Our Doing Business Globally program will offer insights into the trends and best practices that will influence your cross-border investments and commercial decisions. One area of focus will be how to maximize opportunities and minimize risk in cross-border transactions.
Below, Baker & McKenzie Partners Jorge Gonzalez and Roger Bivans discuss five ways that M&A in Latin America differs from the US. This article first appeared in the ACC Dallas-Fort Worth Chapter’s Fall Newsletter.
Mr. Gonzalez and Mr. Bivans will serve as panelists at Doing Business Globally in Dallas discussing cross-border deal terms in Session III.
FIVE WAYS M&A IN LATIN AMERICA DIFFERS FROM THE US
By Jorge Gonzalez and Roger Bivans
Latin America is expected to continue to present one of the best opportunities for investment and M&A transactions in emerging markets. With a few exceptions (notably Venezuela), there is generally stability in most of the region. Argentina has a new more business-friendly government led by President Macri, and the political crisis in Brazil appears to have turned the corner with the recent impeachment of President Rousseff.
There could still be opportunities for companies to acquire assets at bargain prices, even though commodity prices are expected to stabilize and the price of oil is expected to bounce back next year. As credit continues to remain inexpensive and growth remains flat, companies may take advantage to pursue deals in Latin America. All of this bodes well for M&A transactions in the region. This article highlights five key issues and challenges that commonly arise in negotiating M&A transactions in Latin America:
- the practical remedies for enforcing contractual terms
- the complexity of implementing a deal structure that satisfies the global tax goals of the parties
- the challenges in conducting due diligence
- the complications and timing consideration of required regulatory filings or approvals
- the formalities and other requirements for closing of the transaction
1. PRACTICAL ENFORCEABILITY ISSUES
A key consideration in negotiating the terms of a cross-border transaction is how certain provisions would be enforced in practice in a foreign jurisdiction. All Latin American countries are civil law jurisdictions – they do not apply the common law principles familiar to US practitioners. Even if you are able to negotiate provisions favorably on paper, there are some important realities regarding the remedies for enforcing contractual rights in Latin America that can affect how the negotiated provisions are ultimately enforced in practice.
For example, damages are generally difficult to prove and consequential and punitive damages are not recoverable in most Latin American countries. For this reason, penalty clauses, which are usually unenforceable under US law, are commonly used in Latin America. Injunctive relief, specific performance or declaratory judgment are some times difficult remedies to obtain in Latin America or simply not available under local law. This means that the remedies for breach of contract may be limited to the recovery of actual damages, which may not be appropriate for some issues, such as disclosure of confidential information or enforcement of non-compete covenants.
In addition, court decisions in Latin America rarely become case precedent that can be used to help define standards of materiality or interpret common provisions in M&A agreements. Court proceedings also can take a long time, evidence rules are formalistic and discovery is limited. In other words, it is very difficult to resolve disputes through the courts. Fortunately, a choice of US law and arbitration clauses are generally enforceable in most Latin American countries, and are becoming more common in cross-border M&A agreements in the region. Nevertheless, while arbitration can mitigate some of the risks, even enforcement of an arbitral award in a Latin American jurisdiction will ultimately depend on the local courts and the available remedies.
These realities can affect whether to insist on an escrow of the purchase price, the extent of indemnification and any caps on liability, whether to negotiate a special mechanism to enforce shareholder rights, and even the value of reps and warranties and the need to conduct a more thorough due diligence. Several years ago we helped a multinational company negotiate a joint venture in Latin America. At the time, we identified the enforceability issues relating to shareholder rights and recommended organizing the joint venture company in an offshore jurisdiction, where it would be easier to enforce the shareholder and board governance provisions agreed by the parties. We also negotiated an intellectual property license agreement with strong contractual remedies due to the difficulties with enforcement of the joint venture agreement provisions. Unfortunately, a significant dispute eventually arose between the parties but because of the special steps taken by the client regarding enforceability, our client was able to quickly reach an acceptable resolution with the other party to unwind the joint venture. Had the agreement incorporated customary US deal terms, this result would have been much more difficult to achieve.
2. STRUCTURING AND TAX PLANNING
The complexity of US tax and accounting rules often plays an important role in how M&A transactions are negotiated and structured. This can become a challenge in Latin American transactions as often the structure that is beneficial for a US buyer from a global tax planning standpoint can become problematic for a Latin American seller. For example, a US buyer may wish to structure a joint venture through an offshore holding company, so as to make the structure more efficient from a US tax standpoint. But this could cause tax problems for a local joint venture partner, as distributions to the JV may be adversely taxed locally. In addition, structuring the transactions as an asset purchase may be better for a US buyer but it may have adverse local tax consequences for the seller or may be more complicated to close from a local perspective because of the need to specifically list all assets and obtain new permits and licenses, if they are not assignable. In addition an asset purchase in Latin America does not necessarily isolate the tax risks of the Seller. Trying to accommodate the tax goals of both parties can be difficult and result in more complex structures, which could in turn raise even more challenging issues and potentially delay closing.
