Mitigating Risk in Mergers & Acquisitions

Rob Brush:

Whenever you have down markets, recessionary environment, you are likely to see an increase in litigation. Or an increase in certain types of litigation, and M&A litigation being one of them.

Narrator:

Welcome to Accounting for the Future, A BDO Canada podcast for financial leaders to navigate change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday, but we'll definitely have to manage for the future.

Armand Capisciolto:

Hello, and welcome to Accounting for the Future. I'm your host, Armand Capisciolto, BDO Canada's National Accounting Standards partner and leader of Accounting Advisory Services.

On today's episode, I'm joined by Rob Brush, a partner at Crawley MacKewn Brush LLP, specializing in corporate and securities litigation. And Michael Morrow, a BDO partner who provides financial advisory services specializing in capital markets and M&A, mergers and acquisitions.

Today we're going to talk, have a very interesting conversation about avoiding litigation in mergers and acquisitions. Rob, Michael, welcome to Accounting for the Future.

Rob Brush:

Thanks very much, Armand, really happy to be here.

Michael Morrow:

Likewise, great to be here. Thanks, Armand.

Armand Capisciolto:

Yeah, and Rob, you're a litigator, and so I really appreciate you being here. Because this conversation, what we're hopefully going to convey to the listeners today, is avoiding litigation. So, the goal of today's discussion is to help companies avoid having to call someone like you. So, I really appreciate you taking the time when that's the goal here.

But I think I'll start off with a question for you, Rob. When you think of the litigation related to mergers and acquisitions that you work on, what are the main causes of that litigation?

Rob Brush:

That's a good question. I mean, the causes can be as varied as the problems that arise in the company that was acquired. But I think if I was to identify a commonality, it would be something unexpected. It would be surprises.

So, whether that's unexpected litigation that hadn't been disclosed, some kind of contingent liability that came up where they thought the contingency, the contingent event wasn't going to happen, or maybe it's an earnout that they didn't expect to work out quite the way it did. In every case, it's typically something surprising and unexpected that they then have to grapple with.

All right, well, who in the deal bore the risk of that?

Armand Capisciolto:

Yeah, it's interesting. No one, well, I guess we all like pleasant surprises. But I think that the surprises you're talking about there aren't necessarily pleasant ones for one of the parties, and therefore leading to litigation. So, Michael, you work with companies on both the buy and sell side of these transactions. When you're working with a company, what do you advise them on? What can they do to avoid these types of surprises?

Michael Morrow:

I think there's a number of strategies that we talk to clients around really reducing the risk of a transaction. And it's all about being prepared and having a management team in place that can work through a transaction process and having good-quality information.

The diligence process that buyers go through is very robust and detailed, and so having good information systems that provide robust, high-quality, and accurate information is really critical.

The data that's supplied through the diligence process actually becomes schedules to the purchase agreement, which are relied upon from a litigation standpoint. And so, the more information you can provide, the higher quality information that you can provide, and the better disclosure as it relates to M&A, really decreases the risk of a transaction and some ambiguity around the information and the disclosures that are made.

And so really understanding what's going to be asked, and what's available to provide in terms of information. Identifying those gaps and then trying to resolve those gaps in advance of a sale process or an acquisition process is really key.

Armand Capisciolto:

That's interesting. Can I talking about the quality of information, you both know that my area of expertise is accounting and financial statements. So, for me, financial statements are the most important thing in the world, even though to no one else, they are. But to me, they definitely are.

And I would assume financial statements are a big piece of the ... Obviously, it's one of the key pieces of information that any company is making in assessing whether they're going to buy another company.

And one of the things that I've seen over the years is companies who don't necessarily prioritize their financial reporting, their financial statements until they need to. So, it is just a compliance exercise, it's just something you have to do, until someone's trying to buy them and they now want audited statements.

I guess Michael, do you see a benefit and maybe less risk for companies that are doing, I'm going to say, doing the right thing? And that's just because I think financial statements are the most important thing in the world. But are taking care of their financial reporting needs in advance, versus the ones that are maybe just kind of like, oh, I need to do this now because a potential acquirer wants it.

