Exclusive Remedies
What are Exclusive Remedies? Buyers and sellers usually spend significant time agreeing on an indemnification scheme, so they tend to want most claims for breaches of the Agreement to be governed by indemnification. This section identifies the claims that must be pursued through indemnification and those that are exempt from that limitation.
The Middle Ground: Subject to the equitable remedies provided for in the Agreement, this provision limits the parties’ available remedies in the event one of them breaches the Agreement, except for situations involving fraud, criminal activity, or intentional misconduct. More specifically, if a breach occurs that is not due to one of the three listed exceptions and for which an equitable remedy is not available, the non-breaching party’s only option is to make an indemnification claim (if the parties have chosen to make all covenants and other terms subject to indemnification in addition to the representations and warranties).
Purpose: This restriction is intended to limit the parties’ risk by making indemnification the sole avenue for resolving most claims related to the Agreement. In fact, this term is necessary if indemnification is intended to be the Agreement’s main enforcement mechanism, because without it the parties could simply bypass the indemnification process by filing a lawsuit.
Buyer Preference: Being a fairly standard provision, most buyers accept it as part of the Agreement and, consequently, spend a considerable amount of time negotiating their indemnification rights. However, more aggressive buyers may argue for an alternate provision that allows for indemnification in addition to the usual legal and equitable remedies.
Seller Preference: The Seller wants the exceptions included in this provision to be as narrow as possible since it is typically the party against whom a complaint is being made. In particular, the definition of fraud varies from state to state and may not be as limiting as the Seller intends it to be. To prevent an unwelcome surprise, the Seller (and/or its attorney) must be aware of the legal bounds of fraud, criminal activity, and intentional misconduct in the state whose law governs the Agreement.
Differences in a Stock Sale Transaction Structure: None.
Effect of Investigation
What is the Effect of Investigation section? The Buyer and Seller may view the role and consequences of due diligence differently, so this section is used clarify how knowledge gained during due diligence affects the parties’ rights under the Agreement.
The Middle Ground: This clause states that the parties’ indemnification rights are not affected by its pre-Closing knowledge (or that of its Representatives) or by the waiver of any of the Conditions to Closing. It is often referred to as a “sandbagging” provision because the non-breaching party can claim indemnification after Closing even if it knew or should have known prior to Closing that a representation or warranty was inaccurate.
Purpose: This provision is included to fortify the parties’ indemnification rights in situations where one party knew or should have known prior to the Closing that one or more of the other party’s representations was false. Because the Buyer is typically the one conducting an investigation and gathering information, it is most helpful to the Buyer. It lessens the Buyer’s transaction risk, helps it protect the value it receives from the deal, and makes for a much quicker transaction process for both sides.
Without this provision, the Buyer would need to either (i) investigate every time a Seller’s statement doesn’t match up to the Buyer’s information and make an indemnification claim before the deal is even done, or (ii) complete no investigation whatsoever. Both of those options are detrimental to the Buyer and may cause headaches for the Seller (or blow up the deal), so most parties will turn to this provision to allow the Buyer to conduct a thorough but measured due diligence investigation.
Buyer Preference: Because knowledge of a breach may not equate to knowledge of its consequences, and because it is the Seller’s duty to provide accurate representations, most buyers insist that a sandbagging provision be included in the Agreement. The Buyer wants to include this provision even in states that, as a default rule, allow for sandbagging. State statutes may require the Buyer to prove additional elements beyond the falsity of the representation or warranty, so including the provision in the Agreement simplifies the process for making an indemnification claim.
Seller Preference: The Seller will likely try to exclude this provision or add an anti-sandbagging provision that explicitly removes the Buyer’s indemnification rights if it has knowledge of the breach prior to Closing. Alternatively, if the Seller learns that the Buyer knows of a breach prior to the Closing, the Seller may seek to obtain a waiver from the Buyer for that specific breach rather than fighting to have the entire sandbagging provision thrown out. In terms of time allocation, most sellers will prefer to spend time making sure their representations are accurate rather than using up time and negotiating leverage to avoid the cost of a misrepresentation (and buyers will prefer that too, making for a smoother negotiation).
Differences in a Stock Sale Transaction Structure: None.
Indemnification Procedures
What are Indemnification Procedures? While previous indemnification-related sections focus on the circumstances under which a claim can be made, this section details the procedural rights and requirements of both sides once a claim is made. Essentially, it provides the rules that must be followed once the indemnification process has been initiated.
The Middle Ground: The Indemnifying Party’s rights typically include (but are not limited to) receiving prompt notice of the claim and its details, the right to assume and control the defense of the claim (except in a few limited circumstances), and the right to the Indemnified Party’s cooperation in investigating claims. The Indemnified Party’s rights usually include controlling legal proceedings when the Indemnified Party is the Buyer and the claim is brought by a customer or supplier of the Business or when an equitable remedy is sought, as well as participating in the defense of claims when such defense is controlled by the Indemnifying Party.
Purpose: Indemnification is an essential tool used to enforce the terms of the Agreement, and this section lays out the steps that must be taken and the rights of each party involved when an indemnification claim is made. It has a moderate impact on risk for both parties (more so for the Seller, who is typically the Indemnifying Party), yet its main purpose is to give effect to more substantive indemnification provisions. It is important for the parties to strike the right balance between implementing enough procedures and rules to allow the Indemnifying Party to mitigate its risk as much as possible, while not employing so many hurdles that they interfere with the Indemnified Party’s ability to actually receive indemnification.