As a result, analyzing the tax implications for the Latin American counterparty should be done early on, as it would be much more difficult and time consuming to negotiate the deal if objections to the proposed structure are raised at the later stages of a deal. Nevertheless, it is also important to maintain flexibility to change the structure based on how the transaction unfolds, as the results of due diligence or regulatory approvals could have an impact on the desired structure and it may not be possible to know some of these issues in advance.
3. CONDUCTING A COST-EFFECTIVE DUE DILIGENCE
It is somewhat ironic that, while reps and warranties may be of less value in some cases given the enforcement issues discussed above, which would typically justify a more exhaustive due diligence, the main challenges with due diligence in Latin America is that it can be time-consuming and difficult to identify problems or quantify the resulting risks or potential liabilities. This will require a buyer to achieve a careful balance between obtaining broad reps and warranties and appropriate indemnification, on the one hand, and prioritizing and scoping the due diligence exercise to focus on the key issues, on the other. The following are examples of some of the challenges that can arise in the key areas of due diligence in Latin America.
For a US company, anti-corruption compliance continues to be at the top of the list of areas to cover in a risk-based due diligence. Most countries in the region still rank high in terms of corruption risk. As a result, US companies are well-advised to be methodical about anti-corruption due diligence. This will often involve asking for a significant amount of information and require the seller to devote a lot of resources to this area. Forensic experts may be needed to vet the target’s practices from an anti-corruption standpoint. In many acquisition, in particular when the target is a family-owned business, the seller may be surprised at how rigorous the due diligence in this area can be, and this can cause an erosion of trust between the parties. Because of this, it is important early on in the transaction to explain to the seller in an objective manner the importance of anti-corruption diligence for US companies to avoid the perception of a lack of trust in the seller.
Tax is another important area of due diligence in Latin American countries. It is not uncommon to find questionable tax avoidance practices that could often result in significant liability, which are difficult to detect. In a due diligence of a Mexican company several years ago, we found a significant amount of commissions being used as tax deductions to minimize the target company’s income taxes. All of the commission arrangements were properly documented and no corruption issues were initially detected from a review of the documentation. However, during an in-person interview, one of the financial managers of the target mentioned that the commissions were not as high of a cost as it seemed because the commission agents were friends who were expected to return most of the funds back to the company. The manager insisted that everything was properly documented, though, and did not understand that the practice amounted to tax fraud.
Labor and employment is another challenging but important area of due diligence in Latin America. The protective labor laws of most Latin American countries make it difficult for companies to avoid having many issues in this area. But sometimes what appears to be a significant problem can be managed with the proper understanding of the risk and local practices in this area. In a due diligence of a Brazilian company a few years ago, a client was extremely surprised to find that the target company, a company of about 800 employees, had over 50 pending employment court cases with former employees. At first the client thought that the target had a significant problem with its employment practices, to the point that it almost abandoned the transaction. A closer look at the issues, however, revealed that many of the cases were still being pursued for strategic reasons, and that, in Brazil, many companies have that many pending employment cases, as some of these cases can take almost 10 years or longer to resolve. Closer examination and understanding of the issues allowed the client to get comfortable with proceeding with the transaction.
The above examples show why proper scoping and understanding of the real risks in the key areas are crucial elements to be able to conduct a cost-effective due diligence in M&A transactions in Latin America.
4 . REGULATORY APPROVALS – TIMING CONSIDERATIONS
Another challenge in Latin American countries is the delay that may be caused by certain regulatory approvals needed to close a transaction. The most common regulatory approval requirements typically arise under local competition law, which may require that the transaction be notified to or approved by the local competition authorities if certain asset value or revenue thresholds are met by the parties. Foreign investment or exchange control approvals are less common these days but may still be triggered in certain countries, in particular in certain industries. For example, in Argentina, a foreign company must first register with the public registry of commerce in order to acquire shares of a local company, which can be a time-consuming process. In addition, depending on the industry and structure of the deal, certain key regulatory approvals may be necessary for closing.
These potential approval requirements can significantly delay closing in most Latin American countries. While the competition laws of some countries impose specific and relatively short time frames for the authorities to clear a transaction, it is not difficult for the authorities to get around these mandatory time frames and extend the review process by simply making certain specific requests from the parties. The delay can result in reps and warranties becoming stale, raise additional anti-corruption compliance issues, and have other significant adverse effect on a transaction.
