically implement the agreement’s terms (e.g., payment, termination, etc.) as each party performs, or does not perform, their end of the bargain.

What is blockchain?

Blockchain, the technology underlying smart contracts, is a nearly unalterable, decentralized system that implements, verifies and records transactions. By making use of this technology, smart contracts have the potential to drastically reduce the need for lawyers, accountants and other professionals that currently perform that work. Blockchain is already predicted to reduce finance companies’ transaction and infrastructure costs by over 50%, amounting to savings of over $100 billion a year. Similar efficiencies could fundamentally change the structure of M&A legal work as smart contracts verify and execute agreements between parties independently of the current lawyer-dependent system.

Development of smart contracts

The legal industry is notoriously slow to adapt to new technologies, but it is already starting to assess the implications of smart contracts. A consortium of law firms and start-up companies, including Vancouver’s Clio, recently launched the Accord Project, a joint research organization that aims to develop technologies that integrate contracts with real-time data, automatically executing a contract’s terms as the data changes.

There are still many issues standing in the way of smart contract implementation. Security issues remain the largest concern, as demonstrated by the recent theft of $30 million from a smart contract app due to a simple programming error. Additionally, because many legal standards are subjective, current smart contract and computer technology cannot yet replace high-level legal advice. However, the fast pace of technological change and the looming promise of artificial intelligence mean that smart contract technology is already being implemented much more quickly than was thought possible even a few years ago. Companies are already using smart contract technology in everything from bike rentals to loan agreements and it is likely only a matter of time before the legal world follows.

The author would like to thank Jamie Parker, Summer Student, for his assistance in preparing this legal update.

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