Buyer Preference: The Buyer generally favors terms that benefit the Indemnified Party such as including a specific but generous notice period, allowing the Indemnified Party to control all claims against it once the Cap is met (if a Cap is included), and giving the Indemnified Party the option whether to control defense of all claims. The Indemnified Party may also want a say over who the Indemnifying Party enlists as counsel to defend against a claim and/or the ability to control the defense when the Indemnified Party has defenses available to it that are not available to the Indemnified Party.
Seller Preference: The Seller’s preferences will usually be those of the Indemnifying Party. Those preferences typically include the desire for a flexible notice standard (e.g. “reasonably prompt notice”) and the ability to control the defense of all third-party claims and settlements. The Seller may also want to insert an arbitration provision so that disputes over direct claims can be resolved quickly and less expensively than would be the case with litigation.
Differences in a Stock Sale Transaction Structure: If the Stock Purchase Agreement contains a tax-specific indemnification provision tax issues will need to be carved out of this section so there is no question they are governed solely by the tax indemnification provisions.
Conditions to Obligations of All Parties
What are Conditions to Obligations of All Parties? Certain events will make a transaction impractical or even impossible, and this clause is included to give both parties a legal “out” of the deal if one of those events occurs.
The Middle Ground: This provision lists the conditions that must be met at or prior to Closing for both sides to be obligated to move forward with the transaction. The conditions include: (1) all required filings under the HSR Act have been made and any applicable waiting periods have expired (if the Act applies to the transaction); (2) no Governmental Authority has taken any action that would cause the transaction to be illegal or that would otherwise prevent it from becoming and remaining effective; and (3) all consents, authorizations, etc. required to be obtained by either party from any Governmental Authorities were received and have not been revoked.
Purpose: The intent of this provision is to allow both sides to walk away from the deal without penalty if the government interferes with the transaction (or if their approval is required but not given). While there is a very low probability that any Governmental Authority would implement a law or ruling preventing an acquisition in the lower middle market, if it were to happen it would certainly put an end to the transaction. Similarly, it is highly unlikely that either side would fail to obtain a necessary authorization or consent absent sheer incompetence or severe procrastination. Yet, if such failure were to occur it would also be an almost-certain death knell for the deal. Because of the low probability, high magnitude dynamic at play, the provision is worth paying attention as the Closing approaches, but it is not something that is likely to eat up negotiation time or cause significant disagreement.
Buyer and Seller Preference: None, other than deleting certain inapplicable conditions such as the HSR Act filing requirements or obtaining governmental approvals.
Differences in a Stock Sale Transaction Structure: None.
Equitable Remedies and Reasonableness of Restrictive Covenants
What is he Equitable Remedies and Reasonableness of Restrictive Covenants section? These two terms help enforce the three important restrictive covenants: the Confidentiality, Non-Compete and Non-Solicitation provisions. All of those restrictive covenants call for non-monetary (“equitable”) remedies, and the restrictions must be reasonable for a court to enforce them. By agreeing to this section, the Seller is agreeing that a non-monetary remedy is appropriate for the situation and that the specific restrictions included in the restrictive covenants are reasonable in the context of the transaction.
The Middle Ground: The Equitable Remedies provision states that a violation of any of the restrictive covenants would cause the Buyer irreparable harm for which money would not provide adequate compensation. It is meant to allow the Buyer to obtain an equitable remedy such as an injunction to prevent violations. The Reasonableness provision includes an acknowledgement from the Seller that the Confidentiality, Non-Compete and Non-Solicitation covenants are reasonable. It also states that if a court finds the restrictive covenants unreasonable, the Seller agrees that the court should reform the terms to the point where they are considered reasonable but still achieve the desired effect to the maximum extent allowed by law.
Purpose: These two provisions are aimed at protecting the viability of the restrictive covenants. The Confidentiality, Non-Compete and Non-Solicitation covenants do most of the heavy lifting in terms of protecting deal value, and these two covenants perform a smaller risk management function by ensuring that the more important covenants remain enforceable and effective.
Buyer Preference: Although there will typically be a specific performance clause applicable to the entire Agreement, the Buyer wants to include the Equitable Remedies covenant here so that there is no question that it applies to all restrictive covenants. The Buyer wants to be sure to include language that tracks the standard for granting injunctions and other equitable remedies (i.e. “irreparable harm…for which monetary damages would not be an adequate remedy”). In regard to the Reasonableness covenant, the ability to modify restrictive covenants rather than completely invalidating them is not available in all states. So, the Buyer’s counsel should adjust its approach depending on whether the law governing the agreement allows “blue-pencil” revisions. If not, the Buyer may want to include a choice of law clause or reduce the covenant restrictions so there is no doubt they are enforceable.
Seller Preference: If the Seller agrees that the restrictive are reasonable, it will likely have no objection to these two subsections since the entire purpose of both is to protect the viability of the restrictive covenants.
Differences in a Stock Sale Transaction Structure: None.
Confidentiality and Non-Disparagement
What is the Confidentiality and Non-Disparagement section? All businesses possess information that is beneficial to them because it is not known by the public (e.g. customer lists, trade secrets, etc.). Prior to the Closing, the Seller protects that information by requiring the Buyer to keep non-public information confidential. Post-Closing, the Buyer wants to place a similar confidentiality requirement on the Seller, and this covenant is used to accomplish that goal.
