The Art of M&A Due Diligence, Second Edition: Navigating Critical Steps and Uncovering Crucial Data

T H E A RT O F MA & Due Diligence Navigating Critical Steps and Uncovering Crucial Data ALEXANDRA REED LAJOUX CHARLE...

Author: Alexandra Reed-Lajoux | Charles Elson

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T H E A RT O F

MA &

Due Diligence Navigating Critical Steps and Uncovering Crucial Data

ALEXANDRA REED LAJOUX CHARLES M. ELSON

New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. ISBN: 978-0-07-162937-9 MHID: 0-07-162937-8 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-174534-5, MHID: 0-07-162936-X. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. To contact a representative please e-mail us at [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. —From a declaration of principles jointly adopted by a committee of the American Bar Association and a committee of publishers TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGrawHill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.

C O N T E N T S

PREFACE AND ACKNOWLEDGMENTS v INTRODUCTION: The Changing Landscape for Due Diligence in 2010 xi PART ONE

THE DUE DILIGENCE PROCESS

1

Chapter 1

Conducting Due Diligence: An Overview

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Chapter 2

The Financial Statements Review

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Chapter 3

The Operations and Management Review

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Chapter 4

The Legal Compliance Review 95

PART TWO

TRANSACTIONAL DUE DILIGENCE

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Chapter 5

The Documentation and Transaction Review

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Chapter 6

Detecting Legal Exposure under Securities Law

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Chapter 7

Detecting Exposure under Tax Law and Accounting Regulations

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CONTENTS

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PART THREE

A CLOSER LOOK AT COMPLIANCE

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Chapter 8

Detecting Exposure under Antitrust Law and International Economic Law 231 Chapter 9

Detecting Exposure under Intellectual Property Law

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Chapter 10

Detecting Exposure under Consumer Protection Laws Chapter 11

Detecting Exposure under Environmental Laws

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Chapter 12

Detecting Exposure under Employment Law

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CONCLUSION 385 DUE DILIGENCE CHECKLIST 387 LANDMARK AND RECENT DUE DILIGENCE CASES 401 THE FEDERAL CIRCUIT COURTS 461 NOTES 463 INDEX 523

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PREFACE AND ACKNLOWLEDGMENTS

How diligent must an acquirer be during the “due diligence” phase of an acquisition? Judging from the business crises that fill daily news headlines, acquirers cannot be too careful. Some buyers spend millions of dollars identifying every possible risk before signing on the dotted line. This thoroughness is encouraged by the existing guides to due diligence, which feature long lists of applicable laws and legal precedents, depicting the typical selling company as a vast field of land mines that are just waiting to explode. The message of these guides is clear: “Watch out! After you acquire a company, you can become insolvent or get sued, and insurance may not cover you—so beware!” Hearing this, prudent deal makers have only one choice: to walk away from the deal table and go back to their day jobs. Our book aims higher. We will urge not just diligence but due diligence, or the care that is commensurate with the deal at hand—a process of verification tempered with a sensible level of trust. That is, rather than presenting you, the reader, with a barrage of risks to sort out on your own, we intend to show how to predict and—more important—limit the risks that are inherent in acquisitions. ■

To help you predict postmerger risk, Part 1 discusses risk in three categories: financial statement risk, operational risk, and

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liability risk. Moving on, Part 2 covers transactional risk, which can arise from the transaction itself. Part 3 goes into greater depth on liability across the board, assessing potential legal exposures from various laws and regulations. To help you limit all these risks, we explain throughout this book how the U.S. legal system can work to protect your decisions as an acquirer as long as you make those decisions in good faith and with due care.

In covering these topics, we aim to be comprehensive, but no book can cover all the topics that may be of interest to any acquirer. We urge readers to seek the expert opinions of practicing attorneys and accountants— just as we have done. Throughout this book, we use the question-and-answer format used from the beginning of the Art of M&A series, starting with the first edition of The Art of M&A more than two decades ago. As new questions arise, do not hesitate to send them our way for inclusion in future editions. ACKNOWLEDGMENTS

The basic concept of this book began more than two decades ago, in 1987, at Lane & Edson, P.C., in Washington, D.C. The firm’s founders, Bruce Lane and Charles Edson, joining with Stanley Foster Reed, the founder of Mergers & Acquisitions magazine, asked Alexandra Lajoux to interview them and the firms’ mergers and acquisitions specialists on the work that they were doing in due diligence and other areas. The transcripts of those interviews formed the foundation for The Art of M&A: A Merger/Buyout/ Acquisition Guide (now in its fourth edition with McGraw-Hill) as well as a series of “spin-off ” books published by McGraw-Hill. Each of the spin-off books builds on existing sections in the basic Art of M&A (sometimes excerpting sections verbatim), but each book goes into a particular topic in greater depth. The first four titles in the series covered integration, financing, structuring, and due diligence. Dr. Lajoux has been honored to have Professor Charles M. Elson, attorney, scholar, and corporate director, join her in covering this important topic—10 years ago for our first effort, and now for this second edition.


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The authors of this book, in turn, are pleased to draw on the wisdom of others. Former Lane & Edson Partner Eugene M. Propper (now in private practice in McLean, Virginia) contributed substantially to the due diligence chapter in the original (1989) edition of The Art of M&A. Thomas E. Weil, Jr. (now with Skadden Arps in Houston, Texas), was the lead contributor to that book’s chapter on closing. Richard L. Perkal (a partner with Irving Place Capital) wrote that book’s original material on acquisition agreements, and has reviewed relevant portions of the pages ahead. In addition, we would like to extend thanks to the following individuals, chapter by chapter: Chapter 1: Conducting Due Diligence: An Overview. Special thanks go to Mark Schonberger, a partner with Paul Hastings, New York. He generously provided the forms used to create many of the templates in this book, including the forms mentioned in Chapter 1 that can be found on the Web site for the book. We also wish to thank the many founders of the M&A Leadership Council, an educational 501(c) based in Dallas, Texas, that is dedicated to the art and science of M&A. Chapter 2: The Financial Statements Review. This chapter owes a debt to John Flaherty, retired chairman of the Committee of Sponsoring Organizations of the Treadway Commission; and John C. Fletcher, Managing Director, Delta Control Group, Geneva, Switzerland. We also acknowledge the collective wisdom of the members of the National Association of Corporate Directors (NACD) Blue Ribbon Commission on Audit Committees, which convened in 1999 and 2010. Chapter 3: The Operations and Management Review. A major contributor to this chapter was John Verna, CEO & Executive Managing Director, Navigator Associates, previously with Kroll. Other contributors included Bobby Vick, CPA, Cochair of the KSU Corporate Governance Center, Atlanta, Georgia; and Dr. Michael J. Riley, President, Riley Associates. Chapter 4: The Legal Compliance Review. Expertise on director and officer liability insurance came from Ty Salalow,

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Chief Innovation Officer, Zurich North America at Zurich Financial Services. Chapter 5: The Documentation and Transaction Review. Richard Perkal, mentioned previously, was the original author of the basic text of this chapter, and updated it for us for this edition. Riccardo Trigona, an attorney who is CEO and Producer, Trion Pictures, Milan, Italy, also contributed. Chapter 6: Detecting Legal Exposure under Securities Laws. Economist Jonathan Sokobin, Director, Office of Risk Assessment, Securities and Exchange Commission, provided expert commentary for this chapter. Chapter 7: Detecting Exposure under Tax Law and Accounting Regulations. The authors gratefully acknowledge the commentary of John Flaherty (cited previously), who reviewed the accounting portions of this chapter. Chapter 8: Detecting Exposure under Antitrust Law and International Economic Law. In the process of preparing the original version of this chapter, the authors consulted Holly Gregory, Partner, Weil Gotshal and Manges, LLP, New York. Chapter 9: Detecting Exposure under Intellectual Property Law. Sincere thanks go to Julie Davis, Principal, Davis & Hosfield Consulting LLC, for materials on intellectual property due diligence. Chapter 10: Detecting Exposure under Consumer Protection Laws. Nancy H. Steort, Former Secretary, Consumer Product Safety Commission, reviewed this chapter for the original edition, providing valuable commentary. Chapter 11: Detecting Exposure under Environmental Laws. Experts consulted for this chapter include Charles “Lindy” Marrinaccio, Retired Partner, Kelly, Drye & Warren, Washington, D.C.; and James McRitchie, Editor, Corporate Governance (corpgov.net), and Chief, Office of Environmental Analysis, Regulations and Audits, State of California. Chapter 12: Detecting Exposure under Employment Law. We acknowledge gratefully the contributions of Christine A. Amalfe, Chair, Employment Law, Gibbons PC, Newark, New Jersey.


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In addition, we extend our thanks to the following individuals, who provided expert guidance on the following sections at the end of the book or on the Web site: Sample Acquisition Agreement (found on the Web site). The authors extend their appreciation to Richard L. Perkal, mentioned previously. Due Diligence Checklist. This checklist is based on a template originally created by Dan Goldwasser, Esq., New York. Landmark and Recent Due Diligence Cases. The authors have compiled many of these cases based on their own research. As our basic template, we drew on the cases that appear in Stanley F. Reed, Alexandra R. Lajoux, and H. Peter Nesvold, The Art of M&A: A Merger/ Acquisition/Buyout Guide, Fourth Edition (New York: McGraw-Hill, 2007). For recent Delaware cases, we have availed ourselves of expert analysis from the Delaware Business Litigation Report of Morris James, LLP, Wilmington, Delaware, with the firm’s permission. We highly recommend this firm’s coverage of Delaware litigation: http://www.delawarebusinesslitigation.com/promo/ our-attorneys/. In closing, we wish to thank the knowledgeable, talented, and industrious crew at McGraw-Hill. First acknowledgments go to our sponsoring editor, Jennifer Ashkenazy, and her predecessor, Leah Spiro, as well as to senior editing supervisor Pattie Amoroso; assistant project editor Tania Loghmani; senior production supervisor Maureen Harper; copy editor Alice Manning; proofreader Eric Lowenkron; and indexer Kay Schlembach. The McGraw-Hill name is known worldwide for excellence thanks to professionals like these.

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I N T R O D U C T I O N

The Changing Landscape for Due Diligence in 2010

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hether economies are strong or weak, purchases and sales of companies persist, making “due diligence” studies of target companies a necessary aspect of professionalism for managers and advisors alike. With more than 30,000 announced deals worth more than $2 trillion at the end of 2009, and another 19,000 announced deals worth nearly $1.22 trillion by the end of the first half of 2010, M&A continues to be strong around the world.1 But as we go to press with this second edition of The Art of M&A Due Diligence, first published 10 long years ago, we realize that our key term, due diligence, may sound quaint. Rooted in centuries-old English equity court concepts of good human character, these two words inhabit a fair and ordered realm that is quite different from the seemingly random one that has existed in recent years.

BIG CHANGES

Has the nature of economic reality changed since 2000? You decide. ■

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When a few men with box cutters can cause the destruction of a towering financial center and the loss of 2,974 lives . . . When an energy giant’s share price can plummet from $90 to $1 in 18 months . . .

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INTRODUCTION: The Changing Landscape for Due Diligence in 2010

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When a century-old audit firm proudly bearing the name of a man of integrity (once fought over by two rival heirs) can be forced out of business because of one man and a shredder . . . When a cofounder of the Nasdaq stock market can be forced to pay $1 million out of his own pocket in part because he and his colleagues failed to exercise due diligence in their acquisition oversight 2 . . . When Congress can propose and pass a sweeping bipartisan business bill from congressional floor to presidential pen in less than 90 days, including a section that would eventually cost midsized companies an extra $2 million per year in compliance costs3 . . . When equities worldwide can lose half their value in a year because mortgage banks made loans to people who couldn’t pay them back, and transferred the risk to third parties . . .

. . . then you know that your world has been rocked. Indeed, it was unpredictable events like these that inspired philosopher Nicholas Taleb to write his best-selling book The Black Swan, about unknowable risk.4 Yes, all these events and more have transpired in the wake of our first edition, compelling us to reexamine “due diligence,” which seems more arcane by the day. This very notion, applied to mergers and acquisitions, presumes that a management team and its advisors can conduct a reasonably diligent study of a company to be acquired within a reasonable time frame. The events of the past 10 years make this goal far more difficult to accomplish. VALUE OF DUE DILIGENCE

And yet, paradoxically, these surprising events heighten the importance of due diligence more than ever. They raise the stakes for poor due diligence, while at the same time creating, regrettably but inevitably, a narrower margin for error. Clearly, acquirers need to be more careful than ever before as they assess the possible risks of buying a particular company, but how careful do they have to be? Must they think of all possible risks and factor them all into the acquisition price—or only those that are most likely and most important?


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This question has many dimensions, all of which will be explored anew in this new edition. But perhaps the most important one relates to the word due. So far, as of the year 2010, diligence is still subject to interpretation. With the exception of some special applications in securities law, due diligence has not been the subject of federal regulation. It is still largely determined by the courts, case by case. This is good. Fortunately, much of the global economy—and the U.S. economy in particular—still retains some vestiges of the old English common law system or its close cousin, equity law. Under common law, right and wrong actions are decided by legal precedent, with past decisions being used to interpret statutory law. In the case of equity courts, statutory law is less important: the court’s interpretations stem from concepts of fairness. Although modern events may seem to have eviscerated the very notion of fairness, this notion continues, despite attempts to upstage it with ironclad laws and rules that would expand two stone tablets into two million. Common law and equity law take facts, circumstances, and motives in particular situations into consideration, without creating and enforcing single paradigms across different situations. We believe that preserving this heritage is more vital than ever in our new world, where regulations are increasing and responsibility born of common sense seems to be on the wane. Heeding the advice given in this book can help to reverse this unfortunate trend. THE WORLD OF THE 2000 EDITION

Our first Due Diligence book appeared in the year 2000. It offered an overview of the due diligence process, including a review of financial statements, operations and management, and legal compliance. It also covered transactional due diligence (documentation and transaction review) and detecting legal exposure under securities law, tax law, and accounting regulations. In that edition, we took a closer look at legal compliance, with guidance for detecting exposure under various international economic laws as well as for antitrust, consumer protection, environmental, and employment laws. We offered checklists, a sample agreement, landmark cases, and a guide to the federal circuit courts. All of this material remains either in this 2011 edition or on the Web site for this book, using the same general framework, but with considerable updates.


