Liability limitations in contracts
Energy and Resources M&A Transaction Guide
Liability limitation concepts in contracts
How to limit your liability without killing the deal
ABOUT THE GUIDE
- This is the second volume of McCullough Robertson’s Energy and Resources M&A Transaction Guide developed for the resources sector.
ABOUT EDITION 2
- Regardless of whether you are selling or buying, the crafting of warranties requires careful consideration and negotiation. In this Edition, we look at some ways you can limit your liability without killing the deal.
- We’ll wrap up this second volume of the Guide with a Masterclass in Brisbane and Sydney in 2018 where you can ask our expert panel any questions related to undertaking an M&A transaction. Dates will be announced in 2018, but you can register your interest for Brisbane here and Sydney here.
In the first volume of our Energy and Resources M&A Transaction Guide, we discussed potential deal killers in the context of energy and resources industry mergers and acquisitions. In this edition of the second volume, we take a closer look at liability limitation concepts and how to limit your liability without killing the deal. We will start by looking at general principles of liability limitation, and then consider how the chain of responsibility legislation recently introduced in Queensland impacts on these matters.
Liability limitation concepts
Parties to a sale transaction use warranties to attempt to fill the void between the knowledge of the buyer and the seller. Even the most comprehensive due diligence review cannot hope to capture all potentially relevant matters, nor can it possibly identify the way in which a party may act in the future. Warranties allow a party to give comfort to another party that a state of affairs exists, will continue existing, or will exist in the future (that is, at completion of the transaction).
In addition to bridging the knowledge gap, warranties allow for the allocation of risk between the parties, with the party giving the warranty bearing the risk that the warranty is incorrect.
Typically, sellers will offer warranties as to their legal capacity, title, compliance with the law and accounting policies, the state of repair of assets or enforceability of rights and entitlements. Buyers will normally warrant that they are legally capable to enter into and perform their contracted obligations.
Parties will often spend significant time and effort negotiating the warranties and the limitations on those warranties. Generally, parties to sale transactions look to limit their liability using:
- knowledge qualifiers for warranties (that is, statements like ‘to the best of the seller’s knowledge’)
- disclosures made in due diligence or in the transaction documents (including disclosure letters), and
- liability caps and time limits.
Warranties: knowledge qualifiers and disclosures
It is becoming common for sellers to qualify warranties by those matters of which the seller has actual knowledge. A knowledge qualifier further protects the seller because to succeed in a warranty claim a buyer has to establish a breach of the warranty and also that the seller had knowledge of the circumstances leading to the breach. In these circumstances, buyers should seek to include a definition of the knowledge qualifier in the transaction document to require the seller to have taken reasonable care to discover the relevant facts before it can get the benefit of the qualifier (for example, phrases like ‘to the best of the seller’s knowledge’ include all matters within the knowledge of the seller after making reasonable enquiries and undertaking reasonable searches).
Warranties provide the seller with an incentive to reveal relevant information about the target or assets because a disclosure made to the buyer cannot form the basis of a claim. Once the warranties are agreed, the seller will make its specific disclosures, often in a disclosure letter. Specific disclosures will cross-reference particular warranties included in the transaction document. What specific disclosures to make and how much information to disclose requires a careful balancing act by the seller and its personnel: should all information the seller has be disclosed or only those matters in which the seller believes the buyer will be interested? The answer to this question will depend on the nature of the deal. Although, subject to the terms of the transaction document, disclosures made generally need to be full and fair and provide sufficient detail to enable the buyer to assess the disclosure.
Liability caps and time limitations
Other standard mechanisms to limit liability in a sale and purchase agreement include:
- a cap on the seller’s total liability to the buyer
- a minimum threshold and an aggregate threshold that must be met before the buyer can make a claim, and
- a timeframe within which any claim must be made against the seller.
These mechanisms to limit liability are negotiated between the buyer and the seller. Recent experience shows that caps can range from 30% to 100% of the purchase price. Timeframes for claims are usually split between claims for title warranties, claims for tax warranties and claims for the remaining warranties.
Regardless of the limit you are able to negotiate, it is important to carefully review all warranties to ensure that as the seller, you are able to give the warranties subject to any disclosures, and as the buyer, that the warranties give you sufficient comfort and protection following completion.