The Middle Ground: This covenant requires the Seller, its Affiliates, and its Representatives to use their reasonable best efforts post-Closing to keep confidential all information about the Business that is not otherwise publicly available. It also requires the Seller to take certain precautions if it is required by law to disclose the information, such as only providing information it is legally required to provide (as advised by legal counsel) and taking steps to limit who is able to access the confidential information that is disclosed. The parties also agree not to make negative or disparaging comments about each other to third parties.
Purpose: This covenant is intended to protect the value of the Business after the transfer of ownership has occurred by protecting the confidential information of the Business. For a serial buyer such as a private equity firm, it also protects future deals by preventing the Seller from providing potential future sellers with information about terms the Buyer is willing to accept and/or the Buyer’s negotiation strategies.
Buyer Preference: The Buyer wants to pay close attention to the definitions of Affiliates and Representatives to ensure that everyone who has access to the information sought to be protected has a duty of confidentiality with regard to that information. If the sale was initially conducted by auction, expansive definitions of Affiliates and Representatives may not adequately protect the Buyer’s risk, so the Buyer can have the Seller assign the confidentiality agreements signed by the other auction participants to protect the Business’s sensitive information. The Buyer also wants to be able to enforce this covenant using an injunction rather than indemnification, because preventing a violation is more valuable than receiving monetary compensation after one has occurred. To achieve that goal, the Buyer should explicitly carve out this covenant from the Exclusive Remedies provision.
Seller Preference: The Seller may want to include language indicating that the Buyer’s confidentiality obligations (often originating in the Letter of Intent) apply to information disclosed pursuant to the Agreement and that the Buyer’s confidentiality obligations survive termination of the Agreement. Essentially, such language provides protection for the Seller if the deal does not go through. The Seller will also pay attention to the scope of the disclosure restrictions so it can avoid being penalized for sharing information that doesn’t have the potential to hurt the Business or the Buyer.
Differences in a Stock Sale Transaction Structure: None.
Employees and Employee Benefits
What is the Employees and Employee Benefits section? Transferring employees and their benefit plans from the Seller’s business entity to the Buyer’s is a process that involves quite a few underlying issues that must be worked out between the parties. This covenant lays out how the parties have answered questions such as which employees will be transferred, what benefits they will receive, and who is responsible for employee-related issues that pop up after the Closing.
The Middle Ground: In this covenant, the Seller promises to terminate its employees on the Closing Date so the Buyer can hire some or all of them on its own terms. Next, the Seller agrees to be responsible for all compensation (including benefits) owed to its employees up to the Closing Date, and to pay out that compensation by the Closing Date. The Seller also agrees to remain responsible for all insurance, disability, and workers’ compensation claims that are based on events that occur on or prior to the Closing Date. For those employees of the Seller that the Buyer does hire, the Buyer typically agrees to offer them substantially similar compensation and benefits as previously offered by the Seller or as offered to Buyer’s similarly situated employees. Finally, the Buyer agrees to give the employees it hires from the Seller “service credit” under the Buyer’s health and retirement benefits plans according to their length of service with the Seller.
Purpose: The most important feature of this covenant is the Buyer’s promise to hire the Seller’s employees because it can be used to maintain employee stability and quell any panic that may arise after the acquisition is announced. It is something the Seller can point to in order to assure its employees that the sale of the company does not automatically translate to a loss of their jobs. In other words, it is a wonderful risk management tool. However, the Buyer retains the discretion not to hire employees as it sees fit and the other promises made by the Buyer relate only to the employees it ends up hiring. Thus, the covenant does not guarantee that no employees will be worse off after the sale, but if the Buyer agrees to include it that is a good signal that its intent is to disrupt normal operations of the Business as little as possible.
Buyer Preference: The Buyer wants to retain as much discretion as possible, especially with regard to who it must hire and the level of compensation it must provide. While stability is typically in the Buyer’s best interest, some buyers may use the transition as an opportunity to cut costs by selectively reducing the number of employees, and it is not unreasonable for the Buyer to want to maintain the discretion to do so. Also, if the Seller is subject to the WARN Act (or any state-level corollaries), the Buyer wants to ensure that the Seller takes responsibility for any resulting liabilities.
Seller Preference: The Seller will typically seek a promise from the Buyer to hire all or most of the Seller’s employees at comparable compensation and benefit levels. The desire for the Buyer to hire as many employees as possible is even stronger when the Seller is subject to the WARN Act or a similar state law, since liability under the Act can be minimized or avoided entirely if enough employees are hired by the Buyer. Another tactic for the Seller to avoid WARN Act liability is to explicitly shift that liability to the Buyer in the Agreement, but that will likely take significant negotiation leverage.
Differences in a Stock Sale Transaction Structure: This covenant is not included in a stock sale because the target company remains intact so there is no need to transfer employees to a new entity.
Access to Information
What is Access to Information? For many issues that the Buyer will investigate during due diligence, the best or only source of information is the Business itself (e.g. financial statements). So, in order to conduct its investigation, the Buyer needs access to the Business’s records, employees, and advisors. This section grants that access under certain agreed upon conditions.
The Middle Ground: In this covenant, the Seller promises: (1) to allow the Buyer full access to the books, assets, and properties of the Business (including regulatory and tax filings); (2) to provide reasonably requested financial and operating data of the Business; and (3) that its Representatives will cooperate with the Buyer in its investigation of the Business. In return, the Buyer promises not to conduct its investigation in a way that unreasonably interferes with the Business (or other businesses of the Seller). The covenant also states that no investigation by the Buyer or other information received by the Buyer will act as a waiver or otherwise impact the representations, warranties, and other agreements made within the Agreement.