Michael Morrow:

A big part of the information that's going to be requested in a transaction is financial related. If you look at all the items of a information request list that'll be asked by the diligence team, two-thirds of that is financial related. So, it is heavy on that piece, and therein lies a lot of the potential risk as well. Having audited financial statements, again, this is about risk and risk for the buyer. And they'll look at what's been done from a financial management of the business and the quality of the information that's been provided. And having an audit certainly provides a buyer with a level of comfort and reduces the risk.

A lot of the information, or some of the information that buyers will ask for in diligence, is very similar to what's being provided for an audit. So, there is certainly synergies there, in terms of selling your business and having that information pack already that you provide to the auditors. It's very similar pack that you provide to a potential buyer.

And so, there is synergy there in terms of the level of effort and preparedness to do an audit. And the same information is then passed on to the prospective buyer. But it also gives you an opportunity to identify issues, risks in advance of a sale process. And so that's critically important as well. You want a process that runs smoothly and there's no surprises. And certainly, having audited financial statements can help.

Another aspect is that non-audited financial statements can be fine for owner-operated businesses. It allows them to get the information that they need to run the business. But if you're considering a sale of the business to an American or international company, they have different expectations. And certainly, certain buyers will expect that the business be audited in our market, that's not necessarily required. But for international buyers, that's the expectation, rightly or wrongly. And so, when they see a business that's not audited, they immediately see the risk.

And in particular, if it's a publicly traded buyer, they're going to require an audit, typically, of the closing balance sheet if it's a material acquisition for them. And so, part of the diligence and acquisition process may entail an audit in any event if that's the type of buyer that you're going to.

So, thinking about the requirements, who is the buyer population, what quality of information do you have to get through a diligence process is important. And if it's not, if your business isn't audited, we can do something that's called Vendor Diligence Process, where we go in and do diligence on the business as if we were a buyer. But getting an audit done is a great place to start.

Armand Capisciolto:

Yeah, it's interesting that you bring up kind of certain acquirers. If you don't have an audit, they'll walk away, or they'll make you get that audit before closing the deal. Although not the topic for this discussion, because we're focused on litigation risk here.

I've seen deals fall apart because they don't have that. Because it might take too much time, pricing changes, whatever. So other risks as well, of not having your financial reporting aligned.

Michael Morrow:

The first thing they ask when they see its non-audited, they'll ask, why isn't it audited? And then, I have to explain why that's not necessarily the case in Canada. But it's certainly something that they pick up on.

Rob Brush:

Well, certainly, if you've got higher-quality financial information available to the purchaser, then you're reducing your risk of surprise, so you're reducing your risk of litigation.

But I can tell you that, Armand, I know that financial statements are near and dear to your heart just because of how you've chosen to spend your professional life. And I can tell you they're near and dear to a litigator's heart, too, because that's the first place we look. And that's usually the centerpiece of the trial. So, I would also emphasize that having quality financial information and quality financial statements is, that's a must.

I'm a little more sympathetic to the marketplace out there when they don't want to pay for audits because audits are very expensive. But you run a greater risk, I get that. But these risks of surprise we're talking about, you can mitigate that risk somewhat, the risk of litigation, with reps and warranties insurance after the fact. Or you can look at arbitration clauses.

Now we're drifting away a bit from strictly talking about financial statements and financial information. But it's important for the listener to know that there are ways to try and address these risks in addition to making sure you've got the quality statements, to begin with.

Armand Capisciolto:

Yeah. And it's interesting that you bring up the dispute resolution process, maybe using arbitration instead of going to the courts, reps and warranties insurance. Because you can never eliminate all risk. There's always going to be some risk, even if you do everything right. And there are other mechanisms that you described, Rob, that to manage to manage those other risks, right?

Rob Brush:

Yeah. And so, reps and warranties insurance it's becoming more and more common in Canada. And it can certainly help. It's not the complete answer. Arbitration clauses can help. Because an arbitration clause assumes a dispute could happen. And then, if a dispute does happen, it provides a process that's faster, cheaper, and hopefully less distracting than full-bore litigation in court. And that the best arbitration clauses include a resolution process that before you can even launch the formal arbitration. And arbitration is simply a private trial where the parties agree to hire a judge, or usually a retired judge, to judge their case rather than go through the court process.

