CRE acquisitions and disposals

In the first of three articles on corporate real estate, Paul Chases, Micky Yang and Alex Wright ask, what is “market”? A frequently asked question of lawyers involved in UK real estate transactions is how “market” a particular position is. Whether the buyer or seller is a listed company, private equity fund, pension fund, sovereign wealth fund or individual, the concern is typically to ensure that the buyer or seller is transacting “on market” or “better than market” terms. So, what is “market”? For real estate deals involving the transfer of title to the property, the answer is often found in the Standard Commercial Property Conditions (SCPCs). However, a large number of real estate deals do not involve the transfer of title to the property. Instead, they involve the transfer of companies, partnerships or unit trusts which directly or indirectly hold title to the relevant property – such transfers are referred to as corporate real estate (CRE) deals. To understand what is market for a CRE acquisition or disposal, the SCPCs will not help on the points being negotiated. Instead, parties must rely on their (and their adviser’s) own knowledge as to what is and is not market. Here, we consider those points that are often negotiated as part of a CRE acquisition or disposal, looking at: contractual protection for the buyer; classification of warranties; conditionality/termination; limitations on seller liability; and price reconciliation. While there is no single approach to a CRE deal, understanding the current market trends and approaches should assist any CRE buyer or seller in achieving a good commercial deal in a timely manner. Contractual protection for the buyer A buyer will want to negotiate an adequate package of protections (given by the seller) in relation to the company, partnership, unit trust or corporate group that owns the relevant property. This is because the buyer may inherit historic liabilities when acquiring a company, partnership and/or unit trust. Ensuring such liabilities are factored into the price/protected against will be a key buyer concern. In the current market, contractual protections usually take the form of: warranties: contractual statements that are warranted to be true by the seller; and covenants and indemnities: a promise by the seller to pay pound for pound in respect of a specific liability (noting that often a separate tax covenant/deed will also often be negotiated to provide for protection from pre-completion tax liabilities not factored into the price). Classifying warranties given by the seller to the buyer Certain warranties will be of greater importance to a buyer than others. The tendency on CRE deals in the current market is to therefore divide warranties into the following groups: fundamental warranties (relating to corporate ownership of the relevant shares, partnership interests or units and a seller’s capacity to contract); general warranties (relating to corporate administration/filing, debt, litigation, employees etc); and  tax warranties. Dividing warranties in such a manner enables the buyer to identify which warranties are important to it and to then negotiate different limits on the seller’s liability for breach of different warranties. Most sellers will tend to accept the classification of warranties but should be wary of how warranties are grouped. One trend that has emerged is the push from buyers to expand the concept of fundamental warranties to include matters not previously considered fundamental (eg relating to the existence of debt or the extent of liabilities). Given that fewer limitations tend to apply to fundamental warranties, sellers should carefully consider the definition of “fundamental warranties” before conceding any such expansion to the fundamental warranty category. Conditionality and termination Certain conditions may need to be satisfied (between exchange and completion) before a CRE transaction can complete. Conditionality is common in the current market given the prevalence of debt financing and the number of deals subject to regulatory approval (eg from the European Commission in relation to application of the EU merger regulations). Sellers tend to accept conditionality where necessary, provided it is for appropriate reasons and the buyer’s right to terminate a deal is limited. Where there is a split between exchange and completion to cater for conditionality, the buyer will usually request that the seller provides warranties at exchange and, again, at completion. If the warranties provided at exchange are breached, a buyer may push for a termination right. Whether this is acceptable to the seller will likely depend on the bargaining power of the parties. Most sellers in a position of strength will accept the repetition of warranties (subject to limited disclosure) but resist an attempt to include a termination right for a breach of warranty given at exchange. Sellers are likely to only accept a termination right if a pre-determined condition has not been satisfied. When a termination right for breach of warranty is agreed (and this tends to be quite rare), the parties would be well advised to consider such termination arising only if: the warranty breach cannot be remedied (within a sensible time period); and the financial value of the warranty breach exceeds an agreed financial threshold (to avoid immaterial breaches giving rise to termination). Limitation of the seller’s liability – parameters While a buyer will want to ensure that they can claim for any liability arising in the event of a warranty breach or in respect of a covenant/indemnity, a seller will try to limit the extent to which it is liable to the buyer. All CRE deals will typically contain (to a lesser or greater degree) limitations on claims, but the specifics relating thereto will often be heavily negotiated between the buyer and the seller. Broadly, there are three monetary limits to a seller’s liability, each typically expressed as a percentage of overall consideration: total cap – the total cap on a seller’s liability under the contract; de minimis – included to prevent low-value “nuisance” claims; and threshold – the amount that a claim or claims must exceed before the seller will be liable. The table above shows values in relation to each of these monetary limits that may be considered a typical “package” in the current UK market (although the exact limitations for any deal will be influenced by the specific matters relating thereto and the bargaining power of the respective parties). Price reconciliation (post-completion) It is now commonplace for CRE deals to include a post-completion price adjustment based on completion accounts (a trend likely to continue on the vast majority of deals). While the property price should be fixed on a CRE deal, a completion accounting process allows the buyer and seller to look closely at the assets and liabilities of the relevant company, partnership, unit trust or corporate group (that owns the property in question) during the post-completion period to confirm net asset value in order to test whether the price paid at completion was in fact correct. If not correct, the consideration will be adjusted up or down depending on the specific circumstances (either with the agreement of the buyer and seller or in the absence of such agreement as determined by a third party expert). In the current market there are occasions when the completion accounting process is not used – for example on deals involving properties with limited income streams/outgoings; or on highly competitive trophy deals subject to an extensive bidding process. On highly competitive deals a seller may look to fix a price (at exchange) based on financial leakage that is specifically prohibited and permitted in the period between exchange and completion – a concept known as “locked box” accounting. Such an approach is rare in the current market and a seller should expect push back from a buyer (as most buyers prefer the market-recognised post-completion accounting process). Warranty and indemnity insurance One clear CRE deal trend arising in the past three to four years is the emergence of the warranty and indemnity (W&I)  insurance policy which all buyers and sellers in the CRE market should be aware of. Next week’s article looks at the market trends that have developed in relation to W&I insurance in the UK CRE market. Paul Chases is a partner and head of corporate real estate, Micky Yang is a senior associate and Alex Wright is a junior associate in corporate real estate at Herbert Smith Freehills LLP Click here to download Paul Chases’ podcast on CRE themes Part 2: Know your W&I policy options Part 3: “What is market” in 50:50 real estate developments JVs