Purpose: By allowing the Buyer to take an inside look at certain aspects of the Business, this covenant significantly lowers the Buyer’s transaction risk without increasing the risk to the Seller. Buyers will invariably be more comfortable making an investment after conducting its own investigation rather than relying on the promises of the person that stands to benefit from the investment, and this provision gives buyers that opportunity without interfering with the Seller’s operations.
Buyer Preference: The Buyer wants to ensure that the language used here (and in any affiliated definitions) is broad enough to permit the desired level of access. For example, if there are environmental concerns relating to the Business and the Buyer plans to engage an environmental specialist to conduct an investigation, the Buyer can insert language into the covenant detailing the specialist’s rights of access. The Buyer may also want to include language regarding access to the customers and suppliers of the Business, so long as there are no confidentiality-related issues and the Seller does not object to providing such access.
Seller Preference: The Seller’s main concern here is preventing the Buyer’s investigation from interfering with the Business (or any of Seller’s other businesses), especially if the fact that the Business is being sold has not been disclosed to the employees. To prevent problems, the Seller may want to limit the covenant in one or more ways, including: restricting the hours of access, requiring advance notice of visits, requiring any visitors representing the Buyer to be supervised by personnel of the Seller, requiring all communications to be funneled through one or more designated employees, requiring the Buyer to obtain written consent before contacting customers or suppliers, limiting the Buyer’s right to physically inspect the Seller’s properties without advance notice, and prohibiting disclosure of information that is either privileged or could cause competitive harm if the deal does not close.
Differences in a Stock Sale Transaction Structure: None.
Full Disclosure
Significance: Moderately Material
Section: Representations and Warranties of Seller
Negotiation Time: Minimal to Moderate
Transaction Costs: Insignificant
Major Impact: Risk Management
What is Full Disclosure? In this section, the Seller affirms that the information it has provided throughout the Transaction Documents is accurate and complete. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: Here, the Seller represents that nothing in the Agreement, the Disclosure Schedules, or any other Transaction Documents misstate or omit a material fact that would make any statements made in those documents misleading.
Purpose: This representation is included to ensure that the disclosures and representations made by the Seller are not misleading, even if they are technically accurate. Thus, this section is yet another risk management tool being used by the Buyer to avoid bearing the brunt of any unwelcome surprises that arise after the purchase.
Buyer Preference: In addition to this representation, the Buyer may seek an additional representation from the Seller stating that, to the Seller’s knowledge, no undisclosed event or circumstance exists which could reasonably be expected to have a Material Adverse Effect on the Business.
Seller Preference: The Seller will want to exclude this representation in its entirety on the basis that the other representations included in the Agreement adequately address the Buyer’s transaction risk. If successful, the Seller may also want to include a provision stating that it makes no representations or warranties other than those in the Agreement. An alternative option for the Seller is to have the Buyer represent that it conducted its own independent investigation of the Business and that it is relying solely on that investigation and the express representations and warranties of the Buyer in agreeing to the transaction. Both of those additional clauses are aimed at precluding the Buyer from being able to assert non-contract claims based on the Seller representations and warranties (such as a tortious fraud claim), thereby limiting the Seller’s risk.
Differences in a Stock Sale Transaction Structure: This representation tracks the language in Rule 10b-5 of the Exchange Act, and since that rule is applicable in a stock sale the Buyer does not have as strong a need to include the representation in the actual Agreement. However, the Buyer may still try to include it since the substantive and procedural requirements for succeeding on a 10b-5 claim are more onerous than what is required to receive indemnification.
Taxes
What are Taxes? In this section, the Seller provides information regarding tax-related matters of the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The content in this section is based on the assumption that the Business is organized as a stand-alone C Corp that does not operate outside the United States. With that in mind, the typical tax representations include:
(1) All the Seller’s Tax Returns for any pre-Closing period are true and complete, have been, or will be, timely filed, and all related payments have been, or will be, paid by their respective due dates;
(2) Seller has withheld and paid each Tax required to be withheld in connection with its employees, independent contractors, customers, or any other party and has complied with reporting and backup withholding provisions of applicable law;
(3) No extensions or waivers of statutes of limitations have been requested or provided in connection with the Taxes payable by Seller;
(4) Seller has fully paid all deficiencies asserted and/or assessments made against it by any taxing authority;
(5) Seller is not a party to any Action by any taxing authority and there are no pending or threatened Actions of that nature in connection with the Business;
(6) There are no Tax-related Encumbrances upon any of the Purchased Assets nor, to Seller’s knowledge, is any taxing authority in the process of imposing such Encumbrances;
(7) Seller is not a “foreign person” as defined in Treasury Regulation §1.1445-2; and
(8) Seller is not, and has never been, party to or a promoter of a “reportable transaction” within the meaning of Code §6707A(c)(1) and Treasury Regulations §1.6011 4(b).
Additional tax-related representations may be required depending on the nature of the Business (e.g. if the Business engages in “safe harbor lease” transactions), so both parties should consult a tax expert to determine which representations should be included in the Agreement.
Purpose: Tax-related liabilities are generally part of the Excluded Liabilities in an asset purchase, so the purpose of this section is to ensure that all such liabilities, including those that may be imposed in the future based on the Seller’s pre-Closing actions or inaction, stay with the Seller. Including specific tax-related representations also gives the Buyer a better understanding of the Seller’s past behavior in terms of its desire and ability to comply with legal requirements. That information can be a valuable source of risk assessment for the Buyer, and it becomes especially important if the Seller will remain actively involved in the Business following the sale.
