August 25, 2017
In M&A transactions that are structured as asset purchases, the buyer and the seller must define how the various assets and liabilities of the target business are to be divided between them. This exercise is unique to asset deals – in deals structured as mergers or stock purchases, all assets and liabilities of the target business effectively transfer to the buyer. But, in an asset deal, the parties have significantly more flexibility.
This flexibility can be both a blessing and a curse. From the buyer’s perspective, it allows the buyer to cherry pick which liabilities should transfer to the buyer and which liabilities should remain with the seller (leaving liabilities with the seller is obviously good for the buyer). From the seller’s perspective, it allows the seller to cherry pick which assets should transfer to the buyer and which assets should remain with the seller (leaving assets with the seller is obviously good for the seller). As can be imagined, this level of flexibility often engenders significant negotiation and even confusion among the deal teams.
When defining which assets and liabilities should transfer, the parties must consider two core questions: (1) what types of assets and liabilities should transfer (e.g., cash, accounts receivable, accounts payable, facilities, product warranty liabilities, raw materials, etc.) and (2) how should those various types of assets and liabilities be divided temporally (e.g., if the buyer is going to acquire accounts receivable, is it all accounts receivable that exist at the closing? Or just accounts receivable generated in the period between signing and closing? Or some other construct?).
Because of the significant level of flexibility afforded in an asset deal, parties often attempt to simplify negotiations by agreeing to generalized rules for dividing assets and liabilities. Two such rules relate to the temporal division – the "traditional" approach and the "our watch, your watch" approach.
The traditional approach mirrors the results obtained in a stock purchase or merger structure. Specifically, in the traditional approach, the buyer purchases assets and assumes liabilities of the target business regardless of whether such assets and liabilities relate to the pre-closing or post-closing period. For example, the buyer might purchase "all rights in respect of any offensive litigation relating to the target business, regardless of when the facts giving rise to such offensive litigation arise." Conversely, the buyer would assume "all liabilities in respect of any defensive litigation relating to the target business, regardless of when the facts giving rise to such defensive litigation arise."
As can be seen, the traditional approach has no temporal limitation. Instead, the buyer simply acquires everything, as would occur in a stock purchase or merger deal.
In the our watch, your watch approach, the buyer purchases assets and assumes liabilities of the target business only to the extent such assets and liabilities relate to the post-closing period. The concept behind this approach is that the target business was owned by the seller for the pre-closing period, and thus the seller should keep the full benefit and bear the full burden of the business for that period. In essence, the buyer is purchasing only the future, while the past remains with the seller.
In an our watch, your watch deal, the previous example regarding offensive and defensive litigation would be reformulated as follows:
The buyer purchases "all rights in respect of any offensive litigation to the extent (a) relating to the target business and (b) based upon underlying facts and circumstances occurring after the closing."
The buyer assumes "all liabilities in respect of any defensive litigation to the extent (a) relating to the target business and (b) based upon underlying facts and circumstances occurring after the closing."
The seller retains "all rights in respect of any offensive litigation to the extent based upon underlying facts and circumstances occurring prior to the closing."
The seller retains "all liabilities in respect of any defensive litigation to the extent based upon underlying facts and circumstances occurring prior to the closing."
At a high level, neither approach is better than the other. The two approaches are simply different ways of dividing the target business between the buyer and the seller. That said, on balance, most sellers prefer the traditional approach because it results in the buyer assuming all legacy liabilities of the target business. This can be particularly important for businesses that have long-lived liabilities (e.g., asbestos liabilities), where the seller wants to wash its hands of the target business. Conversely, on balance, most buyers prefer the our watch, your watch approach because it results in the seller retaining those same long-lived liabilities. Most buyers envision themselves as purchasing the future, and they would be happy to leave the past behind with the seller.
Depending upon the nature and magnitude of the historical liabilities of the target business, the our watch, your watch construct may warrant a higher deal price than the traditional approach. For example, if the seller is going to retain millions of dollars in projected pre-closing liabilities, it seems appropriate for the buyer to compensate the seller accordingly.
