Better, faster, stronger: revamping the M&A due diligence process with Artificial Intelligence platforms

Voluminous information in M&A transactions

M&A transactions can be time-intensive, often involving contract discovery and analysis, due diligence, data room preparation, verification of representations and warranties, privacy issues and multijurisdictional privacy legislation and intellectual property protection, among other important aspects. As deals become larger in value and scope, the review and analysis of the foregoing information becomes both voluminous and jurisdictionally dispersed. The international nature of companies and deals often result in contracts that are drafted in languages other than those commonly spoken by the lawyers on a file. To maximize efficiency, minimize errors and drive down costs, law firms are increasingly looking to incorporate advanced technology in order to streamline the process.

Artificial Intelligence platforms for information processing

Enter artificial intelligence (AI) platforms. AI enables law firms to review a large number of contracts for standard considerations in a systematic manner, including change-of control, assignability, and term, while minimizing errors or oversights in the function that the AI program is coded to perform. An AI program for due diligence collects the pertinent documents at their source, filters agreements from non-agreements, and then identifies, analyzes, and classifies the content of the contracts. This permits the program to organize and structure the documents in the Virtual Data Room, as well as identify and even complete, to the extent permitted and possible, the missing fields. Due to advances in machine learning, a given AI program run in successive iterations can learn and retain knowledge of key contract clauses and previously encountered due diligence issues. Since AI processes the contracts that are relevant to the transaction, a lawyer’s review of the data output provided by AI is much more time- and cost-efficient than manually performing the review from the outset. This allows lawyers to focus their time on more sophisticated tasks, such as analysis of the data output and providing recommendations to the client. As we reported last year, Kira’s Diligence Engine, a machine learning contract search platform, claims that AI platforms can save lawyers 20-90% of time expended on contract review without sacrificing accuracy.

Uptake of AI

With new and promising developments in AI constantly reported in the media, many individuals and businesses sometimes wonder why the uptake of this technology seems to be slower than expected. Law firms, while eager to adopt new technologies for clients, must consider both suitability and security. AI platforms are still fairly novel and must be refined for the due diligence context in order to outperform the efficiency and effectiveness of current methods. Furthermore, as a relatively new technology, most developers focus their efforts on becoming leaders in AI innovation, so as to obtain first-mover advantage and the corresponding financial and reputational benefits that are conferred through patents. Data privacy and security are often considered and refined in later stages, and it is only at this point, after repeated testing and an established market presence, that law firms and clients can become comfortable with the integration of an AI platform.

The author would like to thank Shan Arora, Articling Student, for his assistance in preparing this legal update.

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Is this the end of European conglomerates?

Is this the end of European conglomerates?

The end may be in sight for European conglomerates. Activist investor Christer Gardell of Cevian Capital predicts a growing trend of “demergers” in the next five to seven years, due in large part to an increasing number of European conglomerates engaging in in spin-off transactions, or “spin-offs.”

Generally, a spin-off refers to a transaction in which a parent company sells or distributes new shares of one of its business units, after which the business unit then becomes a new legally distinct and independent company. The use of spin-offs by conglomerates to “demerge” may suggest a recognition that the path forward requires an unbundling of operations, rather than consolidation.

The growing list of spin-offs in Europe

European conglomerates have been at the centre of spin-off rumours for some time. Recent behaviour suggests that such transactions are rising in popularity. Recent examples include:

  • Shire, an Irish pharmaceutical company, has separated its operations to create two distinct businesses, specializing in neuroscience and rare diseases, respectively;
  • AP Moller-Maersk, a Danish conglomerate, has spun off its oil business in order to concentrate on its container shipping business, earning $7.5 billion in the sale;
  • German utility companies E.ON and RWE each have sold off parts of their portfolios;
  • Honeywell International has announced a spinoff of its transportation systems business and homes product portfolios, both of which will be two publicly traded companies.

The increase in spin-off activity has led to more rumours. Industry experts have predicted that Prudential Financial may spin-off certain business units following its merger with M&G. Similarly, Whitbread PLC is rumoured to be separating two of its business units, Costa Coffee and Premier Inn Brands, in the near future.

Why are conglomerates becoming less desirable in Europe?

As a business model, conglomerates are increasingly viewed as difficult to manage. The need to effectively allocate resources, coupled with increased focus on specialization, has placed tremendous pressure on management teams to devise strategies for maximizing returns.