Despite the time often spent negotiating caps and other limits, claims for breach of warranty should always be considered as actions of last resort (particularly given the costs risks associated with litigation).
Impact of the chain of responsibility legislation
The new Queensland chain of responsibility legislation creates a series of new risks for parties to energy and resources transactions. Any new risks inevitably lead to novel warranties to neutralise, or at least apportion, those risks.
There has been a lot written about the changes to the Environmental Protection Act 1994 (Qld) introduced by the Environmental Protection (Chain of Responsibility) Amendment Act 2016 (Qld). In essence, this legislation gives the Government greater powers to enforce environmental obligations against parties other than the current owner and operator of resource projects. Relevantly for energy and resources transactions, if the current owner of a resource project is unable to discharge its environmental obligations, there are now circumstances in which the Government is entitled to look past the current owner to other parties to seek the fulfilment of environmental obligations.
The extent of this new risk is difficult to quantify because it largely depends on the individual circumstances of each transaction and, as the legislation is new, there are few examples to draw on. The starting position is that the Department of Environment and Heritage Protection (Department) can issue an environmental protection order (EPO) to a company carrying out the environmentally relevant activity (let’s say mining) and the related bodies corporate of that company. The new legislation also allows an EPO to be issued to ‘related persons’ of the original company.
A company’s ‘related persons’ include the company’s parent company, landowners (in certain circumstances) and persons with a ‘relevant connection’. According to the Department’s Guideline on issuing ‘chain of responsibility’ EPOs (Guideline), a person has a relevant connection with a company if the person:
- is capable of significantly benefitting financially or has significantly benefitted financially from the carrying out of a relevant activity by the company, or
- the person is, or has been at any time during the previous two years, in a position to influence the company’s conduct in relation to the way in which, or extent to which, the company complies with its obligations under the Environmental Protection Act 1994 (Qld).
If a person is considered to be a ‘related person’, there are still a series of determinations the Department needs to make before issuing an EPO but regardless, this new legislation creates risks for both buyers and sellers that need to be managed.
It is generally thought, but remains untested, that at a minimum the seller may be liable for environmental failures of the buyer for up to two years after the transaction, simply because they were in a position to influence conduct.
A seller providing vendor finance may even have future exposure because of the control that seller continues to hold. For example, a seller might retain some control over the activities of the new owner to, for example, protect the seller’s ongoing royalty. Considered in light of the chain of responsibility legislation, any input into the activities of the new owner may now mean the seller has a ‘relevant connection’ to the new owner and continues to bear the risk of failure of the new owner to meet the environmental obligations at the mine.
Some techniques which may help reduce a seller’s exposure under the chain of responsibility legislation include:
- extensive due diligence on the buyer to get comfortable that the buyer is able to meet the required obligations
- requiring the buyer to warrant that it has sufficient financial and technical capabilities to perform the obligations going forward
- an indemnity from the buyer’s parent company, or
- ensuring any vendor finance and post completion arrangements do not amount to a significant financial benefit.
From the other perspective, buyers are liable for any environmental issues that may arise after they take over the mine. Buyers could consider:
- deferring payment of part of the purchase price to be held in escrow until sufficient time has passed
- having the seller’s parent company provide an indemnity for compliance with pre-completion environmental liabilities
- ensuring environmental due diligence is thorough, and
- accepting the environmental liability for the time prior to completion and adjusting the purchase price accordingly.
As a general rule, it is important to consider what your potential risks are following the sale (including risks of the other party’s future behaviour) and how to put yourself in the best position going forward. It is also important to keep in mind that we are still seeing how this legislation will play out and how the Department may try to enforce environmental obligations.
Given the obvious tension between the position of a seller and a buyer, limitation of liability in a transaction needs to be done in a way that does not kill the deal. While parties may be anxious to press on and just get the deal done, care must be taken to cover off on potential liability traps at the time of signing and in the future. This is made more challenging by the new chain of responsibility legislation, and the way it potentially spreads risk far and wide. Regardless of whether you are selling or buying, the crafting of warranties requires careful consideration and negotiation.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.