Understanding Warranties, Representations and Sandbagging
An increased certainty that the Affordable Care Act is here to stay has brought buyers of ambulatory care centers off the sidelines.
Much of the bullishness comes from the so-far successful phase-ins of the landmark healthcare law and the summer 2013 Supreme Court ruling that upheld mandatory participation in it, says Tracy A. Powell, a healthcare and commercial transactions attorney in the Nashville, TN, office of Sherrard & Roe.
Last fall’s open enrollment start on the federal and state marked an especially important threshold according to Powell.
“Those seeking to profit from the changes began to say, ‘We need to get out there.’” The ACA itself has been a motivator for both sellers and buyers, having decreased reimbursements from physician-owned care centers to 50-cents to 60-cents on the dollar compared to reimbursement levels for hospitals, Powell notes.
This, he says, has created substantial movement by hospitals to seek acquisition of physician-owned centers to fatten their billings. Centers that rebuff hospital centers are left to compete at a fee-reimbursement disadvantage with other centers the hospitals buy, Powell notes.
“They can charge a full dollar for the procedure,” he said. “It’s a huge driver for the hospitals to buy out the centers.”
As recently as 2010, physician-owned practices made up 90 percent of the ownerships of cardiology-care centers, according to Powell, who puts the percentage today at about half that of four years ago.
He attributes the shift to frustration over lower fee reimbursements leading cardiologists to become hospital employees. As hospital employees, cardiologists must divest themselves of their care centers to avoid conflict of interest issues, Powell says. Further incentives have come from the ACA’s prohibition on physicians owning hospitals, though current physician owners are grandfathered.
A lot of activity is occurring in California as big hospital players such as Tenet Healthcare and large surgery center operators search out physician-owned surgery centers, says Carol Lucas, a shareholder in the Los Angeles office of Buchalter Nemer.
They want a significant stake but seek to keep the surgeons in place by having them maintain an ownership percentage, Lucas notes.
In California, she says, no one is “going to buy a surgery center” without the doctors coming with the purchase. If the surgeon does not own a piece of the center, he is less likely to use it, Lucas says.
While outwardly the leverage seems to be with the surgeon in such partial acquisitions, the “4 times earnings” the surgeon would typically get in a full sale is often whittled to slightly less than half that, according to Lucas, because each physician owner only sells about half his or her interest.
On the other hand, the surgeon selling a stake in the center is hoping to gain improved operation of the center, more state-of-the-art equipment, more in-network contracts and more negotiating clout with insurance carriers, she notes.
With merger and acquisition momentum heating up, Powell, Lucas and other attorneys in the health care and commercial transactions area advise potential sellers to either acquaint themselves or reacquaint themselves with both the fundamentals and nuances of the transactions, as well as with developments in representations, warranties and indemnifications.
Multiples are pretty fair on the seller side, they say, but emphasize the more attractive pricing is accompanied by buyers insisting on more broad and detailed warranties and representations.
“Buyers are trying to tie-up sellers tougher than ever,” Powell says.
Today’s buyer is far more inclined than in previous periods to see reps and warranties as an insurance policy, according to Powell.
Reps and warranties that used to extend one year have been stretched to two years or longer, he says.
A key thing for an owner of a care or surgery center to understand is that reps and warranties do not duplicate the due diligence end of the deal, emphasizes Matt Burnstein in the Nashville office of Waller Lansden Dortch & Davis.
“The reps and warranties are where the sellers stand behind the comprehensiveness and accuracy of what they’ve provided in diligence,” notes Burnstein, who represents surgery and care centers as well as hospital companies.
The assurance they add to the diligence process is important to the buyer, but the disclosures they include also give the seller assurance against subsequent issues affecting the purchase price or triggering indemnification claims,” Burnstein says, referring to claims that arise when an inaccurate representation or warranty costs the buyer money or makes the business less valuable.
Typically, the buyer’s lawyers draft the representations and warranties.
“Of particular interest in the reps and warranties are the use of the typical ‘qualifiers’, a materiality qualifier and a knowledge qualifier,” he notes. “Experienced M&A counsel will know when they are reasonable and when they are not. It is also important that the sellers make their lawyer aware of important operational aspects” such as required licenses and permits and whether they have them in hand, and whether specific government programs are important to the business, Burnstein advises.
Disclosure is the best course if in doubt about something that may or may not come into play later, advises Joshua Kaye, a partner in DLA Piper’s Miami office.
“If a rep and warranty ultimately prove to be untrue after the closing has been completed, then a buyer can likely make a claim against the seller for breach of contract and the seller can have material financial exposure to the buyer,” says Kaye, who focuses his practice on mergers and acquisitions of surgical and ambulatory care centers.
“By way of example, suppose a seller represents to a buyer that there are no pending lawsuits against the seller’s facility. If, after the closing, the buyer learns that a disgruntled employee had actually filed a discrimination lawsuit relating to events that occurred prior to the closing, then the seller is in breach of contract and could be accountable to the buyer for any damages or costs that the buyer must pay to defend or otherwise resolve such matter,” Kaye noted.