In announcing its spin-off, Honeywell’s CEO Darius Adamczyk stated that the proceeds of the spin-off would help the conglomerate repurchase shares, repay its debts and potentially create opportunities for future acquisitions. In other words, by spinning out portions of its business, a conglomerate can theoretically open up opportunities more in line with its core business.

The growing number of European conglomerates using spin-offs to reduce their portfolios suggests that this may be a viable strategy going forward. However, it is unclear if this is a phenomenon specific to the European market. Only time will tell whether conglomerates in other regions of the world will follow suit.

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

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Debt, equity and tax credits: how films are financed

The other day I cued up a new release movie that I had been eagerly anticipating. As the opening credits rolled, I couldn’t believe how many entities were being credited. The list kept going and going, with a range of what appeared to be both governmental and private organizations. What could these organizations all have to do with making this movie? We have all seen the opening credits and title sequences to our favourite films, although if you’re like me, you probably don’t pay much attention to the cleverly named companies and funds that have earned a credit in the film.  The answer, of course, requires us to follow the money. Most of these entities have contributed to the financing to the film, either by way of investment or tax incentive, and as a term of their contribution are entitled to a screen credit. In this post, we’ll look at three of the primary methods by which film producers obtain their financing.

Debt financing

Historically, film producers funded their pictures with their existing capital which was usually by way of retained earnings from other films or with funds from other public or private sources or a combination of both. Many Hollywood films are produced purely using existing capital from the studios involved in the production, which of course negates the need for third party financing.

On the other hand, in the event funding is required (which is the case with many productions, big-budget Hollywood films being no exception) films can be debt-financed by way of loan, typically obtained from institutional or private lenders. Of the big six banks in Canada, a handful of them offer dedicated film finance departments which have either been grown in-house over the years or kick-started by the acquisition of private funds which have become the media financing arm of the bank.

A film credit facility from one of these banks does not differ substantially from a credit facility in favour of any other business, although there are some important nuances which distinguish film financing from a regular financing deal. The lender will typically take security over the borrower’s present and after-acquired personal property which, importantly in this context, includes the intellectual property rights in the content. Lenders want to ensure that the borrower possesses the underlying rights required to create the content and as such a chain of title opinion is usually required. A chain of title opinion involves reviewing the various agreements and assignments between the original creator of the content all the way down to the production company to track the ownership of the underlying rights and ensure that it has been properly transferred, and is given by the borrower’s counsel.

As producers typically establish new production companies for each new venture, the borrower will likely not have any material assets other than the underlying rights to produce the content. As such, the lender will want security and guarantees from certain of the producer’s subsidiary companies.

The closing process of a bank financed film is often more fluid than a standard facility where all deliverables are required to be in place prior to the lender’s advance. A bank may actually advance funds even before the transaction has closed, although in my experience this depends on the relationship between the production company and the lender. An example of this is where errors and omissions insurance (or E&O insurance) is required. E&O insurance is a type of producers insurance which covers legal liability and defense for the production company against, among other things, lawsuits alleging unauthorized use of titles, formats, ideas, characters, plots, plagiarism, and defamation. The timing of when a producer is required to have E&O insurance in place depends on the complexities of the project but is usually required before a film can be released.

Another important piece of the funding process which is crucial to the bank offering the credit is to have a completion bond (sometimes called a completion guarantee) in place. This is a special form of insurance that essentially guarantees that a production will be finished and delivered on schedule and within budget in the event the producer is unable to complete the project. The use of completion insurance is hilariously depicted in the film Lost in La Mancha, the documentary about Terry Gilliam’s attempt to make The Man Who Killed Don Quixote in 1998, a film where the producers famously encountered a series of unfortunate events which did not enable the film to be completed. While Quixote has not yet graced our screens, I recently came across an article that suggests Gilliam has not yet given up on ensuring his film sees the light of day.

Lastly, the typical deliveries such as resolutions, officer’s certificates and opinions will be required by the lender as a condition of closing the deal.