Buyer Preference: The Buyer wants these representations to survive for 60 days after expiration of the applicable statute of limitations for enforcement of tax deficiencies. It also wants the representations to remain as broad as possible to cover all taxes owed or paid by the Seller, although, for the sake of clarity, it may want to specifically list as examples the tax categories it is most concerned about (e.g. sales tax for an e-commerce business). The representation regarding withholding tax is not a necessity in this section, but is generally preferred by the Buyer because it provides specific information about withholding taxes that may not otherwise be disclosed (because the “Withholding Tax” provision is not typically accompanied by related Disclosure Schedules). The Buyer also wants to exclude knowledge qualifiers in representations (5) and (6) if it can do so without giving up something of greater significance. Lastly, the Buyer may want to consult a tax expert who is familiar with the Business to determine whether additional representations should be included.
Seller Preference: The Seller can narrow these representations by limiting them to “Taxes (and Tax Returns) with respect to the Business” rather than referencing the Taxes (and Tax Returns) of the Seller. The Seller may also seek knowledge and/or materiality qualifiers where it would make sense to do so. A more aggressive approach would be to limit the Tax Returns to Income Tax Returns, but most Buyers will resist this since income taxes are not the only source of tax liability for businesses. If the representations would not be completely accurate as written, the Seller will want to include a corresponding section in the Disclosure Schedules rather than risk breaching its representations. Much like the Buyer, the Seller may want to consult with a tax expert regarding the scope of the representations to ensure that it is not taking responsibility for any liability that should be taken on by the Buyer.
Differences in a Stock Sale Transaction Structure: These representations are more critical for the Buyer if the transaction is structured as a stock sale because, in that context, the Buyer inherits the Seller’s tax liabilities. That means the Buyer would be managing much more risk and, consequently, would need to include more extensive representations than those listed here.
Employment Matters
What are Employment Matters? In this section, the Seller provides information regarding its responsibilities to employees and compliance with various employment-related laws. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: In the Employment Matters representation and the related Disclosure Schedules, the Seller provides the name and other employment-related information for all employees, independent contractors, and consultants of the Business. The Seller then represents that:
(1) All compensation has been paid to those employees, contractors, and consultants, and there are no related ongoing financial commitments except for those listed in the Disclosure Schedules;
(2) It is not bound by any collective bargaining agreement or other contract with a labor union and that no such union or group of employees has sought to organize for the purpose of collective bargaining (again, exceptions are provided via the Disclosure Schedules);
(3) It has no duty to bargain with any union, and its employees have not been involved in any concerted refusals to work;
(4) The Business complies with all applicable employment laws and no employment-related claims are pending or, to the Seller’s knowledge, have been threatened or filed against the Business;
(5) It has complied with the WARN Act and has no plans to undertake any action that would trigger the WARN Act provisions (if the WARN Act is applicable to the Business); and
(6) It complies with all regulations required of government contractors and it has not been the subject of an investigation, audit, or enforcement action by any Governmental Authority in connection with a Government Contract.
Purpose: These representations and disclosures give the Buyer a good sense of its employment-related risk and allow it to shift some of its risk to the Seller (namely, the risk stemming from one of the situations outlined above). This information also helps set the Buyer’s expectations in terms of overall employee-related costs and the level of formality required when addressing compensation issues with employees.
Buyer Preference: The Buyer wants this section to be expansive, with no knowledge qualifiers or time restrictions for the disclosures and representations. Additionally, if the Seller is in fact a government contractor, the Buyer will want to include representations that speak to the Business’s compliance with government-mandated employment requirements.
Seller Preference: It’s quite likely that not every representation listed here will apply to the Business (e.g. it is not a government contractor or the WARN Act does not apply). At a minimum, the Seller wants to exclude those inapplicable representations. The Seller also wants to cap the time periods to make certain disclosures, such as the disclosures relating to union organizing activity, as a way to keep transaction costs under control and limit the risk from an immaterial misrepresentation. The Seller can also limit its risk by including materiality or knowledge qualifiers when appropriate.
Differences in a Stock Sale Transaction Structure: None.