In practice, many deals are structured with a "hybrid" approach, in which some assets and liabilities are divided using the traditional approach and others are divided using the our watch, your watch approach. This hybrid structure can result in a very confusing deal, where it is hard to concisely explain how the deal is structured. It can also result in significant negotiation, where the parties fight item-by-item rather than agreeing to a more generalized construct.
Depending upon the negotiating leverage of the parties (and the drafting skills of their attorneys), this hybrid structure can also result in counterintuitive outcomes, where one party may acquire/retain assets for a given period, but not also assume/retain associated liabilities for such period. For example, it is entirely possible that a buyer could acquire all pre-closing accounts receivable, but not assume any pre-closing accounts payable. This seemingly unfair result would be achieved by changing only a handful of words in the purchase agreement.
Even in its pure form, the our watch, your watch construct can create unexpected consequences. None of these consequences are necessarily bad – but they can be surprising.
For example, the our watch, your watch construct obviates the need for a working capital adjustment (and the associated negotiation and accounting diligence that go into such a provision). Since the seller is retaining all pre-closing assets and all pre-closing liabilities, there is nothing to adjust following the closing (as described below, the parties will still need to consider difficult questions about how to temporally divide "work-in-progress" assets and liabilities).
Similarly, the our watch, your watch construct significantly minimizes the utility of many, if not most, of the seller’s representations and warranties and the indemnity backing those reps. This fact can come as a surprise to deal teams that spent significant time and political capital negotiating the reps and the indemnity package.
For example, suppose that the seller represents to the buyer that, as of the signing of the purchase agreement, the seller is not aware of any basis for any defensive litigation involving the target business. However, after the closing, a third party sues the buyer over a pre-closing event that the seller knew about at signing, thus rendering the seller’s rep untrue.
Assuming the deal has a customary indemnity package, under both the traditional and the our watch, your watch constructs, the seller must indemnify the buyer for losses arising from the breached rep. This indemnity obligation will be limited, however, by the caps, baskets and other similar provisions that the parties carefully negotiated.
But, under the typical our watch, your watch construct, the seller must also indemnify the buyer for all of the buyer’s losses arising from the litigation, because the events underlying the litigation arose pre-closing (i.e., on the "seller’s watch"). This indemnity obligation arises regardless of whether or not the rep was breached, and will not be subject to the caps, baskets and the like that apply to rep breaches. Thus, this indemnity obligation effectively moots all of the time and energy that the parties devoted to negotiating both the rep related to pre-closing litigation and the provisions of the indemnity related to that rep.
Finally, the our watch, your watch approach can raise difficult questions about how to temporally divide "work-in-progress" assets and liabilities. For example, assume that the seller is party to a contract under which the target business provides prepaid repair and maintenance of construction equipment, and that right before the closing, one of the pieces of equipment breaks down. The buyer will want the seller to honor the contract, since the breakdown occurred in the pre-closing period and the seller received prepayment for the services. However, the buyer has just acquired the business, including all of the employees, tools and spare parts that would be put to use in repairing the equipment. Thus, the seller is effectively unable to repair the equipment. To further complicate matters, assume the seller believes that the equipment was damaged through negligent use, and therefore does not want to honor the contract for this particular repair. This results in the seller being in a dispute with a customer of the target business. The buyer will not be pleased with that situation, since the seller has every incentive to minimize its liability, even if doing so poisons the buyer’s future relationship with the customer.
The following Gibson Dunn lawyers assisted in preparing this client update: Jonathan Corsico and Benjamin Bodurian.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Mergers and Acquisitions practice group:
Mergers and Acquisitions Group / Corporate Transactions:
Barbara L. Becker – Co-Chair, New York (+1 212-351-4062, [email protected])
Jeffrey A. Chapman – Co-Chair, Dallas (+1 214-698-3120, [email protected])
Stephen I. Glover – Co-Chair, Washington, D.C. (+1 202-955-8593, [email protected])
Jonathan Corsico – Washington, D.C. (+1 202-887-3652), [email protected]
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