Equity funding

Where debt is not the preferred method of funding the film, sometimes equity financing is used by way of private placements or offerings. The formalities of this process can vary from full lawyer-driven equity deals to informal cash-for-shares structures. A good example of the latter is the Coen Brothers’ first film entitled Blood Simple (despite considering myself a big Coen Brothers fan, I admit I have not seen their 1985 debut) where Joel and Ethan corralled a group of private investors by taking their film trailer and going door to door to come up with the US $1,500,000 or so that was needed to make the film – they succeeded and the film was made, and the rest is history. To date, the domestic gross revenue of Blood Simple is just shy of US $4,000,000. It may not be a windfall, but it’s a decent return for the people who took a punt on a couple of unknowns. The Coen Brothers’ true grit, pound-the-pavement ethos is tried and true, and is still used by indies and big studios alike as a way to generate funds to produce their films.

Tax credits

Another significant source of funding is from the use of tax credit incentives. Most Canadian jurisdictions, including the federal level, offer a tax incentive to encourage the use of local personnel and/or local filming locations. The incentives are offered for projects which offer Canadian content or use Canadian production services. The Ontario Media Development Corporation, an agency of the Ontario Ministry of Tourism, Culture and Sport, offers three different film tax credits, which provide refundable tax credits to qualifying entities of up to 35% for certain production expenses. At the federal level, the Canadian Audio-Visual Certification Office (CAVCO) co-administers two federal tax credit programs with the Canada Revenue Agency under the Income Tax Act.

The US also historically offered tax-related incentives to filmmakers, although due to the abuse of tax shelters and tax legislation reforms in the 1980s, producers started to look elsewhere for funding. Cue foreign countries with tax-credit programs to begin marketing to Hollywood to bring their funds overseas to attract investment. In addition to Canada, the United Kingdom, Australia and several other European countries including France, Holland and Germany offer significant tax breaks to attract Hollywood’s money. Germany has among the most attractive incentives for studios, as the German tax code permits a film’s investors to make an immediate tax deduction notwithstanding that a film has not even begun production. The film need not be shot in Germany or use German crew (a condition of many other local tax programs) but so long as the copyright is owned by a German entity the tax incentive applies. Studios get around the copyright ownership hurdle by sale transactions which include immediate lease-back with an option to repurchase at a later date.

The merits of tax credits and the value they add (or the amount they cost) to the taxpayer continue to be debated and in recent years provincial and state tax credit programs have been slowly drying up. That notwithstanding, it is probably fair to say that hit productions such as Breaking Bad or Deadpool probably wouldn’t exist if it were not for tax credits.

To conclude, there are various ways a producer can obtain financing for its project. The fact is that many producers employ all three methods described above to generate the level of funding they require to express their idea (or the idea of someone else for which they have obtained the underlying rights). Each method comes with its own unique challenges and requirements.

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Baskets and caps: limits to indemnification obligations

Indemnification provisions are among the most highly negotiated provisions in private M&A transactions. These provisions set out the terms and conditions under which one party will be required to indemnify the other party for any losses the other party may suffer post-closing. In other words, indemnification provisions set forth the “rules of the road” and allocate the risks involved in a transaction.

While risk allocation may seem conceptually simple, structuring indemnification provisions may become quite complicated. As the size, complexity and economics of a transaction increase, it can sometimes be very difficult to specify the scope of a party’s indemnification obligations in a manner appropriate to the value (actual or perceived) inherent in the deal. However, and to add certainty to their bargain, parties usually arrange their affairs to limit the amounts for which an indemnifying party may be responsible and prevent a party from bringing immaterial claims.

The following terms are typical in indemnification arrangements:

  1. De Minimis Amount: The de minimis amount specifies the minimum threshold a single claim must exceed in order to become eligible for indemnification. Expressed differently, a party can only claim indemnification if a claim’s value exceeds a minimum dollar amount, expressed either as a percentage of the purchase price or a specified amount.
  2. Tipping Basket: A tipping basket specifies the threshold which the aggregate amount of all claims must exceed before a party can bring any claim for indemnification. Once the threshold is exceeded, the indemnifying party will be liable for the entire amount of losses. Like the de minimis amount, baskets eliminate redress for relatively small claims.
  3. Deductible Basket: A deductible specifies the threshold which the aggregate amount of all claims must exceed before a party can bring any claim for indemnification. However, once the threshold is exceeded, the indemnifying party will only be liable for losses that exceed the threshold amount. For example, if there is $1 million deductible, and a party brings a claim for $3 million, the indemnifying party will only be responsible for portion of the claim exceeding the $1 million deductible; i.e., $2 million.
  4. Indemnity Cap: An indemnity cap limits the amount an indemnifying party may be required to pay. The cap amount is generally calculated as a percentage of the purchase price, but may also be a specified amount.