Employee Benefit Matters
What are Employee Benefit Matters? In this section, the Seller provides information regarding employee benefits. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The disclosures and representations made by the Seller in this section include:
(1) The disclosure of all Benefit Plans, written or unwritten, to which the Seller has contributed or under which the Seller or Buyer may have (or reasonably expect to have) any liability;
(2) That the Seller has provided to the Buyer, for each Benefit Plan, accurate and complete copies of the following: (i) the plan documents and amendments for plans that are in writing; (ii) for unwritten plans, a written summary of the material plan terms; (iii) copies of trust agreements or other funding arrangements, insurance contracts, administration agreements, investment agreements, and custodial agreements that are currently in effect or required in the future; (iv) written communications relating to any Benefit Plan, including summaries of plan descriptions and any material modifications to the plan; (v) correspondence from the IRS regarding any Benefit Plan that is intended to be qualified under Internal Revenue Code (the “Code”) §401(a); (vi) a copy of the two most recently filed Form 5500s (if applicable), with attached schedules and financial statements; (vii) recent actuarial valuations for applicable Benefit Plans; (viii) the most recent nondiscrimination tests performed under the Code; and (x) copies of material notices and correspondence from any Governmental Authority relating to the Seller’s Benefit Plans;
(3) Each Benefit Plan (and any related trusts) has been established and maintained in compliance with all applicable laws; nothing has occurred that has subjected or reasonably could subject the Seller or any of its ERISA Affiliates, or the Buyer or its Affiliates, to a penalty or tax under ERISA or the Code; all benefits, contributions, and premiums have been timely paid; and all benefits accrued under any unfunded Benefit Plan have been paid or accrued and reserved for in accordance with GAAP, if the Business follows GAAP;
(4) Neither the Seller nor any of its ERISA Affiliates has (i) incurred any material liability with respect to Title I or Title IV of ERISA or any related Code provisions or local laws; (ii) failed to timely pay premiums to the Pension Benefit Guaranty Corporation; (iii) withdrawn from a Benefit Plan; or (iv) engaged in any transaction that would give rise to liability under §4069 or 4212(c) of ERISA;
(5) With respect to each Benefit Plan: (i) any Multiemployer Plans in which the Seller participates have been disclosed, all premiums have been timely paid, and no withdrawal liability is outstanding or will be incurred upon a future withdrawal from the plan; (ii) no plan is considered a “multiple employer plan” under §413(c) of the Code or a “multiple employer welfare arrangement” under ERISA; or (iii) the Pension Benefit Guaranty Corporation has not taken any action to terminate or appoint a trustee to any such plan; (iv) no such plan is subject to the minimum funding standards or ERISA and none of the Purchased Assets are, or may reasonably be expected to become, subject to a lien arising under ERISA or the Code; and (v) no “reportable event” as defined in ERISA §4043 has occurred with respect to any such plan;
(6) Except as disclosed, no Benefit Plan or other arrangement involving the Seller requires it to provide post-termination or retiree welfare benefits to any individual;
(7) Except as disclosed, there is no pending or, to Seller’s knowledge, threatened Action relating to a Benefit Plan (other than routine benefits claims), and no Benefit Plan has been the subject of an examination or audit by a Governmental Authority or is involved in an amnesty or similar compliance program sponsored by any Governmental Authority;
(8) There has been no change in relation to any Benefit Plan, and Seller has not agreed to make any change in the future with respect to any such plans, that would increase the annual expense of maintaining such plan in comparison to the most recently completed fiscal year. Furthermore, neither Seller nor its Affiliates have committed to adopt, modify, or terminate any Benefit Plan currently in effect;
(9) Each Benefit Plan that is subject to §409A of the Code has been administered in accordance with that section of the Code and Seller does not have any monetary obligations to any third party in relation to §409A;
(10) Except as disclosed, execution of the Agreement or any transactions pursuant to the Agreement will not materially alter the Business’s obligations arising out of any Benefit Plan.
Purpose: By making these representations, the Seller is accepting the risk of any outstanding liabilities under its benefit plans, including the risk of non-compliance with ERISA or the Code. However, the representations do not relieve the Buyer from potential liability for ongoing violations that persist after the sale, so it should pay special attention to the disclosures made in this section of the Disclosure Schedules if it is adopting the Seller’s plan(s). In terms of deal value, the transaction costs of both parties will increase based on this section because it requires review by a benefits plan expert (or, more accurately, an expert review is highly recommended). However, the experts’ review will limit the risk associated with the Benefit Plan(s), making it a sound investment for both sides.
Buyer Preference: The Buyer may want to retain an employee benefits specialist to determine which of these representations need to be included for each specific situation. In general, the Buyer wants robust disclosure requirements and comprehensive representations that do not include knowledge or materiality qualifiers.
Seller Preference: The Seller may want to retain an employee benefits specialist to assess whether the Seller has been compliant with its plans and to advise as to which representations should and should not be included in the Agreement. In most situations, its interests will be the opposite of the Buyer’s; the Seller will want limited representations that ignore immaterial issues and that are based on the Seller’s knowledge.
Differences in a Stock Sale Transaction Structure: The Buyer will typically want more comprehensive disclosures and representations in a stock sale because the Buyer is assuming the Seller’s liabilities. In an asset acquisition, liabilities relating to any Benefit Plan of the Seller are usually expressly excluded from the transaction.
Insurance
What is Insurance? In this section, the Seller provides information regarding the insurance held by the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: In this representation, the Seller provides copies of all current insurance policies relating to the Business, all historical and pending claims relating to those policies, and a description of how those claims were resolved. Additionally, the Seller represents that: (1) the Business carries all policies required by law and/or customarily carried by others in its industry, and those policies are in full force and effect; (2) the policy providers are financially solvent; (3) all past due premiums have been paid and there have been no lapses in coverage; (4) the policies are not subject to cancellation or a premium increase; and (5) the Seller is not otherwise in default pursuant to any of the policies. In the event that Seller is self-insured, the representation should describe the self-insurance arrangement.
Purpose: The information provided here allows the Buyer to assess the risks inherent in operating the Business, as well as the Seller’s response to those risks. More specifically, the disclosures indicate the extent to which risks to the Business materialize, while the representations help the Buyer understand industry risk management standards. In combination, the disclosures and representations allow the Buyer to determine how risk-averse the Seller is, and that is useful information for the Buyer to know if the Seller will remain involved with the Business after the sale.
Buyer Preference: The Buyer wants to include this representation even if it does not plan on continuing the insurance policies purchased by the Seller, because the information is useful for determining the appropriate level of insurance protection. The Buyer may agree to limit the time period for which past and pending claims must be disclosed, but it will want that period to be long enough to get a good sense of the insurance needs of the Business and include at least one business cycle if the Business is cyclical in nature.