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At the time we published our first edition, businesses were operating in a relatively stable economic and political environment. While the decade preceding our publication date, the 1990s, had certainly generated corporate scandals—BCCI, Cendant, and Waste Management come to mind— we could easily see, in retrospect, what had gone wrong in each of those cases. By creating a checklist of red flags, we solved those problems for acquirers—or so we thought. Our first edition did well. It was cited in court cases, such as In re McKesson HBOC, Inc., Securities Litigation.5 It also garnered good reviews, got cited in articles, and sold well to universities, law firms, and individuals.6 But it is time for a new edition. Why? Because between 2001 and 2010, the world has changed in many radical ways—all of which are reflected in this new edition. THE WORLD OF THE 2011 EDITION

We mentioned some dramatic events that rocked our world. Here are some of the repercussions of those events in the business, legal, and regulatory contexts. ■

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The tragic events of September 11, 2001, had many outcomes. Among them was a stronger emphasis on risk oversight. This edition of Due Diligence will report on the newest tools for the detection and prevention or mitigation of major risk in connection with a business purchase. The bankruptcies of Enron and WorldCom were notable not only for their size but also for their surprise. This edition contains an expanded checklist with more warning signs of insolvency. The demise of Arthur Andersen showed that even professional service firms of the highest quality can employ individuals who make grave mistakes, increasing the importance of management involvement in due diligence. This edition can help companies work more effectively with their advisors. The WorldCom case showed the vicious reach of Section 11 of the 1933 Securities Act, which does not require intent on the part of the defendant. The settlement in this case set a record not


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only for impact ($1 million per person paid out of pocket) but also for motivational innocence (the directors who paid this money had no intent to defraud, but merely did a bad job of due diligence, among other failings). This sends a clear message that acquirers must make a careful review of any transaction, especially those involving securities offering documents.7 The passage of Sarbanes-Oxley (SOX) in 2002, related rules of the Securities and Exchange Commission (SEC), and revised listing rules for stock exchanges (New York Stock Exchange, Nasdaq, and Amex), as well as establishment of the Public Company Accounting Oversight Board (PCAOB) transformed corporate life. Changes included requirements to assess internal controls under Section 404 of SOX and Standard 5 of the PCAOB. This edition has a new opening overview, with substantial revisions to Chapter 2, “The Financial Statements Review,” and Chapter 6, “Detecting Legal Exposure under Securities Law.” The crash of the mortgage-backed securities market caused problems in all sectors of the economy that are linked to home buying, with many legal repercussions, such as passage of the Emergency Economic Stabilization Act of 2008 (EESA), the creation of a special inspector general for the Troubled Asset Relief Program, and additional financial legislation in subsequent years.8 This new edition can help financial institutions and other companies adapt to these changes.

And there’s more. In addition to the paradigm-shifting events just listed, consider these additional changes during the past decade. ■

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Increasing use of electronic data rooms for due diligence. This edition includes a revised section on conducting due diligence, including an overview and an update of Chapter 5, “The Documentation and Transaction Review.” A move toward international accounting standards, along with other tax and accounting changes. In August 2008, the SEC announced that the United States would take definite steps to adapt to the International Financial Reporting Standards. As of


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June 2010, more than 100 countries used or were adopting International Financial Reporting Standards, including all the members of the European Union and also Canada, China, Japan, and India. The United States may be engaged in a long-term process to migrate generally accepted accounting principles (GAAP) to this model, to be confirmed in 2011 and completed by 2014. This edition updates our overview, as well as Chapter 2, “The Financial Statements Review,” and Chapter 7, “Detecting Exposure under Tax Law and Accounting Regulations.” The latter chapter in particular required extensive updating, given a decade’s worth of changes. New tools for ensuring compliance with the Foreign Corrupt Practices Act (FCPA). Since our last edition, which covered this landmark law in some detail, the Department of Justice has issued some 20 more Foreign Corrupt Practices Act Opinions. (Any U.S. company may request an FCPA opinion—a statement of the Justice Department’s present enforcement intentions under the FCPA regarding any proposed business conduct.) These current opinions—along with illuminating new standards and resources from the Caux Round Table—can be a powerful tool for due diligence on pending transactions that involve foreign governments. New regulations (as well as more shareholder proposals) regarding global warming and other environmental and social issues. Examples are the Energy Policy Act of 2005, the Pension Protection Act of 2006, and new records for numbers of shareholder proposals and stakeholder legal claims or settlements concerning environmental and social issues. This new edition discusses these laws and related developments in Chapter 11, “Detecting Exposure under Environmental Laws,” and Chapter 12, “Detecting Exposure under Employment Law.” New case law that is of interest, including decisions of the Delaware Chancery Court and the Delaware Supreme Court.9 This edition includes a variety of new cases in the back of the book.


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THE WORLD IN 2020

We have written this book to last another 10 years. Thus, in the following pages, we have a great deal of material that we believe is appropriate for the year 2020. In that year, what will the world be like? For acquirers, here is our optimistic prediction: ■

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The due diligence process will be linked to the entire acquisition process, from predeal strategy to postdeal integration. Use of high-tech tools such as decision-making dashboards and electronic data rooms will become routine. The perfection of translation software will ease the way for more global transactions, enabling better due diligence across national boundaries. Standard setters in the private and public sectors will make a greater effort to consolidate and clarify their terminology and guidance, easing compliance. The reach of federal law will grow, but in response, more states will set up chancery courts to encourage more private actions based on principles rather than rules.

These are our predictions—and our hopes—for the future. We look forward to the next edition—no later than 2020, and perhaps earlier if the pace of change quickens. We hope this volume is useful and encourage your questions and comments. Alexandra R. Lajoux

[email protected]

Charles M. Elson [email protected]


PA R T

ONE

The Due Diligence Process

Conducting due diligence in a merger or acquisition requires a sense of the whole as well as of all the key parts. Thus, in Chapter 1 we provide broad coverage of the M&A due diligence process: what it is, who conducts it, and when it begins and ends. Then, in the following chapters, we go into greater depth on how due diligence is conducted in various areas: financial, operational, and legal. In Chapter 2, after a discussion of financial reporting, we introduce the important topic of internal controls. Citing the Committee of Sponsoring Organizations of the Treadway Commission (COSO), a leading standard setter for this area, we define controls as a process that links financial reporting, operations, and compliance. In Chapters 3 and 4, we cover operations and compliance in greater depth. Chapter 3 shows acquirers how to study a candidate company’s operations and management. Although we emphasize a traditional due diligence approach, we also cover conflict resolution and culture—two new entrants into M&A due diligence work. Chapter 4 shows acquirers how to assess the litigation risks that may lie ahead. We call for caution in dealing with each and every constituency, including customers, employees, shareholders, suppliers, and, of course, the state or federal government, which may sue on behalf of any of these constituencies or the broader public. (In Part 2, we follow through on the

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PART 1: The Due Diligence Process

compliance theme, presenting overviews of the major statutes and agencies in these areas.) Throughout Part 1, we cite the disclosures required under securities laws. We do this not merely to encourage compliance with securities law, although this is certainly important. Rather, we quote these laws to help acquirers and sellers meet their own informational needs. If disclosure rules did not exist, deal makers would have to invent them, because they require such useful information. In Part 2, we continue our constant reference to securities law as a cornerstone of transactional due diligence—the focus of the next section.

CHAPTER

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Conducting Due Diligence: An Overview Risk has always been a companion of reward, inherent in assessing opportunities against a company’s strengths and weaknesses. —Report of the NACD Blue Ribbon Commission on Risk Governance (2009)

INTRODUCTION

The due diligence phase of any acquisition—the study of the risks that the deal poses—can make the difference between success and failure. Many a deal that looks good on the back of an envelope looks bad in a spreadsheet. Acquirers must face all the facts—even worst-case scenarios. This is why due diligence must be considered in conjunction with other acquisition activities and goals, including strategic planning, valuation, financing, structuring, and—most important—charting the future of the combined company, with all its new risks and opportunities. To put due diligence in its proper perspective, we begin this chapter with the legal foundations of due diligence. Next, we discuss the “what, when, and who” of due diligence—that is, its scope, duration, and key participants. We then give some further background on the legal aspects of due diligence (focusing on “due diligence” in the securities law context). Finally, we close with suggestions for verification and risk prevention. Our goal is to build a strong platform of understanding for the more detailed work ahead. LEGAL FOUNDATIONS What are the legal origins of due diligence?

The term due diligence originated in so-called common law, also known as case law—the law that has developed through the decisions of judges 3

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in settling actual disputes. The common law system arose in medieval England after the Norman Conquest and is still in use there as well as in the United States, among other countries. In this approach to legal regulation, judges resolve disputes by using the precedents of decisions in previous cases, rather than relying on legislatively enacted rules. Much of U.S. common law, however, has been codified into the legislatively enacted statutes of individual states and into a widely used guide to commercial transactions called the Uniform Commercial Code. (For more about the U.S. legal system, see Chapter 4.) The precise origins of due diligence are lost in the mists of time. Black’s Legal Dictionary defines due diligence as “the diligence reasonably expected from, and ordinarily exercised by, a person who seeks to satisfy a legal requirement or to discharge an obligation.”1 The concept of diligence clearly goes back to the Roman law concept of diligentia. Roman law distinguished two main types of diligence: diligentia quam suis rebus, or the care that an ordinary person exercises in managing his or her own affairs, and diligentia exactissima or diligentia boni patrisfamilia, a more exacting type of care exercised by the head of a family.2 English law spoke of diligence as early as the seventeenth century, and by the eighteenth century it had developed three kinds: 1. Common or ordinary . . . 2. High or great, which is extraordinary diligence . . . 3. Low or slight, which is that which persons of less than common prudence, or indeed of any prudence at all, take of their own concerns.3 American courts expanded on this to develop an even more complex hierarchy of diligence, from the least degree of diligence to the highest, as follows: ■ ■ ■ ■ ■ ■

Low diligence Common diligence Ordinary diligence Reasonable diligence Proper diligence Extraordinary diligence

CHAPTER 1: Conducting Due Diligence: An Overview

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High diligence Highest possible degree of diligence Utmost diligence4

An obvious question that arises is: what order of diligence is “due” diligence? Is it ordinary, extraordinary, or slight? The legal record suggests that the standard is ordinary, with some important exceptions. Due diligence to a decision stands outside this entire hierarchy to say, it depends. Some circumstances require only low diligence, while at the other extreme, some require utmost diligence. It is a question of facts and circumstances. The following judicial statements make this point abundantly clear: ■

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“Diligence is a relative term, incapable of exact definition. What would amount to due diligence under one state of facts would fall absolutely short of it under another and different state of facts.”5 “What constitutes ‘due care,’ ‘ordinary care,’ ‘diligence,’ or ‘negligence’ depends very largely upon circumstances of a particular case.”6 “Diligence is a relative term, and must be proportionate to the danger against which it is required to guard. More active diligence is required to conduct a locomotive through the streets of a populous town than is necessary to guide a sled drawn by oxen in an unfrequented place.”7 At least 19 cases specifically state that diligence is a “relative” term.

In the United States, the term due diligence describes a general duty to exercise care in any transaction. For example, in securities law, the term refers to the duty of care and review exercised by officers, directors, underwriters, and others in connection with public offerings of securities.8 In most circumstances, case law in the United States suggests an ordinary standard, as explained later in this chapter and in Chapter 4. Clearly, however, the more diligence expended on a transaction, the lower the risk of problems afterward. To be safe, one might well revert to a strict “high Roman” standard. According to one early source, “If the interests of the parties are not identical, the Roman law, at least, requires extraordinary diligence.”9

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How is the term due diligence used in landmark legal cases?

The following quotes make it clear that the standard of due diligence in law tends to be ordinary in the average case. ■

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“Due diligence, in law, means doing everything reasonable, not everything possible.”10 “To constitute due diligence does not require unusual efforts or expenditures, but only such constancy in the pursuit of the undertaking as is usual with those in like enterprises. Such assiduity as shows a bona fide intention to do or complete it within a reasonable time.”11

The most commonly cited “due diligence” case is Escott v. BarChris Construction Corp. (1968). In this case, holders of debt (51⁄2 percent 15year convertible subordinated debentures) sued certain directors and officers of BarChris, a bowling alley builder, as well as the company’s advisors. The plaintiffs accused BarChris of securities fraud after the company went bankrupt. Although this was a securities offering case, not a merger case, it is considered instructive to acquirers. More recently, in Gantler v. Stephens (2009), the Delaware Supreme Court opined on whether a board could be sued, among other charges, for questionable due diligence. Summaries of these cases and many others appear at the end of this book. All these cases—even those that do not directly pertain to M&A due diligence—can help in the conduct of such an activity. What exactly is M&A due diligence?

In mergers and acquisitions (M&A), due diligence refers primarily to an acquirer’s review of an acquisition candidate to make sure that its purchase would pose no unnecessary risks to the acquirer’s shareholders. The term also refers to the mutual review undertaken by the two parties to a merger. Finally, the phrase can apply to a candidate company’s review of the acquirer to ensure that relinquishing control will not violate any duties to the company’s owners. The basic function of M&A due diligence, then, is to assess the benefits and the liabilities of a proposed acquisition by inquiring into all rel-


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evant aspects of the past, present, and predictable future of the business to be purchased. Those who are making this assessment should focus on risk. Acquirers generally do this by creating a checklist of needed information (see the Due Diligence Checklist at the back of the book for a sample), and then obtaining that information by ■ ■ ■

Examining financial statements (see Chapter 2) Assessing management and operations (see Chapter 3) Reviewing legal liability (see Chapter 4)

In this process, acquirers may conduct interviews and visit sites, maintaining records of all this information. Chapter 3 contains guidance on setting up a due diligence data room—virtually as well as physically.12 Caveat: an acquirer cannot, and should not be expected to, discover every possible risk. The sheer effort required to do so would surely bankrupt the acquirer and certainly alienate the seller.13 Companies are complex entities operating in a complex world; no investigation can uncover all potential risks. Due diligence conducted “must be reasonable, not perfect.” Even if an expert can later find fault, its “ability to poke holes in the diligence conducted is not dispositive.”14

THE SCOPE OF DUE DILIGENCE What general areas should the due diligence review cover?