Indemnification provisions are extremely important to both buyers and sellers, and the law affords parties great flexibility to structure their indemnification arrangement. Many deals contain exceptions to the basket and cap limitations, including for claims involving a breach of certain representations or warranties, fraud, willful misconduct, and other matters specific to a transaction. In all cases, when attempting to structure indemnity provisions, it’s important to carefully consider the scope, the duration and the dollar amount attached to an indemnification obligation. To restate the obvious, a small mistake could have a large dollar impact.

The author would like to thank Blanchart Arun, Articling Student, for his assistance in preparing this legal update.

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Global automotive M&A ends 2017 in high gear with no signs of slowing down

As seen in this recent PwC article, global automotive M&A activity was strong in 2017.  Automotive deal value increased 29.9% to $53.2b from 2016 to 2017 primarily as a result of two mega deals in the Auto-Tech sector, which PwC defines as “investments in connectivity, autonomous, electrification, ride-sharing and the software, sensors, intellectual property and other components that support these trends.”  For 2018, it is expected that investments in the Auto-Tech sector will continue to drive global automotive M&A activity.

Auto-tech deals spark M&A activity

Auto-tech deal value increased from $5.3b in 2016 to $26.7b in 2017. Further, deal volume increased 28% from 50 deals in 2016 to 64 deals in 2017.  The main auto-tech attractions in 2017 were driver assistance technologies and alternative powertrains, which include lithium ion battery manufacturing. Other significant investments were made in ride sharing/mobility services and online vehicle dealerships/trading platforms.

Further, while traditional automotive companies were acquiring tech companies, tech companies were also acquiring traditional automotive companies and other auto-tech companies.

Auto-tech attracts venture capital

Last year was a record-setting year for venture capital with 11,042 deals completed worth $164b.  Despite the fact that the auto-tech sector is only a small portion of global venture capital, venture capitalists are showing interest in early stage auto-tech enterprises focused on artificial intelligence, software, and other mobility-related technologies. In 2017, venture capitalists injected significant capital into on-demand ride sharing applications, and electric and autonomous vehicles. PwC aptly predicts that the car of the future will be “electrified, autonomous, shared and connected.”

2018 outlook

2018 will likely see continued investments in the auto-tech sector with particular focus on alternative powertrains, connected car technologies, ride sharing, artificial intelligence and predictive analytics.

As seen in 2017, Asian buyers will continue to be active given further consolidation opportunities, market growth and expected regulations that will drive the need for alternative powertrain technologies. Further, in the US, the recent and significant tax reforms will provide US-based companies and venture capitalists with more cash to drive M&A activity.

As such, 2018 has plenty of fuel it needs for another strong year of automotive M&A activity.

The author would like to thank Peter Choi, Articling Student, for his assistance in preparing this legal update.

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Legal update: common interest privilege in commercial transactions

On March 6, 2018, the Federal Court of Appeal reversed the decision of the Federal Court of Canada in Iggillis Holdings Inc v Canada (National Revenue).

As we discussed in a previous post, the trial court decision in Iggillis Holdings had called into question the availability of common interest privilege in commercial transactions. The trial court found that privilege with respect to a memorandum prepared by purchaser’s counsel (with input from seller’s counsel) outlining the most tax-efficient way to structure a series of transactions had been waived when it was shared on a confidential basis with the seller.

On appeal, the Federal Court of Appeal noted that transactional common interest privilege is a firmly entrenched principle of Canadian law.  Specifically, the Court found that the courts of Alberta and BC (the relevant jurisdictions for the transaction under consideration) recognize that a party to a transaction does not waive privilege by disclosing privileged advice on a confidential basis to another party having a sufficient common interest in the same transaction (at paragraphs 40-41):

These cases and the commentary in The Law of Evidence reinforce the conclusion of the Federal Court judge that common interest privilege “is strongly implanted in Canadian law and indeed around the common-law world” and in particular in Alberta and British Columbia which are the relevant provinces for the definition of solicitor-client privilege in subsection 232(1) of the Income Tax Act, in this case. It was therefore not appropriate for the Federal Court judge to rely on the decision of the New York Court of Appeals to effectively overturn the decisions of the Alberta and British Columbia courts.