Seller Preference: The Seller may try to exclude this representation if the Buyer will not be utilizing the insurance policies purchased by the Seller. If the Seller does agree to provide the representation, it will want to exclude subjective language such as whether the insurance coverage used in the past is “sufficient.” Furthermore, it will not want to include representations that rely on the actions of third parties to be accurate, such as attesting to the financial solvency of the insurance carriers. If those representations are included, the Seller wants to include knowledge qualifiers to limit the risk posed by unknown circumstances or information.
Differences in a Stock Sale Transaction Structure: None.
Undisclosed Liabilities
Significance: Moderately Material
Section: Representations and Warranties of Seller
Negotiation Time: Minimal to Moderate
Transaction Costs: Insignificant
Major Impact: Risk Management
What are Undisclosed Liabilities? One major purpose of the Agreement is to detail how certain liabilities of the Business will be treated after the Closing. This term focuses on a particular set of liabilities, those that are unknown to the Buyer at the time of the sale, and requires the Seller to either disclose them in the Disclosure Schedules or remain on the hook for them post-Closing.
The Middle Ground: Since the Balance Sheet Date on which it was delivered prior to Closing, the Seller represents that all liabilities of the Business are reflected or reserved against in the Balance Sheet, except for immaterial liabilities incurred in the ordinary course of business, consistent with past practice.
Purpose: This representation is targeted at unknown liabilities that transfer to the Buyer (along with the Business) as a matter of law. Major liabilities can usually be predicted and planned for, so it is unlikely the Buyer will be held responsible for a significant, unplanned-for liability incurred by the Seller. Even so, this representation provides some level of comfort to the Buyer by shifting the risk of unknown pre-Closing liabilities back to the Seller.
Buyer Preference: The Seller may try to limit this representation or exclude it altogether, but the Buyer will want to include it as is on the grounds that any liabilities incurred by the Seller should be borne by the Seller. If the Seller does try to limit the applicability of the representation, it will likely argue for (1) a knowledge qualifier, (2) a materiality or Material Adverse Effect qualifier, (3) a GAAP qualifier, or (4) excluding certain specified liabilities. For the Buyer, argument (1) is a non-starter because the entire reason the Buyer wants this provision is to avoid shouldering liability for unknown liabilities, plus the Buyer does not want to be forced to prove the Seller’s knowledge about a particular topic. Similarly, the Buyer wants to exclude the GAAP qualifier because including it would mean the representation does not apply to unknown contingent liabilities and those liabilities are exactly why the Buyer is seeking the protection offered by this representation. Including materiality qualifiers of some sort or excluding specified liabilities may be more agreeable to the Buyer, but the Seller’s risk from small inaccuracies can be addressed just as well by applying a Basket to the Buyer’s indemnification rights, and taking that approach doesn’t create much additional risk for the Buyer.
Seller Preference: The Seller likely wants this representation excluded in its entirety, or, alternatively, to implement one or more of the limitations listed above. The Seller’s best hope is to exclude certain categories of liabilities, especially if they are addressed elsewhere in the Seller Representations and Warranties (i.e. environmental liabilities). Otherwise, the Seller may have to give in on a different point of negotiation in order to lower its risk from unknown pre-Closing liabilities.
Differences in a Stock Sale Transaction Structure: This representation is a necessity for the Buyer in a stock sale since, under that transaction structure, all of the Business’s liabilities are transferred to the Buyer by operation of law. The content of the representation may not change, but the Buyer’s level of risk if the clause is excluded increases exponentially when the transaction structure changes from asset to stock sale.
Financial Statements
What is the Financial Statements section? In this section, the Seller provides information regarding the financial statements of the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The Seller represents that it has provided the Buyer with Financial Statements (i.e. Balance Sheet, Income Statement, etc.) for a specified number of years and for the most recently ended fiscal quarter (the latter being referred to as the “Interim Financial Statements”). The Seller also typically represents how the Financial Statements were prepared (e.g. based on GAAP), that they are based on the books and records of the Business, and they fairly reflect the Business’s financial performance.
Purpose: The purpose of the Financial Statements representation is to confirm that the Financial Statements delivered to the Buyer are, in fact, representative of the Business. This representation could rightly be described as either a deal driver or a moderately material term, the difference being a result of whether the inaccuracy in the Financial Statements is intentional or unintentional. Unintentional inaccuracies that constitute a breach of this representation are certainly undesirable, but they generally have no more than a moderate impact on the value of the deal (otherwise, they would’ve been flagged internally by the Seller). Intentional inaccuracies tend to be larger, thereby influencing deal value to a greater degree. The more troubling result of intentional inaccuracies is that they decimate trust between the parties, and at that point most buyers will walk away from the deal. Thankfully, unintentional inaccuracies are the much more common variety.
Buyer Preference: In the event that the Seller’s Financial Statements are not prepared in accordance with GAAP, the Buyer wants to see an explanation of the Business’s accounting policies and procedures, and will likely conduct a more rigorous due diligence review of the Business’s financial information. A more aggressive Buyer will resist a materiality qualifier as part of the representation that the Financial Statements fairly depict the financial condition of the business, and may seek to include language indicating that the statements are “true, complete, and correct.” A cautious Buyer may also request the Seller’s tax returns in order to confirm the accuracy of the internally-prepared company financials.
Seller Preference: The Seller will want to include a materiality qualifier and/or a “GAAP qualifier” that simply states that the Financial Statements present the financials of the company in accordance with GAAP. Most sellers will settle for one qualifier or the other, but some may seek to include both if they want to rely on GAAP assumptions and are worried about minor inaccuracies or omissions.
Differences in a Stock Sale Transaction Structure: None.