And the best clauses, before you even get to hire that private judge and sue the heck out of each other in court, is you have to engage in an exploration of, is there a business solution that we can get to before we do that? And the more sophisticated the client is, the more experience they have with litigation and lawyers like me, the more inclined they are to really try and find that business solution first. And only go to us as a last resort.

Armand Capisciolto:

Yeah, that's great advice. It's interesting, Rob. Because you were talking about the surprises earlier. And we were talking about financial statements. I'm going to bring it back to financial statements, even though you went off. But I'm going to come back to some other stuff that relates more to the legal side of it.

A lot of those surprises, whether it was an earnout arrangement, or a working capital adjustment, or even unrecorded contingencies, a lot of those potential surprises are all things that should be in the financial statements. And we've seen some clauses.

At least, I've seen some clauses, or I've actually been fielded some calls, where in the agreement it'll actually have provisions related to accounting type of disputes. And they will actually name; if a dispute arises, we will go to this accounting firm as an independent accountant to help resolve it.

And sometimes I'm just get a call, and I'm like, oh wow, our name, our firm's name was in there, and we didn't know anything of it. It might just be because some of the other firms were all conflicted out, and they put our name in. But is that something that you see in the deals that you're involved in?

Rob Brush:

Yes. It's not as common as, for example, an arbitration clause. But as a dispute resolution clause, it can be really effective. And what those clauses try and do is, think of it as cutting to the chase. They know you're going to end up either in court, public court, or in a private arbitration, and you're going to be arguing over the interpretation of an accounting rule and the application of standards.

And you're going to be arguing over that. And what they're saying is, let's identify in advance a third party like Armand at BDO, who we trust, and let's agree that we're going to go to that entity and have them tell us who's right and who's wrong as a way of cutting to the chase and getting to a resolution that's going to be less expensive and less costly. And also in terms of time and distraction.

So that's really oversimplified.

Armand Capisciolto:

Yes.

Rob Brush:

Because there's usually...

Armand Capisciolto:

Yeah. But informative. But still informative.

Rob Brush:

But a lot of, there's usually a lot of conditions around that kind of clause. And it's rare that they're just going to put the dispute entirely in the hands of X accounting firm, even if it's a firm as good as BDO, and not have any kind of avenue of redress if they don't agree.

But those clauses can be really effective, and they can really help people get to that what I call that business solution without having to engage in a couple of years of costly litigation.

Armand Capisciolto:

And it does take time that anytime we're talking about litigation. And that in itself creates risk as distracting from the business.

Rob Brush:

Absolutely.

Armand Capisciolto:

As you both know, the markets are what they are right now. Dealing with some inflation, dealing with rising interest rates, supply chain, are we already, or are we going to be in a recession? All these things are happening.

And I would assume in this type of environment, if I closed a deal a year ago, merger and acquisition a year ago, and I'm looking at what I expected the results to be a year ago and what those results actually are, might be significantly different, because of the current economic environment we're in.

Which may or may not be a surprise. We're going to stick to that, the surprise theme here. Rob, when you ... Does this increase the risk of litigation? Do you see more litigation in this type of environment, less litigation? What does this type of environment do to the prevalence of litigation in these types of transactions?

Rob Brush:

Well, certainly, for my firm, we specialize in complex corporate and securities litigation. And recessionary environments, bear markets, black swans, all of those tend to increase litigation because they reveal problems, or gaps, or issues with a company that were being papered over by good markets.

And so, I would say yes, whenever you have down markets, recessionary environment, you are likely to see an increase in litigation. Or an increase in a certain types of litigation, and M&A litigation being one of them.

Armand Capisciolto:

Interesting. And Michael, when you're thinking about advising either a company buying or selling in this environment, is there anything different in the type of advice you're providing in this environment than the advice would've been providing two years ago? Or, well, even before then, even pre-covid type of environment.

Michael Morrow:

You kind of have to ebb and flow with the market dynamics. And I think when things were a bit more of a frenzy pace last year, if you're in a competitive environment, you had to move quickly. I'd say the environment now is much more cautious and less competitive.

And what that allows you to do is have more time to do thorough diligence process. And so that allow you to do more work over a longer period of time than you otherwise would have. And competitive environment, your diligence timeframe could be as low as two or three weeks to a month.