In some instances, disclosure is easier said than done, notes Lucas, the Buchalter Nemer shareholder.
Her advice: “Always over disclose.”
It’s the “get-out-of-jail-free card,” she says.
For items and issues the seller may overlook, Lucas says some protection can be gained by inserting “materiality” qualifiers into the sales contract, thus waiving later liability for oversights that have only a slight effect on the business. An example, Lucas says, would be an overlooked requirement for certain parking permits or other minor fee obligations. Time – or how far back the reps and warranties should apply – is a key consideration, as is whether certain reps and warranties are qualified by a seller’s knowledge or materiality, advises Kaye of DLA Piper.
In a stock purchase – as opposed to an asset purchase — the buyer steps into the shoes of a selling owner and remains responsible for all actions of the ambulatory care center before and after the purchase. “So, a buyer’s recourse is really only against the seller and therefore the reps and warranties and indemnity provisions are absolutely critical,” Kaye says.
In an asset purchase, the buyer is operating the facility under a new company and thus is less likely to be responsible for actions the center took before the closing. Often, however, the existing facility from whom the buyer purchased the assets continues to be a part of the buyer’s post-closing operations. In that case the reps, warranties and indemnity remain as relevant as they are in a stock purchase transaction, Kaye notes.
With any ambulatory care center acquisition, indemnity provisions are likely to be the most heavily negotiated part of the transaction, according to Kaye.
Such provisions, he notes, carry three key considerations:
*The type of conduct for which a claim can be brought, including breach of reps and warranties; *Survivability or, more specifically, the time in which a party must bring a claim; *Whether a provision will be subject to a “basket” or “cap.” The basket prevents a party from bringing a claim until it has incurred costs and damages that exceed a set dollar threshold; a cap sets the total amount that a party can recover from the other party.
Other important considerations of an indemnity provision include how a claim can be made, who controls the resolution of a third party claim, what types of damages can be recovered, whether an indemnity escrow should be established, and tax and insurance issues.
The indemnity, Kaye says, can be for both past and present conduct depending on the scope of activity covered. “By way of example, an indemnity tied to the reps and warranties typically relates to the accuracy of the reps and warranties for the time period prior to and up to the closing. By contrast, an indemnity relating to a seller’s covenant and agreement not to compete for the five years after closing is tied to a time period after closing,” Kaye says.
Indemnifications are, at least in theory, a way of adjusting the purchase price so that the “true” value paid by the buyer ends up equal to the value the buyer believed it was getting, explains Burnstein of Waller Lansden.
Put another way, he says, the buyer’s lawyer wants to ensure indemnification adjusts the purchase price to offset any inaccurate representations.
How the indemnification should be framed hinges on the number of sellers, Kaye notes. If multiple sellers are involved, close consideration should be given to whether the indemnification is joint and several, thereby making each seller responsible for all of the other sellers or simply several and independent, Kaye said. “This concept should be considered both in the context of whether a seller is making representations just about himself versus about all sellers.”
In negotiating indemnity provisions, Sherrard & Roe’s Powell says he looks to limit his seller client’s exposure to the lowest percentage he can. No matter how bad things get, their seller clients should be on the hook for no more than the purchase price of the center, Powell says. “You’ll find a lot of lawyers who will argue with you on this.” Indemnity caps typically range from 10 percent to 100 percent of the deal price, Burnstein says, and notes caps can be put in place for different issues.
With that in mind, Powell says he insists on anti-sandbagging provisions to protect his seller client in instances in which a buyer knew of a problem with the center but chose to close anyway.
“You bought at your own risk,” Powell says he will argue.
“Of course, the buyer’s counsel will argue we should give something back,” he adds. When caps are put in place for different issues, the size of the deal matters a lot, Burnstein notes.
“A $50 million deal with a 20 percent cap provides a lot of cover for a buyer,” he adds. “A $2 million deal with a 20 percent cap provides very little cover for a buyer for a serious issue that costs a lot to fix.”
On the lower price deal, sellers often can negotiate a “basket” or “deductible,” Burnstein says.
“These come in two flavors: the ‘tipping basket’ is the amount below which the sellers will have no liability for indemnification, but once exceeded, that basket tips over and the entire liability — back to the first dollar of losses — becomes indemnifiable,” he explains. By contrast, the “true deductible” does not go back to the first dollar, he adds.
The higher the basket, the more likely that a buyer will insist that the basket tip back to the first dollar, Kaye says.
As Burnstein sees it, reps and warranties are about 80 percent the same regardless of whether the deal is for a surgical care center, an urgent care center, an anesthesia practice, an auto parts store or a software company.
“Stand behind your financials; promise me you own what you say you own; assure me that I’m not stepping into a lawsuit; give me comfort that the way you made money before the closing — which is what I’m paying you for — is going to be intact after the closing, so I’m going to enjoy the benefit of my bargain,” he says.
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