Authors: Gesta Abols and Neil Kravitz U.S. Practice Co-Leaders, Fasken
Introduction
Northbound M&A activity from the United States to Canada remains robust, fueled largely by optimism for strong economic growth as we emerge from the COVID-19 pandemic, historic levels of government stimulus and incredibly low borrowing costs. Canada resembles the US in its market-oriented economic system, diverse economy and high living standards and the revamped U.S. – Mexico – Canada Agreement (USMCA), which replaced the North American Free Trade Agreement (NAFTA), should facilitate further economic ties going forward. This brief article reviews certain key legal considerations for Americans thinking of buying a Canadian company by way of a private M&A transaction. For public M&A deals, please see: https://www.fasken.com/en/knowledge/2020/07/ma-guide-acquiring-a-canadian-public-company.
Key Considerations
Private M&A transactions in Canada closely resemble those in the United States and the same key deal points often arise in negotiations. Areas where there are important legal differences include:
· restrictive covenants (which generally must be narrower in scope and time and will not be modified by a court (no so-called ``blue pencil``) to an acceptable level if too broad),
· employment matters (where employment law differs in a number of ways including Canadian protections for workers being much stronger in terms of severance entitlements, among other things), and
· stock based compensation (where options are preferred over profit interests or restricted stock grants in terms of the tax treatment for holders).
In addition, tax considerations can drive transaction structures and often result in a Canadian acquisition vehicle being used to mitigate Canadian withholding taxes and to facilitate a potential tax deferral for management or other Canadian resident sellers. While certain corporate statutes in Canada require Canadian resident directors, options are available to avoid the need to find Canadian resident directors.
Additionally, while the United States and Canada are deeply interdependent in matters of defence and security, the past year has tested the outer limits of the ties which bind our two countries. A short-lived but significant dust-up over personal protective equipment galvanized our understanding that even close cousins will, at times, see to their own essential interests before the good of the other. This reality should not have come as a surprise and will drive the examination of foreign investment approval for some time, with Canada weighing carefully the impact of inbound US dollars on the ability of Canadians to be masters in our own house – especially when times are very tough and critical resources scare. Nevertheless, and without doubt, foreign direct investment will be a key component in Canada’s economic recovery from COVID-19 and even with enhanced scrutiny, US-Canada deals will get done, with proponents working just a little bit harder to convince regulators of the down-stream benefits to Canada — or at least the absence of unmitigated risk.
At a granular level, deal studies reveal some differences between deals in Canada and the United States. The most widely cited deal study is the American Bar Association’s (ABA) Canadian Private Mergers & Acquisitions Deal Points Study, the most recent study having been released just prior to the COVID-19 outbreak in North America. A number of members of the Fasken team were involved in the preparation of the study. Certain differences are set out below.
MAC Definition
Although Canadian definitions largely track those in US agreements, there are some notable differences. First, there are still a surprising number of Canadian deals where what constitutes a material adverse change (MAC) is not defined (down to 10% from 13% in the 2016 study, but still in sharp contrast to the US where it is essentially 0%). Where there is a definition, Canadians are still open to including “prospects” (up to 35% from 30% in the 2016 study, whereas US deals included “prospects” in only 15% of deals). Negotiating “prospects” can get fairly animated, as the seller will want to exclude on the basis that it is too vague and forward looking, giving the buyer an unreasonable right to walk away from a transaction. On the other hand, the buyer wants the definition to capture events or circumstances that have not yet, but may in the future, result in a materially adverse change. Some of the explanation for the difference can be found in the inclusion of more specific forward-looking language in the definition, which is only found in 69% of Canadian deals but 96% in US deals. Forward looking language generally takes the form of including “could reasonably be expected to be” a MAC. Canadians are less concerned about war and terrorism than Americans; a carve-out for such events was included in only 51% of Canadian deals (down from 74% in the 2016 study). Finally, Canadians include changes in accounting as a carve-out from MAC clauses in 41% of deals while Americans include it in 89% of their deals.
Representations and Warranties
The practice in Canada and the US with respect to representations and warranties is largely the same and steady, but there remain some notable differences. It is less common in Canada to include a “no undisclosed liability” representation compared to the US as it is included in only 79% of deals compared to 97%. In addition, where such a representation is included, it is qualified by knowledge in 12% of deals in Canada and only 4% in the US. Oddly, the inclusion of a representation related to compliance with laws fell to 89% from 96% in the 2016 study. It is included in virtually every deal in the US and that was the case in Canada in prior studies. Finally, a Canadian deal is more likely than an American deal to include a full disclosure representation (38% in Canada and 26% in the US, largely unchanged from prior studies).
While still not as prevalent in Canada, the representation and warranty insurance market is catching up to that of the United States. Similar coverage at comparable premiums is available for Canadian M&A transactions with limited exclusions from coverage. The result is that strategic decisions for auction processes in terms of continuing liability of sellers can be quite similar to US deals.
Closing Conditions
There are two notable differences between Canada and the US in terms of closing conditions. First, Canadian agreements are far less likely to include a “double materiality” carve-out in the bring down condition that representations and warranties are true (such a provision is included in only 39% of Canadian deals compared to 87% in the US). Could it be that Canadians agree with noted drafting scholar Ken Adams that double materiality is a figment of practitioner imagination? See https://www.adamsdrafting.com/double-materiality-is-a-figment-of-practitioner-imagination-qed/. The other major difference is that Canadian deals are more likely to require opinions from counsel compared to US deals (18% compared to 7%). That said, Canadian practice would appear to be moving toward US practice as the number of deals requiring opinions dropped in half since the 2016 study.
Sandbagging
Sandbagging in the M&A context refers to closing a deal knowing that a representation is untrue and then suing after closing on that basis. This is a very thorny issue to negotiate, as the parties need to consider suing each other and that one might not be truthful in their representations. As a result, the inclusion of sandbagging provisions (pro or anti) fell in Canada to 34% from 46% in the 2016 study. A notable difference in Canada and the US is that “pro” sandbagging provisions are found in only 22% of deals with sandbagging provisions in Canada, compared to 42% of deals in the US. While beyond the scope of this post, it is important to consider the jurisdiction of the agreement in terms of if a court will take a contract-or tort-based approach to considering a sandbagging claim and how that could impact the drafting of an agreement.
Indemnity Caps
Indemnity provisions and their limits remain a keen focus of users of deal point studies. Historically, Canadian deals tended to be far more generous for buyers than those in the US. An indemnity cap of the purchase price remains more common in Canada than the US (13% compared to 4%). That said, capping recovery to the purchase price is becoming less common in Canada as the prior study showed that 18% of Canadian deals had a cap of the full purchase price. The trends continue once one examines the numbers for something less than the full purchase price. For example, a cap in the US of 10% of less represents 73% of deals, whereas in Canada a cap of 10% or less only captures 33% of deals. Notably, that reflects a large increase in Canada, as the prior study showed only 18% of deals having a cap in that range. The difference in caps is likely attributable to the number of small deals (48% are under $50 million) included in the Canadian study.
Conclusion
Although buying a Canadian company represents a foreign transaction for American buyers, the similarities in law, culture and geography make the process relatively seamless. Fasken is a leading full-service law firm with offices in all the major commercial centres in Canada. Our firm has deep bench strength and is involved across our border. Whether we are leading a transaction, or providing the support needed in Canada as a trusted partner to a transaction team, we ensure that deals are done in real time with the highest levels of service and advice. Gesta can be reached at gabols@fasken.com and Neil at nkravtiz@fasken.com.