Based on the decisions of the courts in Alberta and British Columbia, solicitor-client privilege is not waived when an opinion provided by a lawyer to one party is disclosed, on a confidential basis, to other parties with sufficient common interest in the same transactions. This principle applies whether the opinion is first disclosed to the client of the particular lawyer and then to the other parties or simultaneously to the client and the other parties. In each case, the solicitor-client privilege that applies to the communication by the lawyer to his or her client of a legal opinion is not waived when that opinion is disclosed, on a confidential basis, to other parties with sufficient common interest in the same transactions.

With respect to the sufficiency of the common interest, the Court of Appeal noted that, particularly where complex statutes such as the Income Tax Act are at issue, the application of the legislation will be of interest to all of the parties to a transaction and that the sharing of opinions may also lead to efficiencies in completing the transactions.

As noted in our previous blog entry, the trial court decision in Iggillis Holdings was not binding in provincial superior courts, where most commercial cases are litigated and where the courts have consistently recognized common interest privilege in this context. However, this reversal by the Federal Court of Appeal is welcome nonetheless, as it serves to re-establish a consistent approach to common interest privilege across Canada.

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Cross-border agreements and the choice of governing law

In order to meet the demands of a constantly evolving global marketplace, companies often seek to expand their operations through cross-border mergers and acquisitions. When pursuing an international transaction, the parties must consider a unique aspect of the deal – the legal framework in which the deal and any contractual agreements within it are to be governed.

Governing law provisions

Canadian law generally espouses the principles of contractual autonomy and international comity (being respect for a foreign court’s jurisdiction and laws). As a result, when multiple jurisdictions are involved in an M&A transaction, the contracting parties have an opportunity to identify the law by which an agreement should be interpreted. This can be achieved by incorporating a “governing law” or “choice of law” provision into an agreement. For example, a choice of law provision may be drafted to establish Ontario as the preferred jurisdiction of law (i.e., “the laws of Ontario”). In this scenario, the governing law provision will provide evidence of the parties’ express intention to have the laws of Ontario applied to the interpretation, construction and enforcement of any substantive aspects of the contract. Essentially, the objective is to ensure that a particular body of law will be applied in the event of a dispute, and correspondingly, to avoid the laws of a jurisdiction which are thought to be less predictable or favourable. However, to further minimize the possibility that a court may apply the laws of another jurisdiction, contrary to parties’ written intention, conflict of law principles must also be considered.

Conflict of law principles

Where a party is concerned about the application of less favourable laws, counsel can also protect their client’s interests by warding off the application of conflict of law principles. In order to do so, the phrase “without regard to conflict of law principles” should be included in the governing law provision. This phrase further clarifies the parties’ intention that the governing law is to apply regardless of which court has jurisdiction over the dispute or the nature of the dispute itself. In the absence of such language, a party may argue that conflict of law principles permit the application of laws which differ from those chosen to govern in the case of a dispute.

Furthermore, the clause “without regard to conflict of law principles” can be useful in avoiding a renvoi, as it signals the parties’ intent to have the governing law provision apply regardless of whether the matter is considered to be substantive or procedural. As mentioned, the governing law provision would otherwise only apply to the substantive issues of a contract which may prove to be problematic and create a circular argument. For example, consider a situation where a contract is governed by the law of Ontario, but an action is commenced in Delaware to determine whether a limitation period has expired. In Ontario, limitation periods may be considered procedural (as opposed to substantive) and therefore adjudicated by reference to the law of the jurisdiction where the action was commenced. As a result, an argument might be made that Delaware should apply its own laws concerning limitation periods. A renvoi would occur if the limitation period is seen as a matter of substantive law in Delaware and the parties are referred back to the laws of Ontario. In these circumstance, a circular argument would be created as Ontario then refers the matter back to Delaware to determine what limitation periods should apply. The “without regard to conflict of law principles” clause can negate these intricacies created by the renvoi doctrine and the unpredictable circumstances they offer.

Public policy exception

With all this being said, there is one caveat – a party’s ability to expressly choose which law is to govern a contract is subject to narrow exceptions. In particular, the choice of governing law must be bona fide, legal and not contrary to public policy. Despite legal drafting, a choice that appears to circumvent commercial sensibilities will be scrutinized under the bona fide and legal test. In addition, if there appears to be an intention to evade mandatory provisions of the legal system with which the contract had its most substantial connection, the court would likely refuse to uphold the choice of law as a valid one.