At a minimum, the due diligence effort should include ■

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Financial statements review (to confirm the existence of assets, liabilities, and equity in the balance sheet and to determine the financial health of the company based on the income statement and cash flow statement). Management and operations review (to determine the quality and reliability of the financial statements based on an assessment of internal controls and to gain a sense of contingencies beyond the financial statements).

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■

■

Legal compliance review (to check for potential future legal problems stemming from the candidate company’s past). Document and transaction review (to ensure that the paperwork of the deal is in order and that the structure of the transaction is appropriate).

These parts of due diligence are listed in a typical sequence, in which the most accessible information is reviewed first and the least accessible (or the most transaction-dependent) information is reviewed last. But note: these phases may or may not be sequential, and may or may not be in this order. For example, if an acquisition candidate is known to be close to resolving a major lawsuit, then the legal compliance review might occur very early on. The first three areas are covered in separate chapters in Part 1. Transactional review is examined in Part 2. Legal compliance is covered in more depth in Part 3. How extensive should due diligence be?

How far a buyer wishes to go in the due diligence process depends in part on how much time the buyer has and how much money it has to investigate the company it wishes to buy. This will depend to some extent on the status of the company in the community, the number of years it has been in business, whether it has been audited by a major firm for some years, whether executive turnover is low, and any other factors that help to establish the basic stability of the firm, such as long-term customer retention. If a broker is involved in the transaction, the broker may wish to require some basic level of acquirer due diligence. In fact, it is not unusual for brokers to include a contractual requirement that the purchaser undertake due diligence.15 Furthermore, due diligence can vary depending on the type of company. The due diligence work required for the acquisition of a large, diversified, global company in a highly regulated industry is obviously far more extensive than the work involved for a small, single-product, domestic firm in a relatively unregulated sector. Also, it makes a great difference whether a firm is publicly or privately held, as discussed later. Also, the type of transaction can limit the due diligence effort, since stock purchases trigger more due diligence responsibilities than do asset purchases.


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9

In any sale of stock, no matter how it is accounted for, the resulting entity will bear all the liabilities of both parties to the transactions, so the level of due diligence obviously has to be as extensive as possible. In sales of assets, by contrast, the structure of the transaction can make a significant difference. In general (with some exceptions), when a company sells or otherwise transfers all its assets to another company via acquisition, the successor is not liable for the debts and legal liabilities of the predecessor unless it expressly assumes them.

In classic asset sales, therefore, the due diligence effort need not include a study of debts and legal liability exposure. On the other hand, acquirers that are used to the protections of securities laws should realize that these laws do not apply to any transaction that is structured as an asset sale. Note also that if the asset sale is structured as a merger, then the acquirer does assume debts and legal liabilities unless the seller expressly retains them. Asset sales that are structured as mergers are rare, but they can and do occur. For example, there may be a sale of multiple assets (in which some of the assets of a business are purchased separately from the stock of the company that owns the rest of the assets), followed by a merger of the seller and the buyer. This hybrid form of transaction puts debts and legal liabilities squarely in the hands of the acquirer, unless they are expressly assumed by the seller. Source of financing is another factor that can influence the intensity of due diligence. In acquisitions that are financed through equity, all parties are interested in uncovering problems early, because postdeal problems that could or should have been uncovered can be very expensive to solve, and can result in lawsuits against all parties involved. As one due diligence expert states, “Risk disclosure is cheap. Defending litigation is not.”16 So it is useful for a company that is conducting due diligence to continually ask itself (as well as those interviewed during the due diligence process) what could possibly go wrong, and to disclose all material risks that have any likelihood at all of occurring. We emphasize the term material, because it is crucial to due diligence—and a staple of U.S. disclosure rules. Public companies must disclose “material” contracts, debt, litigation, and risks in their 10-Ks, 10-Qs,

10


registration statements, and proxy statements filed with the Securities and Exchange Commission (SEC), and the SEC’s Regulation Fair Disclosure requires prompt public disclosure of “material” information.17 In a word, material means “important,” and the point of due diligence is to identify potential risks that could be important later on. In the aftermath of Sarbanes-Oxley, the due diligence lexicon gained more conceptual clarity in the important area of internal controls. The SEC defined “material weakness” and a “significant deficiency.” ■

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Material weakness in internal controls is “a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis.”18 By contrast, a significant deficiency in internal controls is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the registrant’s financial reporting.19

The judiciary has provided helpful guidance on what is and is not material information. Consider the cases cited in the U.S. Supreme Court’s finding in Nacchio v. United States of America (2009), which threw out the criminal conviction of Joseph Nacchio, the former CEO of Quest.20 Over time, a number of quantitative benchmarks for materiality have evolved—“more than 5 percent,” “more than $1 million,” and so forth. Many of these are contained in U.S. securities and tax laws themselves. (Consider the 5 percent ownership disclosure triggers of Section 13B and the $1 million pay cap for compensation deductions under Section 162(m) of the tax code.) Setting numerical benchmarks is helpful, and such benchmarks usefully appear in due diligence documents. But these thresholds, while useful, may not be enough. According to the August 1999 Staff Accounting Memorandum 99 (SAM 99) of the SEC, materiality is not merely a matter of percentages or amounts. Rather, it is a highly relative term. It


11

refers to a level that would be considered significant by the average prudent investor.21 How is due diligence different for public and private companies?

As mentioned, due diligence for public companies is different from due diligence for private companies. Public companies have greater disclosure obligations than ever under such relatively new laws as the Sarbanes-Oxley Act of 2002 and the Emergency Economic Stabilization Act of 2008— to name just two major laws that have revolutionized public company due diligence. The downside for acquirers is future work—disclosure obligations going forward. But conversely, the upside to public company due diligence is that it can draw on past work. Any company that has issued securities has already been the subject of a due diligence study by its underwriters and their counsel in preparing the company’s original prospectus. Acquirers, then, can use the company’s prospectus as a guide, and can rely to some extent on the due diligence that the prospectus required. The extent of this due diligence will depend on the size of the offering and the history of the company’s previous security registrations, as explained further in the section on securities laws. If the candidate company has issued stock at any time in the last several months, the acquirer can rely on the due diligence conducted by the underwriter at that time, with “bringdown” updates as necessary. Underwriter due diligence conducted a year or more ago, however, leaves a cold trail that acquirers will need to retrace—and perhaps even reconstruct in detail. The work of the due diligence analyst will also be eased by the internal controls disclosures required under Section 404 of Sarbanes-Oxley, and also the executive compensation risk disclosures that became effective February 2010.22 In the area of financial services, companies that received funds under the Troubled Asset Recovery Program under the Economic Recovery Act of 2008 will have made additional disclosures regarding compensation. All these disclosures can be useful for due diligence purposes. If the candidate has been a public company for some time, it will have 10-Ks, 10-Qs, and proxy statements on file with the SEC—along with other filings. The buyer should obtain copies of these and examine closely the

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agreements, contracts, and other significant company documents that may be filed with them as exhibits. In private companies, due diligence becomes a much more intensive process. The acquirer will have to do more investigation of the seller, and will ask the seller to provide assurances via representations (statements) and warranties (promises) in the acquisition agreement. Although representations and warranties are seen in contracts with both public and privately owned candidates, they are more extensive in private company deals. Thus, the scope of a private company investigation depends in part on what information the seller is willing to give in the form of representations and warranties to be included in the purchase agreement. Beware the seller that resists making any representations or warranties. Such deals are highrisk transactions and are rarely the bargains they appear to be. If stockholders wind up losing money, the law may not necessarily protect the hasty wheeler-dealer on either side, despite the shelter of the famed business judgment rule, explained in Chapter 6. Claims of “fraudulent conveyance” (also known as fraudulent transfer) can and do arise after the fact. Acquirers can sue sellers, citing Section 548 of the bankruptcy code (within the larger tax code, part of the U.S. Code). The astute investigator can learn a lot from court opinions weighing the merits of such claims.23 Many sellers discourage thorough due diligence. In negotiating reductions in the representations and warranties, they will insist that buyers “see for themselves” by visiting a key plant or office. By all means, buyers should do so, but without letting such “eyeballing” and “tire kicking” relieve the seller of any possibility of misrepresentation. Even if the buyer decides to rely on the seller’s representations and warranties, it must nevertheless still conduct at least enough due diligence to be assured that there will be a solvent company and/or seller to back the representations and warranties. If there is any doubt, the acquirer must establish cash reserves. How can the buyer conduct proper due diligence without harming its relationship with the seller?

Communication is key. This process begins with the letter of intent and is reinforced in the acquisition agreement. Negotiated by both buyer and


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seller, these documents should lay down the ground rules for due diligence. For example, they should ■ ■

State the time available for due diligence. Promise the buyer access to the selling company’s personnel, sites, and files.

With respect to site examination, here is some sample language from a typical acquisition agreement (which can be found on the Web site for this book): Section 6.6. Investigation by Buyer. The Seller and Company shall, and the Company shall cause its Subsidiaries to, afford to the officers and authorized representatives of the Buyer free and full access, during normal business hours and upon reasonable prior notice, to the offices, plants, properties, books, and records of the Company and its Subsidiaries in order that the Buyer may have full opportunity to make such investigations of the business, operations, assets, properties, and legal and financial condition of the Company and its Subsidiaries as the Buyer deems reasonably necessary or desirable; and the officers of the Seller, the Company, and its Subsidiaries shall furnish the Buyer with such additional financial and operating data and other information relating to the business operations, assets, properties, and legal and financial condition of the Company and its Subsidiaries as the Buyer shall from time to time reasonably request. Prior to the Closing Date, or at all times if this Agreement shall be terminated, the Buyer shall, except as may be otherwise required by applicable law, hold confidential all information obtained pursuant to this Section 6.6 with respect to the Company and its Subsidiaries and, if this Agreement shall be terminated, shall return to the Company and its Subsidiaries all such information as shall be in documentary form and shall not use any information obtained pursuant to this Section 6.6 in any manner that would have a material adverse consequence to the Company or its Subsidiaries. The representations, warranties, and agreements of the Seller, the Company, and its Subsidiaries set forth in this Agreement shall be effective regardless of any investigation that the Buyer has undertaken or failed to undertake.

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A few notes about this language (as stated in the annotations to this agreement found on the Web site for this book): ■

■

■

The first paragraph of this clause is called an investigation covenant. It ensures that the seller will cooperate with the buyer by granting access and logistical support for the buyer’s due diligence review of the seller and its subsidiaries. This is one of the most valuable parts of any acquisition agreement. The second paragraph, sometimes nicknamed a “burn or return” provision, may help allay the seller’s fears about confidentiality. Note, however, that the seller will often require the prospective buyer to enter into a separate confidentiality agreement. Two sample confidentiality agreements can be found on the Web site for this book. The third paragraph might be called an off-the-hook clause. It makes a statement that removes the burden of perfect investigation from the acquirer. Without such a statement, the seller can avoid liability following a breach of contract. It can argue that since the buyer could have discovered the breach during its investigation of the seller’s company, the seller should be relieved of any responsibility for such misrepresentations.

How can the buyer ensure seller cooperation in a due diligence investigation of broad scope?

The seller is more likely to cooperate when the buyer (or the buyer’s counsel) conveys the important message that honesty is the best policy: full exploration of facts and risks benefits everyone. At the very least, it can help protect against the risk of an even more adversarial process involving cross-examination in court if either the seller or the buyer is sued after the transaction is closed.24 For example, just as a buyer can be sued for paying too much money for an acquisition, a seller may be sued for accepting too little money. Also, a seller’s reputation may be damaged if—even inadvertently—it provides false information. The buyer’s investigation of the seller’s representations can thus be a boon to the seller.


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Buyers can invite sellers to conduct their own due diligence. All sellers need to conduct some kind of due diligence in connection with the legal opinions to be given. And the seller will need to conduct due diligence by analyzing the buyer’s financial condition when the buyer is paying for the acquisition with its own stock. Finally, it is in the interests of the seller to investigate the buyer if the seller’s ownership and/or employment will continue after the sale of the business. By conducting its own due diligence, the seller is more likely to develop an appreciation for what the acquirer is doing in a due diligence investigation. Throughout the process, the buyer should be sensitive to the stress on its own personnel and on its relationship with the seller. The due diligence effort is a disruption of the ordinary business routine and may be viewed by the seller as a sign of unwarranted suspicion and disregard for the seller’s interests on the part of the buyer. The seller may fear adverse consequences for the conduct of its business and its future sale to others if the contemplated deal does not close. Indeed, many potential transactions do fall through because of the rigors of the due diligence process, which can alienate and inconvenience the seller, the buyer, or both. Thorough due diligence can lessen the feelings of mutual trust between buyer and seller. It can also substantially increase pretransaction costs and can absorb the attention of key employees who have other jobs to do. Nonetheless, it is unavoidable. The key is to make the process thorough, yet reasonable. Suppose the seller refuses to produce the requested documentation but offers access to its files?

