Representation and warranty insurance reduces complexity in private company deal negotiations. However, because “known” liabilities are excluded from coverage, it does not resolve all complexity.
One common liability class that can cause problems are pre-closing tax liabilities discovered in buyer’s diligence. An increasingly common area are issues with state and local sales and use tax compliance.
The inherent complexity in complying with tax regimes across multiple jurisdictions means that even well-run companies often have sales and use tax exposures. The most common form of non-compliance by a company is a failure to identify that “nexus” exists with a state.
Until recently, nexus required physical presence in a state under the U.S. Supreme Court’s decision in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). While this standard was, itself, hard to comply with, the nexus analysis became even more complex after the Supreme Court’s recent decision in South Dakota v. Wayfair Inc., 2018 BL 219995 (U.S., June 21, 2018). In Wayfair, the Court—motivated by the explosion of e-commerce and the arbitrariness of the physical presence requirement—overturned the physical presence rule.
Now, a business needs to conduct complex and comprehensive analysis of the law in each tax jurisdiction. While a state’s reach is still theoretically bounded by constitutional limits, Wayfair declined to provide clarity on the extent of these limits. Unless a company wants to engage in the costly endeavor of litigating with a state (which is impracticable in the M&A context), it is functionally bound by a state’s asserted authority. In addition, a company that was historically compliant may be thrown out-of-compliance by Wayfair. The Court also declined to unequivocally provide that the decision only applies prospectively, which may exacerbate disagreements over liability assessments.
The problem in M&A deals is that this can result in ballooning and divergent calculations of contingent liabilities. A failure to file returns typically means a company is not protected by statutes of limitations. This makes them different than most contingent liabilities evaluated in connection with transactional diligence, which if not realized within a short time following closing (e.g., 2-3 years), are unlikely to materialize. These types of contingent liabilities may be easier for parties to allocate than sales and use tax liabilities. Additionally, because sales and use tax liabilities are often unbounded by time, small compliance issues can translate into large liabilities.
As a result, prospective compliance is often not a sufficient solution (and sellers often resist allowing a buyer to take positions different than those in historical tax filings). Buyers typically want to be proactive in cleaning-up identified sales and use tax compliance issues promptly after closing. The first step in the remediation process for companies in the business-to-business space involves obtaining compliance certificates from customers. A compliance certificate, stating that the customer has paid applicable taxes, can be provided to state authorities to demonstrate the target business does not have tax obligations in respect of revenues derived from such customer.
Where obtaining compliance certificates is not entirely successful or is impracticable (e.g., in the retail context), remaining liabilities are typically addressed by self-reporting through a voluntary disclosure agreement (VDA). Leniency can often be obtained from states in return for a VDA. This leniency could include limiting the look-back period for non-compliance, limiting the scope of any audit to the reasonableness of the company’s self-reported liability, waiving the application of penalties for non-payment, and sometimes reducing applicable interest (and, more rarely, waiving it entirely).
A VDA appears to be an easy answer. One complicating factor is that there is often information asymmetry (usually in buyer’s favor) when sales and use tax liabilities become a significant transactional concern. Sellers are put in the position of playing catch-up to buyer’s diligence and often do not have as solid a grip on potential exposure as does buyer. That is a scary situation for a seller. There are also frequently large gaps in buyer and seller liability assessments (even without the Wayfair wrinkle). From sellers’ perspective, a VDA allows a buyer to enter into settlements on the sellers’ dime.
Material Difference in Liability Assessments
When the difference in liability assessments is material, it can become a major sticking point. These liabilities can scuttle a transaction, or, in the best case, result in significant delay as thorny issues are negotiated. The type of issues that need to be negotiated include:
- Is the buyer permitted to pursue VDAs or does that cut-off indemnity coverage?
- If a buyer is permitted to pursue VDA processes, is it an unfettered right? Or does the buyer first have to try to mitigate exposure? Is a buyer limited to pursuing VDAs in specific states?
- What level of input do sellers have with VDAs? If sellers have meaningful input, what happens in the event of disagreement between the parties?
- Are sales and use tax liabilities backstopped by a special escrow?
- If there is an escrow, how long does it stay in place? Is it a general escrow? Or are there separate escrows for individual states?
- Is there an aggregate cap on sellers’ exposure? State-specific caps? Is the buyer required to bear any percentage of amounts paid as a result of any VDAs?
It can be difficult to achieve common-ground on these issues. Wayfair has made the problem more complex. While representation and warranty insurance does not solve these problems, “transactional risk insurance” products that ensure against known risks, may ultimately offer a solution. However, these products have not yet seen widespread adoption. Market participants view premiums on these products as too expensive, the underwriting process as too long or the conditions imposed by the insurer as too restrictive (i.e., the same concerns that limited receptivity to representation and warranty insurance a decade ago).
Time will tell if these broader products will evolve and enjoy more widespread adoption. It seems to us that sales and use tax liabilities might be a good place for insurers to wedge into the marketplace. An insurer has the opportunity to (1) arbitrage differences between buyer and seller liability exposure assessments on sales and use taxes, and (2) make it easier to transact.
Kyle S. Gann is a partner at Winston & Strawn LLP in Chicago. He concentrates his practice on private equity and mergers and acquisitions, and he has participated in a number of recent, high-profile transactions.
Robert B. Heller is a partner at Winston & Strawn in New York. He concentrates his practice on all aspects of corporate and partnership transactions, specifically structuring and negotiating domestic and international M&A transactions.
Jason D. Osborn is a partner at Winston & Strawn in Chicago. He focuses his practice on M&As and private equity, and has extensive experience representing well-known financial firms in a variety of complex matters.
Benjamin C. Galea is an associate at Winston Strawn in Chicago. He represents financial sponsors and their portfolio companies in a variety of complex transactions.