5. CLOSING FORMALITIES AND OTHER RELATED ISSUES
Most Latin American countries require more formalities than the US to execute documents and close a transaction. Many transaction documents must be notarized locally (i.e., put in the form of a notarial deed) or registered with a public register in order to be valid or have legal effects under local law. In Latin America, notaries, who are normally lawyers, have significantly more power, authority and responsibilities than notaries in the US, and they can often raise questions about the provisions of an agreement if they believe it does not comply with local requirements or simply because the laws requires them to verify certain obligations.. In addition, public registries, like local courts, are often backlogged with filings, which can result in significant delays in registration of certain documents. For example, in Mexico a merger is not legally effective until the merger agreement is registered with the public register of commerce, and that registration can often take longer than two months. In addition, documents executed in the US may first need to be legalized in order to be valid or recognized in a Latin American jurisdiction. Legalizing a document in the US normally involves notarization, certification by a county or state agency, and consularization by the consulate of the country where the document is intended to be used. For many countries, the legalization process can be expedited by getting the document apostilled, a much faster process than consularization, as a result of the Hague Convention on the Legalization of Foreign Public Documents, but for countries that are not signatories to this treaty the legalization process can be time-consuming.
It is also very important to confirm that the person signing on behalf of a Latin American party has the necessary authority to bind its company. To legally bind a company in most Latin American countries, the signatory must have actual authority to sign pursuant to a power of attorney or the appropriate corporate action. Latin American countries generally do not recognize the US concept of apparent authority that would normally allow an officer of a US company to bind the company simply by virtue of his or her title.
In addition, having to negotiate the transaction documents in both English and Spanish or Portuguese can present an additional challenge. Obviously, local language and translation resources will be needed as part of the due diligence, but in general it is possible to negotiate the main transaction agreements solely in English, assuming the agreements are not subject to local notarization or registration. However, a local court will only interpret an agreement based on a local language version or its official translation, so even if the main transaction documents are negotiated in English, it is important to address who will have control over any translations required for any local proceedings, to make sure the translations are accurate.
ADDITIONAL OBSERVATIONS ON LATIN AMERICAN PRACTICE
The Baker & McKenzie guide, “Customary Issues in Negotiating Cross-Border Acquisitions,” provides a useful resource to understand the key differences in M&A transactions around the world. The guide, which covers over 35 countries, including the US and seven Latin American countries, was based on a survey of local practitioners regarding whether certain terms that are typical in US M&A transactions are common or not under local practice. The terms surveyed include the use of purchase price adjustments, earn-outs and escrow accounts, having no “material adverse event” as closing condition, and provisions regarding reps and warranties, such as covenants to update them, level of materiality and knowledge qualifiers. It also addresses limitations of liability, including caps, deductible baskets, and de minimis indemnification claims, mitigation of damages and “anti-sandbagging” provisions, as well as governing law and procedures for dispute resolution.
While some differences between US and Latin American practice do exist, they are not as significant as one would expect, and the trend is for the US practice becoming more common or accepted in Latin America. Notably, in many Latin American countries, it is uncommon to include an express set off of indemnity claims against tax benefits, insurance proceeds or third-party recoveries of the buyer, or an obligation to mitigate damages. The common law obligation to mitigate damages does not exist in most civil law countries. Another difference was that in some Latin American countries earn-out provisions are not yet that common.
Part of the reason why there are not that many differences in the deal terms used may be attributed to the globalization of transactions in the last decade, and the fact that parties, even in small transactions, have become more sophisticated and open to using the US standard as the model for M&A transactions. Nonetheless, a great deal of complexity remains. In a recent Baker & McKenzie global survey on the complexity of M&A transactions (from a US outbound perspective), countries were classified in 5 different bands, with band 1 being for countries representing less complexity, like Australia, the UK and Canada, and band 5 for countries with the most complexity, like Russia and China. The key countries in Latin America were classified in either band 4 (Argentina and Brazil) and 3 (Colombia, Chile, Mexico, and Peru), which still represents a high-degree of complexity.
CONCLUSION AND BEST PRACTICES
The globalization of M&A has resulted in cross-border transactions having more common elements, at least in terms of how key deal terms are negotiated. However, there are still challenges in doing deals in Latin America that can make the transaction more complicated and require more preparation and the right allocation of resources to achieve a successful closing. Understanding the key differences from the outset can help make negotiation of a deal easier and set realistic expectations for closing. The following are some best practices that will help address some of these challenges in the Latin American region:
- Proactively manage and anticipate the differences to minimize deal disruption and maximize deal success.
- Take time to understand the different perspective in the transaction and practical remedies and leverage them to your benefit in negotiations.
- Carefully review the tax considerations of both parties and agree upon the deal structure at the outset while maintaining flexibility during the transaction.
- Properly scope the due diligence by identifying and focusing on key areas of risk.
- Identify and develop an early plan for obtaining any required government approvals.
- Map out and carefully plan for closing by identifying all closing logistics and do not overlook formalities, authority of signatories, and the possible need for translation of transaction documents.