If the buyer is faced with a do-it-yourself due diligence process, it must organize a document review effort. Advances in electronic record keeping can enable remote access to files, but even so, on-site visits can be beneficial. Thus due diligence review will often require traveling to the entity’s corporate headquarters and, depending on the number of sites involved and the nature of the business conducted at each site, other sites as well. As mentioned before, the acquisition agreement will form the basis for a checklist, which the acquirer may expand as necessary. The seller

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should be willing to direct the buyer to employees with knowledge of each subject of inquiry detailed on the checklist, or at least to the relevant files. The acquisition agreement should include the seller’s representation to the buyer that the buyer will have access to all relevant files for requested information. The buyer should also ask the seller to provide sufficient personnel to transmit electronic copies of all significant documents produced by the review effort. Most of these documents will already be in electronic format, but if there are hard-copy documents involved, these can be scanned and transmitted. File management expectations may also be specified in the acquisition agreement. If the seller refuses to cooperate, the buyer may have to hire temporary help at its own expense. This is not of grave consequence, but the seller should be urged to cooperate. A refusal to support appropriate due diligence will not look good for the seller should the acquisition ever undergo judicial review for any reason. As a courtesy to the seller and to avoid confusion over documents, some identification system involving numbering should be devised to keep track of the documents produced, especially for any that must be created from hard copies. For a sample numbering system, as well as suggested access codes, see the Establishing Data Site Security Precautions at the end of Chapter 3 (Appendix 3A). What forms can an acquirer use to keep the due diligence review on track?

All important financial, operational, legal, and transactional elements should appear in the two key documents driving the due diligence process: ■ ■

Due diligence checklist Acquisition agreement

The checklist should be drafted first, and should undergo constant revision as the acquirer discovers additional important points. The acquisition agreement will express the most important elements on the checklist. In fact, the two documents should parallel each other. An example of a


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checklist appears at the end of this book, and an example of an agreement can be found on the Web site for this book.25 The checklist reminds buyers of the types of issues that they should investigate. As mentioned, the list will often parallel the structure of the representations and warranties that the seller makes in the acquisition agreement. It is important to note, however, that in its early stages, the list cannot be considered final. It is a living document that changes as the investigation continues. In drafting a workable checklist, acquirers should concentrate on areas that are of particular relevance to the transaction at hand. For example, inquiries regarding the frequency of returned goods are more relevant to a consumer goods retail business than to a management consulting business. Similarly, questions regarding environmental violations are obviously more critical in acquiring a manufacturing operation than in buying a department store chain. In the acquisition of a large company, the checklist may reflect a threshold of materiality. For example, it may include only capital expenditures above $50,000, or it may set a limit of five years back for certain documents. Often a company’s existing policy of board approval and document retention will specify these levels already, and it may be most effective to work within these preexisting boundaries. Materiality limits are obviously practical when an all-inclusive checklist would impose high costs and provide little benefit. Nonetheless, such limits should be used with caution. As noted earlier, materiality transcends simple numbers: the acquirer should search for what is truly material, even if it lies beyond a threshold. Another possible drawback of materiality limits is that the seller may try to apply the same threshold to its representations and warranties. Such a “tit for tat” is clearly not in the interests of the acquirer, which will want the representations and warranties to be as extensive as possible. The due diligence checklist should be broad, but not overly ambitious. The seller will not welcome any request for information that requires the creation of new documentation. Therefore, whenever possible, the checklist should require the seller to produce only documents that are already in existence. The purchaser should attempt to obtain other data through interviews with the seller’s officers or by other appropriate investigative means.

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What other forms are useful in conducting due diligence?

In addition to the checklist and agreement, it is very important to have the following forms: ■ ■

Transaction timetable Document request lists

Samples of these documents can be found on the Web site for this book. Also, in collecting and managing information about the selling company, the acquirer will find the following forms useful:26 ■

“Closing memorandum,” including: ■ Abstract for review of minute books ■ Index of documents

Copies of these forms can be found on the Web site for this book. Chapter 5 goes into more detail about “transactional due diligence”—that is, making sure that the documentation of the deal is in order. What agreements should the acquirer sign before engaging in due diligence?

Initial forms include ■ ■

Confidentiality agreement Engagement letter for consultant

Samples of these documents can be found on the Web site for this book. How can technology such as a virtual data room help in the gathering and management of due diligence documents?

Some acquirers have invested in the use of a secure virtual data room (VDR) to supplement or replace a traditional paper data room. Accessible


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from an Internet browser, a VDR can speed transaction time, reduce expense, and enable multiple parties and prospective buyers to participate in the due diligence process concurrently. How can an acquirer make sure that its VDR is secure?

The best VDR solutions are certified. ■

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Some VDRs meet the requirements of ISO 27001, “Information Security Management—Specification with Guidance for Use.” This standard from the International Standards Organization helps companies establish and maintain an effective information management system, implementing the Organization for Economic Cooperation and Development (OECD) principles governing the security of information and network systems.27 Other VDRs are certified by SAS 70 Level II, a Statement of Accounting Standard published by the American Institute of Certified Public Accountants (AICPA) and (for public companies) the Public Company Auditing Oversight Board (PCAOB). It is part of a broader standard: AU Section 324, Service Organizations.28

THE DURATION OF DUE DILIGENCE When does the due diligence process begin?

The initial stages of due diligence unfold during the search, valuation, and financing processes. During these phases, the acquirer asks and answers three opening questions: ■

■ ■

Is it in our stockholders’ long-term interests for us to own and operate this company? How much is this company worth? Can we afford it?

More thorough due diligence goes beyond these questions and asks:

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Do the firm’s financial statements reveal any signs of insolvency or fraud? Do the firm’s operations show any signs of weak internal controls? Does the firm run the risk of any major postmerger litigation by the government or others?

The next three chapters of this book are devoted to these questions. How long should the due diligence process take?

Due diligence occurs throughout the acquisition process, which can last from a few weeks to a year or more. A rule of thumb is, “As long as it takes—but no longer.” If the parties are eager to deal, they may substitute extensive warranties for the due diligence process. When buyers do initiate a formal, organized due diligence investigation, they should put it on a fast track. Speedy due diligence ensures minimal disruption of ongoing business activities and lower out-of-pocket costs for both parties. Another benefit can be smoother relations between the parties. The most valuable result of fast-track due diligence is timely information so that the buyer can quickly determine whether the acquisition is of interest and, if so, on what terms and conditions. The buyer can then focus its attention on determining the appropriate structure for the transaction; the basis for calculation of the purchase price; what representations, warranties, and covenants should be negotiated into the final acquisition agreement; and what conditions to closing need to be imposed. The earlier the acquirer can draw up its list of “conditions to closing,” the better. Once that document is on the table and under constant revision as due diligence proceeds, all parties seem to feel more optimistic about the likelihood that the deal will close. Although there may—and usually should—be “bringdown” due diligence at the very end, this need not extend the deal indefinitely. What is bringdown due diligence?

Bringdown due diligence is the performance of due diligence right up until the closing date. Deal makers speak of “bringing down” the due diligence


21

through additional meetings, conference calls, reexamination of disclosure items, and updating of seller warranties and representations. Bringdown due diligence can protect a buyer against a claim that it should have uncovered some eleventh-hour development that was not included in representations and warranties. The term is also used in underwritings for the due diligence conducted immediately prior to the effective date of a registration statement.29 For more information about bringdown due diligence, see Chapter 5. When does the due diligence process properly end?

As important as it is for due diligence to be completed rapidly, the due diligence effort really should extend beyond closing. The discipline imposed by the process—dealing with the realities of the complications of business—should never be abandoned, and it is a rare deal that does not have, on closing day, a revision of the acquisition agreement covering unfinished items of due diligence inquiry. This bringdown list can be extensive, and may require extension of the effective closing date—or, in effect, two closings. To avoid a double closing, some prefer to wait until absolutely every aspect of the transaction is completed and the purchase agreement can be executed simultaneously with closing the deal. (For more about transactional matters, see Chapter 5.)

THE KEY PARTICIPANTS IN DUE DILIGENCE Who conducts due diligence?

To conduct due diligence, the acquirer typically draws from in-house sources of expertise and from retained consultants and advisors. At a minimum, the due diligence team will include accounting personnel for the financial statement review and legal personnel for the liability exposure review. The two have separate and distinct responsibilities, although they may communicate with each other.30 The acquirer may also bring in management consultants, financial advisors, engineers, environmental experts, or other professional talent as needed. Typically, the acquirer’s outside counsel directs the review, with help from a variety of other agents of the acquirer. These agents might include

22


senior management (especially the chief financial officer), internal legal and accounting staff, external accountants, and investment bankers. The party directing the review should be free from any conflict of interest. What are some working definitions of “conflict of interest” for the purpose of due diligence investigations?

If a firm has a consulting engagement with the company it is studying, it may have a conflict of interest with respect to the transaction. The most egregious conflicts of interest on the part of deal advisors are banned or discouraged by existing laws and standards. Guidelines for auditors approved in 2000 require disclosures of any stock ownership by an auditor in a firm that he or she is auditing.31 Also, under the Sarbanes-Oxley Act of 2002, public company auditing firms may not also serve as consultants to the companies that they audit.32 The nine categories of prohibited nonaudit services included in Sarbanes-Oxley are ■

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■ ■ ■ ■

■ ■

Bookkeeping or other services related to the accounting records or financial statements of the audit client Design and implementation of financial information systems Appraisal or valuation services, fairness opinions, or contribution-in-kind reports Actuarial services Internal audit outsourcing services Management functions or human resources Broker or dealer, investment advisor, or investment banking services Legal services and expert services unrelated to the audit Any other service that the board determines, by regulation, is impermissible

These bans are based on three fundamental principles: (1) an auditor cannot function in the role of management, (2) an auditor cannot audit his or her own work, and (3) an auditor cannot serve in an advocacy role for his or her client.33


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Some conflicts, however, do not violate any law or standard; they merely defy common sense, and it is up to the acquirer to exercise judgment in their regard. For example, some acquirers pay their advisors a contingency for the completion of the transaction. Although this is a common practice for many professionals, it can jeopardize objectivity. Therefore, advisors who are paid on contingency clearly should not direct the due diligence review, although they may participate in it. In sum, the independence of advisors is very important in the conduct of due diligence. This is a key topic under U.S. federal securities laws, as explained in the next section.

DUE DILIGENCE AND THE LAW What laws require due diligence?

There are two basic sources of responsibility for due diligence: common law, including the law of contracts; and statutory law, especially state and federal securities statutes. (In Chapter 4, we explain how these types of laws fit into a broader liability scheme.) ■

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If a company (whether the acquirer or the company to be acquired) has issued a private placement for stock pursuant to a purchase agreement, then it is responsible to the other party to the contract for some level of due diligence (lack of negligence) in the transaction. If a company (acquirer or acquired) has issued a public offering of stock, then it is responsible for some level of due diligence (lack of negligence) under state and federal statutory law.

Is due diligence required by federal securities laws?

Not exactly. Neither of the two most significant statutes—the Securities Act of 1933 and the Securities Exchange Act of 1934—employs the term due diligence. But although the term is not used in federal securities laws, securities lawyers do use a “due diligence defense” to protect their clients from lawsuits alleging violation of securities laws. Diligence and negligence are opposite qualities; the presence of one suggests the absence of

24


the other. Due diligence activities, by their very name, imply the absence of negligence; conversely, the absence of due diligence activities suggests some degree of negligence. The latter was a finding in Escott v. BarChris Construction Corp. (1968), which established that it is not reasonable to rely exclusively on management for key data. Data must be double-checked through an independent investigation. Even outside directors must ask for reasonable assurances that facts are correct. On the positive side, consider the court’s finding in Glassman v. Computervision (1996), which puts it succinctly: “Due diligence is equivalent to non-negligence.”34 Thus due diligence, well conducted and documented, can be a defense against charges of negligence during the transaction. How can an acquirer show due diligence (avoid negligence charges) under the Securities Act of 1933?

First, a general comment about the 1933 Act. Although it applies to the issuance of securities (which is not always a part of a merger transaction), it has broader implications. Some of the concepts in the 1933 Act, and in rules promulgated under this law, have had far-reaching influence on court decisions. Therefore, mastering the disclosure principles in the 1933 Act can help companies, both public and private, maintain good business practices. The following summary of the key sections of the 1933 Act may prove useful to acquirers who are interested in conducting due diligence studies of acquisition candidates.35 Section 11

Section 11 forbids “material” misrepresentations and omissions in registration statements. To defend itself against such charges, the accused can state (or, better yet, show) that it exercised due diligence. The so-called due diligence defense arises under Sections 11(b)(3) and 11(c). Under Section 11(b)(3), there is a dual standard for due diligence: expert versus nonexpert.


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■

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If the accused parties are experts who are advising or testifying about a transaction (e.g., expert witnesses), their due diligence means that they made a reasonable investigation into the facts, and that they had reason to believe, and did believe, that the statements that they made were true and complete at the time. There is a long line of legal cases clarifying who is and who is not an expert. This is referred to as the “Daubert” standard, based on a U.S. Supreme Court ruling of the same name.36 (For more on the Daubert standard, see Chapter 3.) Nonexperts (e.g., directors and officers) may rely on experts. Thus, nonexperts are not automatically liable for misrepresentations or omissions made by experts. To avoid liability, they merely have to show that they had no reason to believe that the information that they approved was false or misleading. However, nonexperts must show that they took reasonable steps to ensure that the statements were truthful. One such reasonable step would be to ascertain the independence of the expert.

For example, federal securities laws recognize the importance of independent audits by requiring, or allowing the SEC to require, that financial statements filed with the commission by public companies, investment companies, broker/dealers, public utilities, investment advisors, and others be certified (or audited) by independent public accountants. Federal securities laws also grant the SEC the authority to define the term independent. (See notes 30 and 31 for the SEC’s current definition.) Going beyond the subject of expert versus nonexpert diligence and related concerns about independence, Section 11(c) addresses the subject of reasonableness. It sets an important limit on the lengths to which a person must go to ensure the accuracy and completeness of a statement. In defining “reasonableness,” Section 11 draws on the famed “prudent man” theory— a time-honored image of the due care taken by a “prudent man in the management of his own property.” The SEC has issued Rule 176 to clarify this approach.

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Rule 176

Rule 176 of the Securities Act of 1933 succinctly describes “circumstances affecting the determination of what constitutes reasonable investigation and reasonable grounds for belief under Section 11 of the Securities Act.” In defining a “reasonable” amount of attention, Rule 176 says that it depends on a number of factors. See box.