In any event, where a party has a preference for the laws of a particular jurisdiction to govern, an analysis of the legal framework to be applied in the case of a future dispute remains key.

The author would like to thank Joseph Palmieri, Articling Student, for his assistance in preparing this legal update.

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Inherited liability under a workers’ compensation system: a surprise to avoid

Canadian provinces and territories all administer some form of a workers’ compensation system within their jurisdiction. Funded by employer-paid premiums, these no-fault insurance systems provide wage replacement and medical benefits to injured employees who relinquish their right to sue their employer for losses arising from their injuries. In Ontario, for example, the relevant legislation is the Workplace Safety and Insurance Act (WSIA).

Why is workers’ compensation relevant to M&A?

When acquiring a business, it is important to be aware of the seller’s record under the applicable workers’ compensation legislation. In Ontario, for example, when an employer sells its business, the buyer may be liable for all amounts owed by the seller under the WSIA immediately before the disposition. Unless the buyer is a person who falls within the persons excluded from this provision, the buyer will inherit the seller’s work record, which will in turn affect the amount of the buyer’s contributions under the WSIA.

Liabilities are unpleasant surprises, and inquiring into the seller’s record can help buyers eliminate one source of such surprise. In Ontario, again, as an example, buyers can obtain a “purchase certificate” from the Workplace Safety & Insurance Board (WSIB), the agency that administers the province’s workers’ compensation system. A valid purchase certificate verifies that the seller has WSIB coverage and that there are no outstanding debts on the seller’s account. In effect, the purchase certificate waives the buyer’s liability for any amounts charged to the seller’s account, up to the date of the sale.

As always, when buying an employer’s business, proper inquiries can help buyers steer clear of acquiring unwanted liabilities.

The author would like to thank Blanchart Arun, Articling Student, for his assistance in preparing this legal update.

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Working capital adjustments: lessons from De Santis and Iacobucci v Doublesee Enterprises Inc.

In complex M&A transactions, there could be a significant delay between the initial valuation of a target company and the closing of the deal. As we explained in our previous article, “Net working capital adjustments: what’s the deal?”, parties can protect themselves against fluctuations in value during this period by negotiating purchase price adjustments (PPAs). According to the American Bar Association’s 2016 Canadian Private Target Mergers & Acquisitions Deal Points Study, the most common PPA is the working capital adjustment (which was included in 83% of recent Canadian M&A deals with a PPA).

Mechanics of working capital adjustments

Typically, working capital adjustments provide for an adjustment to the purchase price based on the level of working capital at closing. For purposes of negotiating the purchase price, the parties assume that the target company’s working capital at closing would be at a certain level or range at closing (target amount). At closing, if working capital falls below the target amount, the purchase price is reduced to reflect the fact that the purchaser may need to inject additional cash into the business. Conversely, if working capital at closing is greater than the target amount, the purchase price is increased to ensure that the purchaser does not receive a windfall.

While the working capital adjustment may be conceptually straightforward, it is important not to lose sight of the details. For example, when should the adjustment take place? A closing balance sheet needs to be prepared to form the basis of the adjustment, but it generally cannot be finalized immediately on the date of closing. Therefore, parties typically agree to make the adjustment post-closing once the closing balance sheet is finalized (usually 30-90 days after closing). This can be done in either a single adjustment, or a two-part adjustment where an initial adjustment is made based on estimated information at closing and a final “true-up” when the finalized information becomes available.

De Santis and Iacobucci v Doublesee Enterprises Inc.

Failure to account for such timing considerations could lead to uncertainty and disputes, as demonstrated by the recent Ontario Superior Court decision in De Santis and Iacobucci v Doublesee Enterprises Inc., 2018 ONSC 400 (De Santis).

In De Santis, parties entered into a Share Purchase Agreement (SPA) for the sale of Mavis Auto Collision and Auto Glass Ltd. (TargetCo) at a total price of $465,000. The SPA contained a unique type of working capital adjustment which provided that, on closing, TargetCo must not have negative working capital, otherwise there would be a corresponding reduction in the purchase price dollar-for-dollar. In other words, the target amount of working capital was effectively zero. As it would make no commercial sense for the vendors to leave additional funds in TargetCo in excess of this target amount, the SPA allowed TargetCo to declare and make a “special dividend” of any excess prior to closing.