Purchase Price Adjustment
What is the Purchase Price Adjustment? Businesses do not shut down operations during the transaction, so there is often a need to adjust the payments after the Closing to reflect the actual state of the Business on the Closing Date. This provision provides a way to make the necessary adjustments.
The Middle Ground: If the parties agree to adjust the Purchase Price based on one or more particular business metrics, the Purchase Price Adjustment section outlines the specifics on how that criteria will be used to adjust the price, and a time period for when the calculations must be made (typically by the Buyer). This section also details how long the Seller has to object to the calculations and, if an objection is made, the procedure for settling the dispute. For example, a popular basis for adjusting the Purchase Price is to calculate the final Working Capital figure (specified Current Assets less specified Current Liabilities), and a popular dispute resolution procedure is to first rely on good faith negotiation and, should that fail, to select a third-party accountant to resolve the discrepancy between the parties. To limit the disputes under this section and encourage resolution through negotiation, the Agreement may allocate payment responsibilities for the accountant’s fee to the party whose Working Capital figure is furthest from the accountant’s final determination. Another good way to avoid post-Closing Purchase Price Adjustment disputes is to clearly define how Accounts Receivable will be counted when calculating Working Capital at Closing. If money is billed before Closing but received after, whose money is it? What is the Buyer’s obligation to pursue the collection of funds that will ultimately flow to the Seller? Such terms are highly fact-specific, meaning there’s no clear middle ground, but it’s important to take those considerations into account in order to maximize the chance of avoiding post-Closing disputes.
Purpose: A Purchase Price Adjustment provision functions to ensure that value paid for the Business matches its current value. The magnitude of this provision’s impact depends on the specifics negotiated by the parties, such as which measurement is used to determine the adjustment. Unless there is a massive change in the value of the metric being used to determine the adjustment between the signing and Closing dates, the shift in Purchase Price will not be significant compared to the overall value being transferred. Despite the relative size, Purchase Price adjustments are often heavily negotiated because neither side wants to end up with less value than they give away.
Buyer Preference: The Buyer wants to be the party preparing the evaluation of the metric(s) in question. If the Buyer prepares the evaluation, it will support a scheme whereby the accountant’s fee is paid proportionally based on how close each side is to the accountant’s final determination. That scheme reduces the likelihood for disputes because taking an unreasonable position may lead to higher costs for the party taking that position, and since the Buyer is preparing the evaluation (in its ideal scenario), the Seller is more likely to accept it unless they are firmly convinced that their valuation will be closer to the accountant’s final determination. The Buyer will typically hold a portion of the Purchase Price in an escrow account until the adjustment is made; it will usually want that account to be separate from an escrow account used for potential indemnification claims to make sure that indemnification payments will be made if a claim arises. As for treatment of Accounts Receivable, the Buyer will likely want to assume those accounts to maintain the Business’s normal cash flow cycle, but in doing so it may request a representation from the Seller about the creditworthiness of the customers or even a guarantee requiring the Seller to pay for any Accounts Receivable that ultimately isn’t paid.
Seller Preference: The Seller wants to prepare the evaluation on which the Purchase Price adjustment is based. When the Seller is in control it will favor a fee arrangement that discourages the Buyer from challenging its conclusion. Timing of the evaluation may also be an important consideration because the Seller will want the adjustment to be based on the company’s performance while still under its control. The Seller is typically against both an escrow arrangement and applying interest to the adjustment. That is because the Seller generally wants to be paid the entire Purchase Price as soon as possible (i.e. no escrow) and adjustments typically favor the Buyer (i.e. no interest), perhaps because the Seller is more likely to be overconfident about the Business’s future performance. The Seller wants to be compensated for the full value of Accounts Receivable that are transferred to the Buyer rather than retaining the risk of nonpayment and relying on the Buyer to collect on the accounts. In other words, the Seller wants to treat these accounts just like any other current asset being factored into Working Capital.
Differences in a Stock Sale Transaction Structure: None.
Excluded Assets
What is the Excluded Assets section? The Excluded Assets section consists of a detailed list of the Seller’s assets that will not be transferred as part of the acquisition.
The Middle Ground: The assets to be included here are specific to the deal, and the list will be created in conjunction with the list of Purchased Assets. Basically, any assets of the Business that are not listed as Purchased Assets are considered Excluded Assets.
Purpose: In the event of any sort of confusion regarding the list of Purchased Assets, this list provides clarity about what is and is not being transferred as part of the acquisition (reducing the risk of uncertainty). It is especially useful when the Purchased Assets section lacks detail, or when there are assets with similar names or descriptions but not all of them are being included in the purchase.
Buyer Preference: In terms of the content of this list, the Buyer wants to include assets that hold no value for the Buyer (e.g. unnecessary organizational seals, books, and records), especially if those assets come with significant contingent liabilities (e.g. benefit plans). In drafting terms, the Buyer’s main objective is to achieve the right degree of specificity, ensuring it does not exclude an asset it intends to purchase or include an asset it intends to leave behind.
Seller Preference: The Seller’s motivations in drafting this section largely depend on whether it is selling its entire business or whether it is only selling one division or line of business. If only selling a portion of its business, the Seller will want this section to read broadly so that it retains the assets necessary to continue its own operations. If the Seller will not continue to operate after the sale, a short and detailed list of Excluded Assets is usually not a cause for concern.
Differences in a Stock Sale Transaction Structure: This section will not be included in a stock sale because the Buyer will be purchasing the entire company and will not get to pick and choose which assets to include in the transaction.