Rule 176. Circumstances affecting the determination of what constitutes reasonable investigation and reasonable grounds for belief under section 11 of the Securities Act. In determining whether or not the conduct of a person constitutes a reasonable investigation or a reasonable ground for belief meeting the standard set forth in section 11(c), relevant circumstances include, with respect to a person other than the issuer. (a) (b) (c) (d) (e)

The type of issuer; The type of security; The type of person; The office held when the person is an officer; The presence or absence of another relationship to the issuer when the person is a director or proposed director; (f) Reasonable reliance on officers, employees, and others whose duties should have given them knowledge of the particular facts (in the light of the functions and responsibilities of the particular person with respect to the issuer and the filing); (g) When the person is an underwriter, the type of underwriting arrangement, the role of the particular person as an underwriter and the availability of information with respect to the registrant; and (h) Whether, with respect to a fact or document incorporated by reference, the particular person had any responsibility for the fact or document at the time of the filing from which it was incorporated. Source: Securities Act of 1933, Rule 176. Obtained from http://www.merrilldirect.com/ services/law/1933*act/r230-176.htm, updated December 3, 2009.


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Although Rule 176 originated as an SEC guide to what constitutes a reasonable investigation under Section 11, it is a ready-made summary of the vast wisdom of case law on the subject of due diligence in any transaction. As such, Rule 176 can help acquirers prepare well ahead of time to show that they exercised due diligence in a transaction, as follows: ■

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Type of issuer. As mentioned earlier, the due diligence conducted for a diversified multinational will obviously be more extensive than the due diligence conducted for a singleproduct domestic concern. Type of security. Some transactions do not involve securities; an acquirer may pay cash for assets. But many transactions do involve securities—whether purchased from the seller, paid for by the buyer, or both. The more complex the security, the more extensive the due diligence. This was the lesson of the financial crisis (or panic) of 2008, which is still affecting the global economy as we go to press with this edition. Although the root causes of this debacle are deep and complex, it is widely agreed that a key catalyst was risk transfer via securitization— specifically, transferring the risk of mortgage defaults from the original lender and borrower to the holder of mortgage-backed securities. In analyzing any securities involved in a transaction, it is important to ask: (1) what are the risks embedded in this security, (2) who bears those risks, and (3) is this bearer of risks aware of this danger? Good ethics would suggest that anyone bearing a risk should be informed of the risk—a notion that is supported by both case law and regulation. (For more on securities laws, see Chapter 6.) Type of person. The level of due diligence expected of individuals will rise in accordance with the person’s role in the transaction and the person’s status. Clearly, a chief financial officer, as a knowledgeable and accountable insider, is expected to exercise more diligence in a transaction than an outsider of lesser rank, such as an advisory board member. The notion of “differential liability”—that is, a higher level of liability for experts—is controversial, but there is some support for it.37

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Level of reliance. If an acquirer’s senior managers do the due diligence work themselves, then they can control its level of diligence. If they delegate this work to others, then they lose direct control over it, thus potentially (but not necessarily) lowering its level of diligence. In determining the quality of diligence, courts will accept delegation or reliance, but only if it is appropriate and well monitored.

Relying on independent sources is considered better than relying on sources that are not independent, and relying on experienced individuals is considered better than relying on inexperienced ones. If a due diligence effort uses junior people, then those people should undergo special training, and they should document their work for review by senior people.

SECURITIES EXCHANGE ACT OF 1934 What does the Securities Exchange Act of 1934 have to say about due diligence?

This law is literally the sequel to the Securities Act of 1933, discussed previously. The 1933 Act covers the initial registration and sale of securities, while the 1934 Act effectively covers the exchange of those securities. Since mergers more often involve the exchange (rather than the registration) of securities, the so-called due diligence portions of this law are even more important for acquirers to master. Like the 1933 Act, the 1934 Act does not use the term due diligence anywhere, but due diligence may be used as a defense in a suit alleging a violation of the act. In particular, such a defense may sometimes be useful in defending against charges under Rule 10b-5, promulgated under Section 10(b) of the 1934 Act. Many deal makers involved in stock-based transactions have been surprised when they are targeted in suits under Rule 10b-5. Yet its reach is broad. What does Rule 10b-5 say?

Rule 10b-5 forbids certain practices that are deemed to be fraudulent in connection with the purchase or sale of a security. The fraudulent acts must


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be committed intentionally, with scienter, a Latin term meaning “with knowledge,” and (in legal tradition) with implied malicious intent. Legal complaints can come from any buyer or seller of a security who claims to be harmed by such a fraud—not just from the government. The text of Rule 10b-5 reads as follows: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange: (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Can the due diligence defense be used in all 10b-5 cases?

No. The defense can be used only in those 10b-5 cases in which the plaintiff alleges that the fraud in question stemmed from extreme negligence or recklessness, as opposed to a conscious intent to deceive. As mentioned earlier, diligence suggests the absence of negligence. Recent court decisions indicate that recklessness may meet the scienter requirements of Rule 10b-5, making 10b-5 suits a threat to acquirers that have done insufficient due diligence in the conduct of acquisitions involving public companies. Some cases have held that the scienter requirement for a 10b-5 case can be satisfied by showing that the defendant acted with recklessness, “a mental state apart from negligence and akin to conscious disregard[.]”38 Unless and until the courts reject recklessness as a type of scienter requirement, plaintiffs will be able to cite a breakdown in due diligence as evidence in suing under Rule 10b-5 or in other private securities litigation suits.39

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VERIFICATION AND RISK PREVENTION To what extent is an acquirer expected to verify representations made by the seller?

A classic case in this regard is In re Software Toolworks Inc. Sec. Litig. (1994). In this Ninth Circuit case, the court stated, “It would be unreasonable . . . to rely on management representations when said representations could have been reasonably verified.” On the other hand, the court also stated, “It is not unreasonable, however, to rely on management representations with regard to information that is solely in the possession of the issuer and cannot be reasonably verified by third parties.” In other words, some kinds of information can be verified independently, and others cannot be. In conducting a due diligence investigation, attorneys (or others) need to obtain independent verification of facts wherever this is reasonable. Can you give an example of reasonable, independent verification of facts?

Reasonable, independent verification, based on accepted wisdom concerning due diligence in securities offerings, usually means referencing information sources outside the company as well as inside the company. For example, if a company is the subject of a tender offer, the board of that company might wish to obtain a fairness opinion as to the appropriateness of the offering price. The opinion must be from a qualified independent source, such as an investment banking firm, a commercial banker, an appraiser, or a consultant specializing in valuation. It is important to verify the basis for the fairness opinion. The court in the above-mentioned case of Escott v. BarChris Construction Corp. (1968) stated that it is not “sufficient to ask questions, to obtain which, if true, would be thought satisfactory, and to let it go at that, without seeking to ascertain from the records whether the answers in fact are true and complete.” In reviewing the actions of underwriters asserting a due diligence defense in specific transactions, courts have suggested that certain practices help to satisfy the requirements of such a defense. These practices, in effect, show diligence.40 (Clearly, all these due diligence practices are


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applicable to M&A transactions, when an acquirer is looking to buy the shares or the assets of another company.) ■

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Courts have been impressed with underwriters’ direct contacts with the issuing firm’s Accountants Bankers Customers Distributors Lenders Licensees Suppliers Courts are also impressed by efforts to cross-check statements made by insiders of the firm—for example, speaking with lower-level employees to verify the statements of upper-level management. On-site visits to a company’s facilities can prove diligence. Diligence can also be shown by examining documents that provide the factual basis for officers’ statements. Further verification can be accomplished by reviewing press and analysts’ reports about the company and its industry. One’s own economic models can be used to test those offered by the company.

As the above-cited Software case found, cross-checking is particularly important when negative or questionable information arises. What kinds of “negative” or “questionable” information might an acquirer look for?

Throughout this book, we will identify many examples of such information. The following are warning signs that need to be investigated to some degree: ■

Financial red flags (covered in Chapter 2) include the resignation of external or internal auditors, changes in accounting

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methods, sales of stock by insiders, and unusual ratios. These may indicate fraud and/or potential insolvency. Operational red flags (covered in Chapter 3) include very high or very low turnover and sketchy reporting from important nonfinancial programs (for example, quality or compliance). These may indicate unstable operations. Liability red flags (summarized in Chapter 4 and explored more fully in later chapters) include potential exposure to litigation from regulators, consumers, and employees. Transactional red flags (covered in Chapters 5 through 7) include potential securities law violations stemming from the transaction, and conflicting accounting and tax goals for the deal.

In addition to identifying such risks, the acquirer can take steps to limit them. There are many ways to do so. The first and most obvious is to consult with a broker of liability insurance that protects directors and officers (D&O) of the acquiring company against acquisition-related risks, and to enter into an agreement with an insurance provider. Since D&O liability insurance providers employ actuaries who specialize in predicting risk, acquirers can learn a lot from talking to them. Insurance brokers and vendors are natural allies of those who seek to limit risk.41 In seeking acquisition candidates in the first place, the acquirer can favor companies that have in place strong programs for financial reporting, risk management, and legal compliance. If suspicions arise during standard due diligence, acquirers can employ the services of private investigators. (See Chapters 2 through 4.) In addition, the acquirer can make sure that the various deal-related agreements include adequate protections against postacquisition losses stemming from preacquisition conditions. In documenting and structuring the transaction, the acquirer can minimize risks through various technical devices. (See Chapters 5 through 7.) Above all, the acquirer needs to make sure that its own due diligence process includes all the steps that are generally considered to show “due care” under relevant law.


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CONCLUDING COMMENTS

Due diligence provides two distinct benefits to any acquirer. First, individuals who have had hands-on involvement in the due diligence process will gain good insight into the financial, operational, and legal areas that they studied. They may be called upon during the postacquisition “re-start-up” period under new ownership to answer questions or provide guidance. (There are always items of unfinished business growing out of the due diligence process that must be resolved after closing. They should be listed and assigned to people to solve, with completion dates attached, and someone should be assigned to follow up.) Second, in the event of a claim by the buyer or the seller against the other, the resolution of the claim may go back to a due diligence issue— that is, whether or not one party disclosed certain facts or made certain documents available. Insofar as the acquisition agreement fails to identify the information that the defendant was supposed to know or learn, the due diligence process must be examined to determine where liability lies. Acquirers that have conducted a thorough due diligence process, and have kept records of their efforts, will be prepared to meet this challenge—as well as the more important challenge of dealing with the combined company’s future risks and opportunities.


CHAPTER

2

The Financial Statements Review When you can measure what you are speaking about, and express it in numbers, you know something about it. —William Thomson, Lord Kelvin, Lectures and Addresses 1891–1894

INTRODUCTION

For many acquirers, the review of financial statements may be the single most important aspect of due diligence. Although the due diligence journey begins the moment an acquirer contemplates a potential acquisition candidate, no acquirer can really “hit the road” before seeing some hard numbers. A good set of numbers is like the dashboard on a car: it can tell you the essentials about the vehicle you are about to operate. The purpose of due diligence is not to set a value on a company. Corporate valuation is a complex process conducted by management and its advisors, and a good deal of sound guidance is available on this topic. Rather, the purpose of due diligence is to spot any anomalies that others may have missed in the process of valuing the company. Spotting such anomalies begins with a review of the financial statements.1 Financial statements review entails, at a minimum, a thorough reading of the candidate company’s filings with the relevant government agencies. For U.S. public companies, this review will include all recent 10-K filings, 10-Q filings, and proxy filings. In particular, the acquirer should pay special attention to the classic financial statements contained in these filings and the key ratios derived from them. This chapter covers these points and then lists some red flags for attention.

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The effective review of financial statements is not really just about numbers, however. To assess the quality of a company’s numbers, an acquirer needs to assess the strength of the company’s internal controls, adopting the perspective of a state-of-the-art audit committee. Therefore, this chapter ends with a discussion of this important topic.

FINANCIAL STATEMENTS What are the “classic” financial statements that the acquirer should study?

The balance sheet and the earnings (or income) statement are clearly the two most critical ones,2 with the cash flow statement close behind in importance. In addition, any statements that the company has made about the quality of these financial statements (for example, in the “Management Discussion and Analysis” section of the annual report and 10-K filing) are also important. These statements are common both in the United States and in other countries. However, the rules for recording values on these financial statements vary depending on the accounting standards followed. For example, U.S. companies follow generally accepted accounting principles (GAAP), including standards deemed “authoritative under the Accounting Standards Classification (ASC) of the Financial Accounting Standards Board (FASB),” while companies in other countries follow international financial reporting standards (IFRS), issued by the International Accounting Standards Board (IASB). U.S. standards are being reconciled with IFRS with the goal of a single global standard by 2014. The discussion that follows is based on U.S. standards, but we note relevant IFRS standards as well. To complicate matters, credible sources believe that accounting standards for privately owned companies should be adjusted to those companies’ specific needs, and the FASB, along with the American Institute of Certified Public Accountants (AICPA), is considering these views.3 What does the balance sheet show an acquirer?

A balance sheet, as its name indicates, shows two equally balanced items. For a particular date (typically the end of a company’s fiscal year), the balance sheet shows

CHAPTER 2: The Financial Statements Review

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What a company owns—its assets—on the left-hand side How the company financed its assets—its equities—on the right-hand side; equities are composed of liabilities (debt) and owners’ equity (the value remaining after subtracting the value of debt from the value of assets) The total for each of these two sides, by definition, will always be identical. Key assets of the company might include ■ ■

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Cash (bills, coins, and amounts in demand checking accounts). This is considered a current (or “liquid”) asset. Short-term investments (temporary investments in stocks and bonds made for a period of less than one year—recorded at book value in the balance sheet, with market value given in a footnote). These are generally considered to be liquid and therefore are current assets.4 Long-term investments (investments made for periods longer than one year). These are generally considered to be illiquid and therefore are noncurrent assets. Property, plant, and equipment (buildings, land, factories, and machines—recorded at historical cost and adjusted for depreciation). Trade receivables (money owed to the company by customers). These are considered current assets. Inventories (the physical goods that are on hand and available to sell). Prepaid expenses (bills paid by the company prior to the receipt of the item). Deferred charges and other assets (goodwill, intangibles, long-term receivables, and investments in affiliates 5 ).