And now the standard is more normal, which would be typically a 60-day diligence period. So, compare and contrast different environments and intensity of the market will allow you to adjust your plan. So, these days, compared to last year, you can certainly do more work, reduce the risk because the competitive tension is lessened in the market right now.

Armand Capisciolto:

Yeah, it's interesting. In a competitive market, you just got to get the deal done, right? Because there's other things happening, and if you take your time, you might miss out on a deal.

That's a much different environment now, where it's not as competitive, giving more time. You can do more diligence; you could potentially make better decisions in these. And I would think better decisions lead to really reduce the risk of litigation.

Rob Brush:

Look, I agree with that. And I think one of the best things you can do to avoid litigation is get the right advisors in place. And I'm not talking about lawyers like me, who are litigators. Litigators, all we see are problems. And once we're engaged, it's almost too late to avoid the problem, almost.

But I'm talking about getting the right kind of advisors in place so that the problem never materializes. And whether that's accountants like yourselves, or good corporate lawyers, investment bankers, you want to use experienced professionals who can guide you through the M&A process. In my view. That's one of the best ways to avoid litigation.

Armand Capisciolto:

Yeah, no, I think you're right, Rob. We often, at a certain point, things are going to cost money, right? It's kind of pay now or pay later. And I think if you pay later, you might be paying more, especially if it's litigation. Because litigation is what it is, it's not an inexpensive ordeal.

So, with that, Rob, Michael, anything you want to leave our listeners with? Any last thoughts you want to leave our listeners with today?

Michael Morrow:

Sure. I'd say similar themes that we've been talking about, make an investment upfront. I know you'll spend some dollars but do it right. Most of our clients really only have one opportunity to sell the business. So, spend some money, get the right people around you to do it right.

I'd say most of our clients, around 75% of those, are selling their business because they're looking to retire. And they want to retire in peace. They don't want to have to be dealing with disputes, litigation after they've sold the business and want to enjoy retirement. So, spend some time and money investment upfront to do it right. The process will go smooth more smoothly. You'll likely increase the value, ultimate value of the business and decrease the risk of litigation thereafter.

So definitely get the right people around you, help plan for this really important transaction. But that's how I would leave it with the listeners today.

Rob Brush:

And I'd build on that. And I would say, all right, and then if you are so unfortunate as to have a problem arise where there is something unexpected has happened, and there's a dispute over which side of the deal bears the risk for that unexpected problem, try and take some of the emotion out of it, and approach the dispute the way you approach the original deal. Take a hard look at the realities of the dispute and try and find a business solution.

And I know I've said that earlier, and it sounds like a catch-all phrase. And it is a bit. Because on a podcast like this, we don't have time to go into the gory details. But when I say try to find a business solution, it's, look for common ground and ways in which you can resolve the dispute where everyone walks away a little bit unhappy. That's often the fair result.

Armand Capisciolto:

If everybody's a little bit unhappy, it also means they're a little bit happy too. Right?

Rob Brush:

Exactly. And you'll be a lot happier than at the end of a trial. Where if you go all the way to the end of a trial, which is like one out of 20 cases, it's a binary outcome. You're either very happy or very unhappy. But 19 to 20 cases settle, and they typically settle with everyone being a little bit unhappy. So, see if you can get to that point at the beginning rather than going through all the pain of the litigation process.

I don't sound like ... It's not a very good advertisement for what we do, but it is the truth. You want to avoid having to use me if you can. And if you do find yourself in litigation, then you want to use counsel who are going to try and cut to it as soon as they reasonably can. And then if you can't, you've done what you ... You've done your best, and move on and win the case.

Armand Capisciolto:

Okay. Well, this was great, guys. Rob, Michael, thank you so much for your insights on this topic. I know I enjoyed it. Our audience, I just assume they're going to enjoy it because I just assume they enjoy all our episodes. And they really appreciate your time and your expertise.

So, I'll thank the listeners for tuning in today. I'm Armand Capisciolto. This has been BDO's Accounting for the Future. Please let us know if you found this topic interesting and useful and remember to subscribe if you liked it. We'll see you next time.