On the day prior to closing, the vendors’ accountant required additional time to calculate the amount of excess working capital in TargetCo. The vendor therefore prepared, signed, and delivered a draft resolution for a special dividend to the purchaser’s lawyers, which showed a dividend payable on the day prior to closing but the amount of the dividend was blank. The purchaser’s lawyers did not object or take issue with this approach. Several months later, the vendors’ accountant finally calculated the excess working capital in TargetCo, which was $68,263. However, when the vendors requested that the special dividend resolution be signed and paid out, the purchasers refused on the basis that the special dividend must be declared and paid prior to closing. The vendors brought an action to, among other things, recover the amount of the special dividend or alternatively rectify the SPA to deal with the special dividend payment.

The Court dismissed a motion for summary judgment by the defendant purchasers, as these issues require a trial for a fair and just determination. Despite the vendors’ non-compliance with the SPA, the Court found that the purchasers’ failure to object to the vendors’ approach could establish that the parties agreed to the payment of the special dividend after closing. In any event, the purchasers are estopped from denying entitlement to the special dividend or rectification.


Aside from the obvious lesson that a prudent party intending to rely on a contractual term should clearly object to any instance of noncompliance, De Santis demonstrates the importance of addressing timing considerations when drafting a working capital adjustment. Simply put, the working capital adjustment in De Santis was neither practical nor realistic. If the vendors in De Santis were to strictly comply with the requirement to dividend out excess working capital prior to closing, they would have had to finalize the balance sheet weeks or months in advance or otherwise rely on an estimate. Such information could be outdated and inaccurate upon closing, thereby defeating the purpose of the working capital adjustment.

In addition to timing, drafters of working capital adjustments should also keep in mind other key considerations as outlined in our previous article. For example, should an adjustment arise from any deviation from a working capital “peg”, or only deviations outside of an acceptable band of working capital? Which party’s responsibility is it to prepare the closing balance sheet? What standard of accounting applies to the balance sheet? Should a portion of the purchase price be held back by the purchaser or placed into escrow pending the adjustment? As adjustments to purchase price directly impact the core of the deal, addressing such considerations in advance is critical to the transaction.

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Hacking your way through cyber due diligence

Last year saw an increase in the frequency of data breaches and this trend is unlikely to disappear in 2018. We previously reported on the importance of cybersecurity in the M&A due diligence process. Conducting due diligence of a target’s cybersecurity procedures has become even more crucial in light of Canada’s new notification requirements. These requirements, regulated by the Personal Information Protection and Electronic Documents Act (PIPEDA), are based on amendments made to PIPEDA in 2015 as well as a regulation proposed in 2017 called Breach of Security Safeguards Regulations (Regulations). The Regulations will impose new notice requirements in the event of a ‘breach of security safeguards’ and are expected to come into force later this year.

The new security breach notification requirement is three-pronged. It requires:

  1. a report to the Office of the Privacy Commissioner of Canada;
  2. a notice to affected individuals; and
  3. a notice to other organizations (where such notification may reduce the risk of harm).

Organizations will also be required to retain records of every breach of security safeguards involving personal information for a period of 24 months after the day on which the organization discovers the occurrence of such breach.

Cybersecurity due diligence

In light of the new requirements, the following are some critical questions to ask when conducting due diligence in an M&A deal:

  1. Nature and risk profile of the data: Does the target company clearly articulate what IT systems, data sets and business processes are most valuable and vulnerable, and explain how they are protected?
  2. Cybersecurity controls and crisis management plans: What administrative, technical and physical information security controls safeguard the target’s most critical data sets?
  3. Senior management: How cyber-savvy is the senior management? How well do they understand the importance of data security?
  4. Third-party exposure: Do vendors or other partners hold or have access to any of target’s sensitive data? If so, does the target have a vendor risk management program in place?
  5. Cyber insurance: What are the details of target’s cyber insurance policy, such as exclusions, deductibles, coverage periods and limitations?
  6. Testing security protocols: In what manner and how frequently are the target’s security protocols tested?

Cybersecurity playbook

Data breaches can occur as a result of an external hack or even because of an error made internally by an employee. Companies are recommended to maintain an internal playbook to assist with crisis management in case of a data breach. Such a playbook would not only assist an acquirer in conducting due diligence but would also ensure a simpler integration of cybersecurity issues into the M&A due diligence process.

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

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