Any assets placed on the balance sheet are assigned a monetary value. This value is subject to impairment, and there are rules for noting this impairment. As of early 2010, the subject of accounting for asset impairment is under review by accounting authorities.6 Key equities of the company might include

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Liabilities—current (a year or less in term) and long-term (more than one year in term) Owners’ equity (share capital and retained earnings)

In studying a balance sheet, where should the acquirer focus?

There are different levels of assets to consider. ■

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First, and most important, the acquirer should assess the value of tangible assets used in the business that are independently marketable, such as machinery, real property, and inventories. Appraisal of these is most important, and is mandatory in any transaction that is funded heavily by debt (a leveraged transaction). Such appraisals can be key for lenders, who base the amount of their loans on the market value of the assets that are available as security. And remember, these assets are carried at historical cost, which may be much lower than current market value. Look for “hidden gold” here. The market value of land is often far greater than its book value. Second, the acquirer should appraise the value of tangible assets not used in the business, such as unused real property, marketable securities, excess raw material, investments in nonintegrated subsidiary operations, and reserves in the extracting industries. Here too, there may be hidden values. Finally, the acquirer should appraise intangibles, such as patents or trademarks, that support an earnings stream. Again, these may add tremendous value to the acquired company.

As for liabilities, the focus should be on various ratios that include current liabilities, as discussed later in this chapter. These ratios can be very significant for any acquirer that is planning to finance the deal with borrowed cash. Obviously, if the debt-to-equity ratio and similar ratios are already high, a leveraged transaction may not be wise. The balance sheet is very sensitive to industry differences, and many key ratios used in particular industries will reflect those differences. The


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balance sheets of banks and insurance companies are discussed later in this chapter. What does the income statement show an acquirer?

Unlike the balance sheet, which shows what a company owns and how it got it as of a particular date, the income statement shows how a company made and spent money during a particular period—typically a fiscal quarter or a year. The parts of the income statement are in fact part of a formula: sales minus expenses equals earnings. ■

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Sales is revenue from the goods and services sold during the period. Cost of goods sold is the direct expense incurred to produce the goods or services. Additional expenses are often broken into two categories: operating expenses (such as “selling, general, and administrative expenses”) and interest expenses (interest paid on loans outstanding). Earnings, also called net earnings, are what is left after subtracting expenses from sales. If you subtract only operating expenses, you get operating earnings, also called earnings before interest and taxes (EBIT). Many acquirers focus on operating earnings, rather than the alternatives.

What does the cash flow statement show an acquirer?

The statement of cash flows shows the amounts of cash moving in (sources) and out (uses) during the previous fiscal year. In fact, this used to be called the sources and uses statement. ■

A major contributor to cash flow is cash flow from operations. This number will be similar to net earnings (losses), with adjustments for items that were not received or not paid in cash.

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Another contributor is cash flow from investing. If the company purchases new assets or securities, it will use cash, thus lowering the cash level. On the other hand, if it sells assets or securities, it will receive cash. The third major category is cash flow from financing. This includes borrowing or repaying debt, selling shares to the public, paying dividends, and purchasing treasury stock on the open market.

Cash flow in each of these categories may be positive (with more coming in than going out) or negative (with more going out than coming in). Acquirers will prefer a company that has an overall positive cash flow, with most of the cash coming from operations, rather than from investing or financing activities. What about statements that the seller makes about the future of the candidate company—for example, in registration statements, press releases, or the Management Discussion and Analysis section of the annual report? Can the acquirer rely on these?

The wise acquirer will take such statements with a grain of salt, and the wise seller will make a disclaimer against its “forward-looking statements.” Under the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, companies can make forward-looking statements about financial performance as long as they include an appropriate disclaimer.7

KEY RATIOS What are some valuable ratios to calculate when studying a company’s financial statements?

The most popular ratios come from the balance sheet, the income statement, or a combination of the two. Balance sheet ratios, like the balance sheet, show what a company has.


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Current ratio: current assets divided by current liabilities (shows liquidity) Debt ratio: total liabilities divided by total assets (shows quality of leverage) Debt/equity: total interest-bearing debt divided by total equity (shows degree of leverage)8 Net working capital: current assets minus current liabilities (shows available funds) Quick ratio, also called acid test ratio: current assets such as cash, securities, and accounts receivable (but excluding inventories) divided by current liabilities such as short-term bank debt and accounts payable (measures liquidity)

The recent financial crisis drew attention to a kind of leverage that does not appear on balance sheets: the so-called embedded leverage contained in instruments that a company holds.9 Income statement ratios, like the income statement, show how a company is doing. ■

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Contribution margin: revenue minus variable costs (shows rate of contribution to profits) Contribution margin per unit: revenue per unit minus variable costs per unit (shows how much each unit is contributing) Gross margin: sales minus cost of goods sold, divided by sales (shows efficiency) Interest coverage: EBIT divided by interest expense (shows strength of earnings) Operating margin: EBIT divided by sales (shows efficiency of operations) Profit margin (also called return on sales): earnings divided by sales (shows degree of profitability)

Hybrid ratios (those combining items from both the balance sheet and the income statement) show how what a company has relates to what it does. ■

Asset turnover: sales divided by average assets (shows the productivity of assets)

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Debt to sales: total debt divided by total sales (shows how well the company is employing its borrowed capital) Dividend payout ratio: common stock dividend divided by net income (shows the generosity of the company’s dividend policy) Return on assets: earnings divided by assets (shows productivity of assets) Return on equity: earnings divided by equity (shows shareholder wealth derived from the ongoing operation of the company)

Market-driven ratios (including the current price of the company’s shares) are used for public companies. ■

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Earnings per share (EPS): The earnings of the company for the previous year divided by the number of shares outstanding Market cap to sales: Total market capitalization divided by sales (shows the worth of the company in the marketplace) Price/earnings ratio: The current market value of a company’s common stock, per share, divided by the company’s EPS during the previous year

During periods of market volatility, it is especially important to compare stock market values (and ratios based on them) against those of peer companies, not merely against the company’s past performance. In 2008, the U.S. stock market lost half of its value, although by the end of 2009, many stocks had rebounded to pre-“crash” levels. Any given stock might look bad for that period, especially for 2008, but by comparing companies to their peers during the same period, the due diligence analyst can see relative rather than absolute anomalies. The question is not, “How much value did this company lose?” but rather, “How much less (or more) did this company lose compared to its peers, and does this performance meet standards of respectability and credibility?” Ideally, the company will have strong performance, credibly reported. Other ratios may use items outside financial statements, such as number of employees or number of key assets, such as beds (for hospitals) or rooms (for hotels). Such ratios include


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Sales per employee: sales divided by number of employees (shows market productivity of employees) Earnings per employee: earnings divided by number of employees (shows operational efficiency of employees)

SPECIAL INDUSTRY CONSIDERATIONS How much does financial analysis vary by industry?

Financial analysis varies greatly by industry—and even within the same broad industry groupings. Take, for example, the financial services industry. Analyzing a bank requires a different set of tools from the set used to analyze an insurance company. How should an acquirer analyze balance sheets for a bank?

The acquirer should think like a banker. For an acquirer who is accustomed to analyzing balance sheets for other types of companies, this requires a new perspective. Whereas in a manufacturing company, a checking account is an asset and a loan is a liability, in a bank, the situation is just the opposite: the checking accounts that the bank manages are liabilities, while loans are assets. Furthermore, loans are classified as “earning assets,” an important category in financial analysis. In a bank, assets (and liabilities) generally are not divided into current and noncurrent accounts. Instead, they are classified as earning assets (such as loans that the bank makes) or nonbearing assets (such as real estate that the bank uses). In reviewing a bank’s balance sheet (also called a statement of condition), an astute bank acquirer will10 ■

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Review the disclosure of the market value versus the book value of investments. This review may indicate that the market value of investments is substantially above or below the book amount. Pay particular attention to foreign loans and the political stability of the area, as well as the general business climate.

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Evaluate the loan loss reserves. Look for changes and for particular loans that have been identified as problem loans. Review the footnotes for disclosure on nonperforming loans, which are loans from which the bank is receiving no or inadequate income. Pay attention to renegotiated loans, especially in the area of real estate development. Closely review the liabilities for significant changes in trends. Look also at any footnotes that describe commitments and contingent liabilities. In reviewing the statement of stockholder’s equity, look for any significant changes.

What are some ratios to use in analyzing bank financial statements?

Useful ratios in the banking industry include ■

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Earning assets to total assets: average earning assets divided by average total assets (shows what percentage of assets are earning money for the bank) Equity capital to total assets: average equity divided by average total assets (shows strength of equity) Deposits to capital: average deposits divided by average stockholders’ equity (shows strength of deposits) Loans to deposits: average net loans divided by average deposits (shows strength of loans, a key asset, in comparison to deposits, a key liability)

What about analyzing balance sheets for an insurance company?

Here, too, a special perspective is required. When you look at the assets of an insurance company, you must remember that there is a claim against the key asset—collected premiums. The tail of the payout stream can be long and unpredictable. Also, insurance companies typically invest the money that they collect in premiums, and the returns on those investments can be uncertain. A competent acquirer of an insurance company will ask:


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Does the company have sufficient assets to satisfy potential claims on policies? Is the risk taken with invested funds appropriate, given the capital of the business? What are the main sources of revenues for operations, and are the revenues clearly matched with related expenses? Are reserves adequate to protect against unlikely events? Does the insurer’s mix of assets and liabilities appear reasonable in comparison with others in the industry?

What are some ratios to use in analyzing insurance company financial statements?

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Premium level: premiums divided by insurance in force Premium sales growth: the difference between the current year’s and the past year’s premiums divided by the past year’s premiums (shows rate of growth in premium generation) Investment performance: investment returns divided by average portfolio value (shows overall effectiveness of investments) Payout ratio: policyholder benefits divided by insurance in force Renewal rate: current year renewals divided by policies in effect at the beginning of the year

Moving beyond financial services, what about high-technology companies? What are some special considerations here?

According to one expert, there are several key ratios for analysis in any high-tech company.11 They are ordinary ratios used in the analysis of every business (see the previous discussion for definitions), but they have special importance in high-technology firms. Here are the ratios, along with benchmarks for high-tech companies. ■

Asset turnover: two times is good; three times is very good; four times is excellent.

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Debt to sales: this probably should not exceed 0.50 percent.12 Gross margin: over 50 percent is good; over 65 percent is very good; 80 percent or more is excellent. Market cap to sales: this shows level of Wall Street zeal. Operating margin: Over 20 percent is good; over 25 percent is very good; 30 percent or more is excellent. Revenue and profit per employee: Amounts vary greatly. Check the Inc. 500 list for the current year to see what the top 10 are reporting. (A level of $1 million in revenues per employee is not unusual in small, efficient companies.) Trend in gross margin: Is this going up or down? If it is going down, the company needs to trim expenses.

RED FLAGS What kinds of red flags should acquirers be able to spot?

Every acquirer should develop its own list, based on the industry it is investigating. A number of organizations have produced helpful lists of red flags, including the Institute of Internal Auditors (IIA), the American Institute of Certified Public Accountants (AICPA), the Canadian Institute of Certified Accountants (CICA), and the Association of Certified Fraud Examiners (ACFE). Periodically the ACFE issues a Report to the Nation on Occupational Fraud and Abuse. The ACFE defines “occupational” fraud and abuse as “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” This is precisely the kind of fraud that the due diligence review can bring to light. The most recent annual report has a short checklist that can be useful in any due diligence review of financial statements.13 It breaks fraud down into three types. All three can be detected through a review of financial statements, which contain clues to these kinds of fraud: ■

Asset misappropriation. In an asset misappropriation scheme, the perpetrator steals or misuses an organization’s resources.


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Common examples of asset misappropriation include false invoicing, payroll fraud, and skimming (taking a percentage of revenues off the top for unauthorized and undisclosed personal enrichment). Asset misappropriation is the most common kind of fraud.14 Corruption. In corruption, perpetrators use their influence in business transactions in order to obtain a benefit for themselves or someone else, rather than being loyal to their employer. For example, employees might receive or offer bribes, extort funds from third parties, or engage in conflicts of interest. (For a checklist on corruption, see Box 2.1.) Corruption is less common than asset misappropriation, but also more expensive.15 Financial statement fraud. Financial statement fraud involves the intentional misstatement or omission of material information in the organization’s financial reports. Cases often involve inflating assets and hiding liabilities in the balance sheet to inflate equity, or inflating revenues or hiding expenses in order to make an organization appear more valuable and profitable than it really is. This is the least common type of fraud (fortunately).16

BOX

2.1

RED FLAGS FOR FCPA RECORD KEEPING AND ACCOUNTING VIOLATIONS

For firms doing business multinationally, the financial statements review should include review for potential record-keeping and accounting activities that would violate the Foreign Corrupt Practices Act of 1977 (FCPA). The FCPA Opinion Procedure enables any U.S. company to request an opinion of the attorney general as to whether certain prospective conduct violates the Justice Department’s enforcement policy. Currently, such conduct includes: ■

Vague, nonspecific descriptions of payments made in entries

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Documents that conceal the true identify of an in-country representative or agent Payment descriptions that do not correspond to the appropriate account General-purpose or miscellaneous accounts that can be used to hide improper payments Overinvoicing or false invoices Unrecorded accounts or transactions Travel and expense forms with incomplete information that are used to obtain cash for improper payments Submission of false or inaccurate expense account reports Misstatement of transactions, e.g., recording a payment to the wrong payee

Source: Sharie A. Brown, Chair, FCPA and Corporate Compliance, DLA Piper (US) LLP

Another good general list is provided by the American Institute of Certified Public Accountants (AICPA) AU 316, “Consideration of Fraud in a Financial Statement Audit.” This document covers ■ ■ ■

Risk factors relating to management characteristics Risk factors relating to industry conditions Risk factors related to operating conditions

A reprint of AU 316 appears at the end of this chapter (Appendix 2A). In Chapter 3, we will cover the subject of fraud in more depth, since it is often uncovered during the review of management and operations, rather than in the financial statements review.

In addition to these general areas, what are some red flags that one might see in a financial statement?

Again, each acquirer must find its own path. The following list, however, may be useful. It is from a panel assembled by the National Association of Corporate Directors in Washington, D.C.17


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Complex business arrangements that are not well understood and that appear to serve little practical purpose18 Large last-minute transactions that result in significant revenues in quarterly or annual reports Changes in auditors over accounting or auditing disagreements (i.e., the new auditors agree with management and the old auditors do not) Overly optimistic news releases or shareholder communications, with the CEO acting as an evangelist to convince investors of future potential growth Financial results that seem “too good to be true” or significantly better than those of competitors—without substantive differences in operations Widely dispersed business locations with decentralized management and a poor internal reporting system Apparent inconsistencies between the facts underlying the financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and the president’s letter (e.g., the MD&A and letter present a rosier picture than the financial statements warrant) Insistence by the CEO or CFO that he or she be present at all meetings between the audit committee and internal or external auditors A consistently close or exact match between reported results and planned results—for example, results that are always exactly on budget, or managements that always achieve 100 percent of bonus opportunities Hesitancy, evasiveness, and/or lack of specifics from management or auditors regarding questions about the financial statements Frequent instances of differences in views between management and the external auditors A pattern of shipping most of the month’s or quarter’s sales in the last week or last day of the period Internal audit operating under scope restrictions, such as the director not having a direct line of communications to the audit committee

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Unusual balance sheet changes, or changes in trends or important financial statement relationships—for example, receivables growing faster than revenues, or accounts payable that keep getting delayed Unusual accounting policies, particularly for revenue recognition and cost deferrals—for example, recognizing revenues before products have been shipped (“bill and hold”) or deferring items that normally are expensed as incurred19 Accounting methods that appear to favor form over substance Accounting principles or practices that are at variance with industry norms Numerous and/or recurring unrecorded or “waived” adjustments raised in connection with the annual audit Use of reserves to smooth out earnings—for example, large additions to reserves that get reversed Frequent and significant changes in estimates for no apparent reasons, increasing or decreasing reported earnings Failure to enforce the company’s code of conduct Reluctance to make changes in systems and procedures as recommended by the internal and/or external auditors

Another item to watch in any public company is insider sales of stock. One expert observes: “If insiders have sold, are selling, and/or want to sell . . . a large amount (relative to their total holdings) of stock, appropriate investigation should be made to provide comfort that such sales do not reflect a pessimistic view of the issuer’s future financial results.”20 (This statement is about underwriting, but the words can apply to M&A as well.)

ASSESSING INTERNAL CONTROLS Why is it important that an acquisition candidate have strong internal controls?

First of all, it is important because two major laws require strong internal controls for publicly held companies in the United States.


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The Foreign Corrupt Practices Act of 1977 set forth a requirement of “reasonable” internal controls for every publicly held company. More specifically, Section 13(b)(2)(B) of the Securities Exchange Act of 1934, as amended, requires public companies to “devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances” in a number of areas.21 There are also judicial incentives for good internal controls as an aspect of an overall system for legal compliance, as explained in Chapter 4. Second, the Sarbanes-Oxley Act of 2002 makes key officers of most public companies accountable for internal controls with respect to reviewing and signing financial reports (Section 302) and reporting on the internal control function (Section 404). Companies with material control “deficiencies” or “weaknesses” often experience a decline in stock price after such reports are filed. (Extensions for smaller companies will be expiring at the end of 2010.)22

Second, purely from a business perspective, good internal controls are a valuable asset for any acquirer. If a company’s internal controls are strong, the risk of postacquisition surprises is relatively low. Thus, determining the strength of internal controls—in the full sense of this term—should be one of the chief aims of due diligence. What exactly is an internal control system?

According to one authoritative definition, advanced by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, an internal control system is a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: ■ ■ ■

Effectiveness and efficiency of operations. Reliability of financial reporting. Compliance with applicable laws and regulations.23

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The first category, notes COSO, addresses an entity’s basic business objectives, the second relates to published financial statements, and the third deals with compliance. The three categories are overlapping, yet distinct. Internal control, says COSO, can be judged “effective” if a board of directors and management (and, we would add, a potential acquirer) have reasonable assurance concerning ■ ■ ■

Achievement of business goals Reliability of financial reporting Degree of legal compliance (including compliance with financial reporting regulations)24

Internal control has five components, says COSO: ■

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Control environment. This includes management’s philosophy and operating style, and the attention and direction provided by a board of directors. Risk assessment. Identification, analysis, and monitoring of key risks facing the organization. Control activities. Policies and procedures that help ensure that management directives are carried out. Information and communication. Reports to shareholders and others. Monitoring. Ongoing evaluation of the previous four items, and of the quality of monitoring itself.

A key factor in all of these is the audit committee. An acquirer should assess the quality of the audit committee in the company it is acquiring. If the audit committee is weak, then the acquirer (or its audit committee) needs to assume this important role on a temporary basis. What is the role of an audit committee, and how does this relate to the review of a candidate company’s financial statements and internal control?

At a minimum, the audit committee of any company ensures that the company’s financial statements are prepared in accordance with the appropri-


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ate regulatory guidelines. In the United States, this would be in accordance with generally accepted accounting principles. Today, however, the role of the audit committee has expanded to include risk management as well as reporting. A Blue Ribbon Commission on Audit Committees, formed by the National Association of Corporate Directors (NACD), describes the role of the audit committee as follows: ■

Audit committees, functioning as an organ of the board, focus the attention of the board, top management, and the internal and external auditors on the importance of strong financial reporting and risk management (identification and control of key risks).25

With respect to the reporting and risk management responsibilities of the board, the NACD Blue Ribbon Commission recommended that ■

Audit committees should define and use timely, focused information that is responsive to important performance measures and to the key risks they oversee.26

Thus, if the audit committee of an acquisition candidate meets such a standard, it may already be in possession of precisely the information needed by an acquirer. An acquirer can and should ask for this information from the directors of the candidate company. CONCLUDING COMMENTS

When reviewing financial statements, acquirers need to look for the “positives” of hidden values as well as for the “negatives”—the potential for fraud and insolvency. The financial statements contain many of the clues needed. In our next chapter, we will see how interviews with managers and others can reveal further clues about the opportunities and risks that lie ahead.

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APPENDIX

2 A 27

AU Section 316 Consideration of Fraud in a Financial Statement Audit (Supersedes SAS No. 82)

DESCRIPTION AND CHARACTERISTICS OF FRAUD

.05 Fraud is a broad legal concept and auditors do not make legal determinations of whether fraud has occurred. Rather, the auditor’s interest specifically relates to acts that result in a material misstatement of the financial statements. The primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. For purposes of the section, fraud is an intentional act that results in a material misstatement in financial statements that are the subject of an audit.28 .06 Two types of misstatements are relevant to the auditor’s consideration of fraud—misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets. ■

Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles

_________ Source: SAS No. 99; SAS No. 113


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(GAAP).29 Fraudulent financial reporting may be accomplished by the following: ■

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Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure

Fraudulent financial reporting need not be the result of a grand plan or conspiracy. It may be that management representatives rationalize the appropriateness of a material misstatement, for example, as an aggressive rather than indefensible interpretation of complex accounting rules, or as a temporary misstatement of financial statements, including interim statements, expected to be corrected later when operational results improve. Misstatements arising from misappropriation of assets (sometimes referred to as theft or defalcation) involve the theft of an entity’s assets where the effect of the theft causes the financial statements not to be presented, in all material respects, in conformity with GAAP. Misappropriation of assets can be accomplished in various ways, including embezzling receipts, stealing assets, or causing an entity to pay for goods or services that have not been received. Misappropriation of assets may be accompanied by false or misleading records or documents, possibly created by circumventing controls. The scope of this section includes only those misappropriations of assets for which the effect of the misappropriation causes the financial statements not to be fairly presented, in all material respects, in conformity with GAAP.

.07 Three conditions generally are present when fraud occurs. First, management or other employees have an incentive or are under pressure, which provides a reason to commit fraud. Second, circumstances exist—

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for example, the absence of controls, ineffective controls, or the ability of management to override controls—that provide an opportunity for a fraud to be perpetrated. Third, those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. However, even otherwise honest individuals can commit fraud in an environment that imposes sufficient pressure on them. The greater the incentive or pressure, the more likely an individual will be able to rationalize the acceptability of committing fraud. .08 Management has a unique ability to perpetrate fraud because it frequently is in a position to directly or indirectly manipulate accounting records and present fraudulent financial information. Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively.30 Management can either direct employees to perpetrate fraud or solicit their help in carrying it out. In addition, management personnel at a component of the entity may be in a position to manipulate the accounting records of the component in a manner that causes a material misstatement in the consolidated financial statements of the entity. Management override of controls can occur in unpredictable ways. .09 Typically, management and employees engaged in fraud will take steps to conceal the fraud from the auditors and others within and outside the organization. Fraud may be concealed by withholding evidence or misrepresenting information in response to inquiries or by falsifying documentation. For example, management that engages in fraudulent financial reporting might alter shipping documents. Employees or members of management who misappropriate cash might try to conceal their thefts by forging signatures or falsifying electronic approvals on disbursement authorizations. An audit conducted in accordance with GAAS rarely involves the authentication of such documentation, nor are auditors trained as or expected to be experts in such authentication. In addition, an auditor may not discover the existence of a modification of documentation through a side agreement that management or a third party has not disclosed. .10 Fraud also may be concealed through collusion among management, employees, or third parties. Collusion may cause the auditor who has properly performed the audit to conclude that evidence provided is persuasive when it is, in fact, false. For example, through collusion, false evidence


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that controls have been operating effectively may be presented to the auditor, or consistent misleading explanations may be given to the auditor by more than one individual within the entity to explain an unexpected result of an analytical procedure. As another example, the auditor may receive a false confirmation from a third party that is in collusion with management. .11 Although fraud usually is concealed and management’s intent is difficult to determine, the presence of certain conditions may suggest to the auditor the possibility that fraud may exist. For example, an important contract may be missing, a subsidiary ledger may not be satisfactorily reconciled to its control account, or the results of an analytical procedure performed during the audit may not be consistent with expectations. However, these conditions may be the result of circumstances other than fraud. Documents may legitimately have been lost or misfiled; the subsidiary ledger may be out of balance with its control account because of an unintentional accounting error; and unexpected analytical relationships may be the result of unanticipated changes in underlying economic factors. Even reports of alleged fraud may not always be reliable because an employee or outsider may be mistaken or may be motivated for unknown reasons to make a false allegation. .12 As indicated in paragraph .01, the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error. However, absolute assurance is not attainable and thus even a properly planned and performed audit may not detect a material misstatement resulting from fraud. A material misstatement may not be detected because of the nature of audit evidence or because the characteristics of fraud as discussed above may cause the auditor to rely unknowingly on audit evidence that appears to be valid, but is, in fact, false and fraudulent. Furthermore, audit procedures that are effective for detecting an error may be ineffective for detecting fraud.


CHAPTER

3

The Operations and Management Review “Ain’t nothing like the real thing, Baby.” —Refrain and title of Marvin Gaye song (1968)

INTRODUCTION

Analyzing a company’s financial reports is important, but no due diligence analysis is complete without a sound understanding of a company’s actual ongoing operations and management. The financial reports tell a story, but “ops” and management are the “real thing.” How can an acquirer get a good sense of these phenomena? This chapter provides guidance. Operations and management review defined

The review of operations and management can span a broad range, from the “hard” science of process engineering to the “soft” science of cultural environment. In the previous chapter, we defined internal control as including “effectiveness and efficiency of operations.” The Committee of Sponsoring Organizations of the Treadway Commission (COSO) defines operations as meaning an entity’s “basic business objectives, including performance and profitability goals and safeguarding of resources.”1 The term management describes the people setting and reaching those goals. Thus operations and management encompasses the essential “what and who” of any company: its activities and the people who direct them. Studying these elements is often called “business due diligence” (as

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opposed to “accounting” or legal due diligence), and it merely requires an effective process for collecting and analyzing key information. EVALUATING OPERATIONS AND MANAGEMENT: AN OVERVIEW How can an acquirer gain a good sense of a company’s operations and management during a due diligence review?

Clearly, learning what a company does and who does it cannot happen overnight. But buying a company does not always entail a time-consuming and expensive management study. In fact, only one aspect of operations and management must concern the investigator: material risk. If time and money allowed, conducting a “due diligence” investigation of anything and everything in corporate life would seem ideal. Indeed, business publications often carry articles and advertisements urging “due diligence” or an “audit” in the area of the writer’s or advertiser’s expertise. Common appeals include the supposed need for “marketing due diligence,” “IT due diligence,” and “cultural due diligence.”2 ■

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“Marketing due diligence” is the study of the marketing efforts of the combining firms to ensure that the combination will produce maximum synergies. It might include research on advertising, branding, competition, customer satisfaction, concept testing, positioning, pricing, or product research.3 “IT due diligence” might include research on technological currency, hardware and software status, level of automation, financial implications of a company’s technology plans, opportunities for leveraging the technologies of the company’s operations, or tasks needed to merge the companies’ technologies.4 “Cultural due diligence” includes research into what the people in an organization routinely believe, think, and do, including attitudes and mental processes (how people feel and think), behavior (what actions get performed and rewarded), functions (how people do things), norms (what rules get enforced), structures (how the above are organized and repeated), symbols (what

CHAPTER 3: The Operations and Management Review

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images and phrases have special meaning), and history (what stories and traditions get passed on to future generations) All of these elements tend to be synchronized within a culture. So, for example, if attitudes are risk-averse, the behavior, functions, norms, structures, symbols, and history will also be risk-averse.5 Such nontraditional “due diligence” endeavors are all well and good, but pursuing all of them fully would strain the time frames and budgets of most acquirers. Remember, courts have held that the due diligence conducted must be “reasonable,” not necessarily comprehensive or perfect.6 So the question really is, how can an acquirer gain a good sense of the material risks contained in a company’s operations and management? Once again, we turn to the area of internal controls, introduced in the previous chapter, “The Financial Statements Review.” In that chapter, quoting COSO, we said that any acquirer should assess the internal control system of a candidate company, stating that internal controls can provide reasonable assurance concerning the effectiveness and efficiency of operations, the reliability of financial reporting, and compliance with applicable laws and regulations.7 We also said that an internal control system does this through various means, including risk assessment—the key to operational effectiveness and efficiency. How can an acquirer assess the riskiness of the operations and management of a company?

The best way is face-to-face interviews, but even before this stage, an acquirer can find out a great deal by reading analyst reports, articles in the business press, analyses from credit reporting agencies such as Dun & Bradstreet, and other traditional business research sources. Such sources include ■

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Annual reports and 10-Ks filed with the SEC (see especially Management’s Discussion and Analysis,8 or MD&A, describing the key risks of public companies) Reports from credit rating agencies such as Moody’s, Standard & Poor’s (S&P), Fitch, Dominion Bond Rating Services, and A.M.Best.9

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Newspapers such as the Wall Street Journal and the Financial Times Magazines such as BusinessWeek and the Economist Research services such as Value Line Investment Survey Stock brokerage and independent research reports World Wide Web sources (search under company name)10

Of all these sources, for publicly traded companies, the information contained in the MD&A may be the most important.

USING THE MD&A AS A CHECKLIST How can an acquirer use the MD&A as a checklist?

The acquirer should conduct its own study to confirm the information contained in the candidate company’s MD&A. If the company is nonpublic, the acquirer should endeavor to discover such information. In most cases, the acquirer can conduct or insist on the production of such a study and obtain seller cooperation. (One obvious exception is a hostile takeover bid, when buyers are dependent on publicly available information.) In brief, the MD&A discusses the following information for a company (and, if appropriate, for its units or divisions):11 ■

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Demands, commitments, events, or uncertainties that may decrease the company’s liquidity Material commitments for capital expenditures Trends, favorable or unfavorable, in capital resources (equity, debt, or off-balance sheet financing12) Significant economic changes that have affected the amount of reported income from continuing operations Known trends or uncertainties that have had or could have a major impact on net sales or will cause a major change in profits Sources of higher profits, if any (increases in prices, increases in volume, or introduction of new products or services) Impact of inflation Impact of seasonal factors Overall material changes in the results of operations


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Could you give more detail on these MD&A areas?

Here are some direct quotes from Regulation S-K. In particular, Item 303(a)(1) asks companies to discuss ■

Liquidity. Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action that the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquid assets.

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Capital resources. Describe the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period, and indicate the general purpose of such commitments and the anticipated source of funds needed to fulfill such commitments. ■ Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any offbalance sheet financing arrangements. ■

Item 303(a)(3) seeks details on ■

Results of operations. Describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, indicate the extent to which income was so affected. In addition, describe any other significant components of rev-

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enues or expenses that, in the registrant’s judgment, should be described in order to understand the registrant’s results of operations. Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.13

All of this information, whether required by the SEC or not, would obviously be useful to any owner. Also useful (although largely untested) is the typical information required in any offering memorandum or prospectus. Although the candidate company itself might not have filed such a document recently, filings by competitors of the candidate company can give a good idea of the risks out there for such a company. This all sounds like a lot to check out—far more than analyzing a few financial statements. What is the cost-benefit on all this?

Once again, we emphasize the due in due diligence. There is no point in an acquirer’s depleting its resources by chasing every single potential risk, no matter how small or remote. The risk must be both material and possible. For example, if you are acquiring a chain of luxury goods stores, you might want to acknowledge and even analyze the risk of recession (both material and possible), but you need not focus on the risk of petty cash theft (likely but not material) or consumer boycotts (material but not likely). Some areas are both material and likely, but are so pervasive that it is difficult to check them out. For example, an acquirer who is buying a mutual fund family containing 80 diversified funds might be concerned about potentially risky investments made by all the funds. To save money, the acquirer can consider a random sampling of the funds.14 Another way to save time is to use preexisting forms for due diligence rather than creating one’s own forms. Although these forms may need to be


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customized for the candidate company’s industry and stage of growth, having them in hand can save time.15 DUE DILIGENCE IN PRIVATE COMPANIES How can information be obtained if a company is privately held and does not report to the SEC?

First of all, certain public records can and must be checked. To take a complete look at a company’s past and current standing, the due diligence team should check out the present and previous corporate names and all trade names, service marks, and trade dress registrations. The team needs to make sure that the acquisition candidate has protected its intellectual property—and hasn’t infringed on anyone else’s. (See Chapter 9 for guidance.) In dealing with a privately owned company, the buyer must confirm that the corporation was legally formed and continues to legally exist. To do so, the buyer must establish the jurisdiction in which the company was incorporated and document the company’s organization by finding and examining the articles of incorporation, including any amendments such as name changes, and also the corporate bylaws and any amendments to these. Articles of incorporation are public documents that may be obtained (in the form of certified copies) from the secretary of state of the jurisdiction of incorporation. The acquirer should also obtain, from the same office, evidence of the corporation’s continuing status in good standing in the state of incorporation. It is also necessary to review carefully the minute books of the board, the executive committee, and any stockholder meetings to establish that the articles of incorporation and any amendments have been properly adopted in accordance with the company’s charter, bylaws, and state statutes, and that no action has been taken to dissolve the corporation. (We will go into more depth on these and other legal matters in the next chapter.) Board books, including all meeting minutes, should be up to date and should reflect the election or appointment of the corporation’s current directors and officers. The company’s corporate secretary will be the guardian of these documents, and an important contact for the due diligence team.

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Having established that the corporation was indeed duly formed, the buyer’s due diligence team then examines the company’s qualifications to do business in jurisdictions other than its state of incorporation—in other words, in whatever other states or countries in which it may conduct business. To be thorough in wrapping up this initial due diligence stage, the buyer must seek out good standing certificates and tax certificates from each of the states and foreign jurisdictions in which the company operates. Once the acquirer satisfies itself with respect to the corporation’s formation, qualification, and good standing, it should then confirm that the company actually owns the assets that it claims to own. This would include examining evidence on key tangible assets, including titles, title insurance policies, and mortgages. Having confirmed the ownership of property, the team should search for liens, encumbrances, and judgments that may exist against the company or any of its assets. Sources to be searched in uncovering liens, encumbrances, and judgments include the following: ■

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The office of the secretary of state for the state in which the company’s principal office is located and other relevant states County clerk offices, where filings are made to disclose creditors’ interests in assets under the Uniform Commercial Code All relevant Recorder of Deeds offices All relevant courts, including federal, state, and local Any special filing jurisdictions for ■ Special industries, such as aviation and maritime assets ■ Bankruptcy (e.g., U.S. Bankruptcy Court) ■ Copyrights (see Chapter 9[Au: Change OK? Please verify.]) ■ Patents and trademarks (see Chapter 9)

(If government officials balk at requests for any of these documents, the acquirer can invoke the Freedom of Information Act.) In addition to this check of public records, traditional due diligence investigations of operations and management rely on two very important elements that are dependent on relations with the seller: ■ ■

Access to files On-site interviews


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The acquirer needs to ask (and convince) the seller to allow such access. As mentioned in Chapter 1, this access ideally will appear as part of the acquisition agreement. If such access is not granted, the acquirer should be able to extract discounts from the price paid for the company to offset the greater risk of purchase. It is better, however, to conduct due diligence and pay a higher price than to skip due diligence. CONDUCTING INTERVIEWS Why are interviews important in conducting due diligence?

Interviews are a good way to corroborate written material or to provide documentation when no written material exists. Courts consider interviews with managers—especially a large number of them—as one indication of appropriate due diligence. In the case of Weinberger v. Jackson, involving an underwriting, the court granted summary judgment to the underwriters based in part on the fact that they had held “over 20” meetings with various management personnel.16 Interviewing directors and officers comes first. To put these individuals and their roles and responsibilities in context, it is a good idea to request an organization chart showing lines of reporting and areas of responsibility. An increasing number of organizations may have a chief risk officer, who will be a natural interview subject. Other important candidates include any person with the title of chief audit executive, chief ethics officer, or chief compliance officer. Interviews might expand to include divisional heads, plant managers, division accountants, sales managers, purchasing agents, and so forth.17 The choice will depend on the risk patterns uncovered as the study proceeds. Interviews may be face to face or by written questionnaire. If the company has recently conducted a public offering, the acquirer should refer to Form S-1 when interviewing directors and officers. If the company has received FINRA funds, the acquirer can ask for a copy of the FINRA questionnaire results. (The questionnaire can be found on the Web site for this book.) Of all officers and directors, the most important one to interview, if he or she is still living, is the company’s founder. Such an interview can give the acquirer a good sense of the “heart and soul” of the company, and an insight into goodwill value.

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Interviewers can expand the checklist as necessary to add any relevant items as the investigation unfolds. The goal is to check off or scratch off items as needed, documenting what has been done or, if something was not done, why not. The reason for this exercise is twofold. ■ ■

First, the acquirer will have a better sense of postmerger risks. Second, the acquirer will have a better defense against a charge of negligence if anyone sues over the transaction.

What guidelines should a buyer follow when conducting interviews?

In conducting interviews with officers, directors, and key employees, the investigator seeks to ■ ■ ■

Corroborate the documents on the checklist. Fill gaps in the documents on the checklist. Identify any areas of potential liability (or assets of potential value) that are not identified in the checklist.

It is not a bad idea to have an extensive checklist, even if you do not actually wind up investigating everything on the checklist. You must, however, document the reasons for not investigating the items that you do not examine. Interviewers should bring outlines of the areas they plan to cover. In the case of Picard Chemical Inc. Profit Sharing Plan v. Perrigo Co. (1998),18 defendants in a due diligence case had neither good notes nor a clear memory of interviews, but the court found that they had showed due diligence, thanks to the preinterview outline. The judge accepted this as evidence that the interviews had indeed taken place. Good interview notes will include the following: ■ ■ ■ ■

Time and place of the interview Name and title of the person interviewed Scope of the interview Significant disclosures made during the interview


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Status (confidential versus nonconfidential) of the interview

What happens if an interview identifies new assets that haven’t been reported?

This is a good problem to have. In fairness to both the seller and the buyer, these assets should be valued and disclosed. Depending on the size and structure of the transaction and the importance of the assets, the acquirer may wish to use a real estate appraiser to value any owned real property involved, an engineer to inspect any plants and equipment, and/or an accounting team to review any inventory. Highly specialized industries require the use of experts—a geologist and safety expert to confirm the value and operational safety of mines, a programmer to inspect the value of software, and so forth. The accountants should also review the seller’s financial statements with respect to these items. Suppose the opposite happens? Suppose the interview leads to a discovery that some assets that are being reported in fact do not exist?

Those who do not know history are doomed to repeat it. Here are some famous frauds that will never happen to you if you remember them. Many of them would be difficult to detect via financial statement review, but could come to light during a review of management and operations.19 If the shortfall is material, this could indicate fraud, and the acquirer may have an ethical obligation to report this to the authorities (for example, the SEC if this is a public company). Consider the case of Cascade International, Inc., whose founder, Victor G. Incendy, disappeared in 1991 following the discovery that the company had overstated not only its sales and profits, but the number of stores and cosmetic counters that it owned. By comparing financial records with state tax records and with industry rules of thumb, outside sources were able to determine that the exaggeration was at least 300 percent. Later investigation found that this was a conservative estimate. Other cases in point include Crazy Eddie Stores, where founder Eddie Antar created a “giant bubble” of a company, according to

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the U.S. attorney in Newark, and MiniScribe Corp., where managers shipped bricks to distributors and booked them as sales. (For a sector-bysector guide to fraud, see Box 3.1.)

BOX

3.1

EXPOSURE AND RESPONSE TO FRAUD— BY INDUSTRY SECTOR Financial Services: HIGH Exposure, HIGH Response

Financial services has the broadest exposure to fraud issues:20 money laundering, financial mismanagement, regulatory and compliance, internal financial fraud and information loss or theft. It faces the most severe threat of any sector from money laundering and regulatory or compliance breaches. Its exposure[,] in other words, is both deep and broad. It also has the highest adoption of anti-fraud measures: it focuses on financial controls, staff background checking, reputation management, risk officers and risk management systems. Professional Services: LOW Exposure, LOW Response

Professional services has the most narrowly focused set of fraud issues: only information theft, loss or attack is a serious hazard. Its levels of investment in fraud management are similarly low compared to other sectors. Manufacturing: HIGH Exposure, HIGH Response

Manufacturing’s issues are significant, and primarily internal and staff-related: theft of assets and stock, financial mismanagement, and IP [intellectual property] theft, as well as (in some cases) bribery and


corruption. The sector has invested in due diligence on partners, vendors and clients; staff training and whistleblower hotlines; IP protection; and physical security. Health Care, Pharmaceuticals, and Biotechnology: MODERATE Exposure, MODERATE Response

This sector has a narrower set of challenges than some others: financial mismanagement, regulatory and compliance, and IP theft, piracy and counterfeiting. Compared with other sectors, it has invested significantly in IP protection and staff screening. Technology, Media, and Telecoms [TMT]: LOW Exposure, LOW Response

TMT has a narrow set of issues around information—IP theft and information loss or theft (to which it is the most vulnerable). The sector has a greater focus than others on IT security. Natural Resources: MODERATE Exposure, HIGH Response

Natural resources confronts bribery and corruption, theft of assets, and management conflict of interest. Its patterns of operations raise its risk profile. The sector (which has received a lot of criticism) has invested in due diligences on partners, clients and vendors; staff training; reputation management; and risk management systems. Retail, Wholesale, and Distribution: HIGH Exposure, LOW Response

Predictably, this sector’s biggest issue is with theft of stock; it also has a persistent set of issues around internal financial fraud or theft and vendor fraud. All of these result directly from its operations and structure—reliance on large groups of suppliers, often geographically very widely set apart. The addition of information loss or theft indicates the trend towards regarding information as a highly valuable asset that

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is vulnerable. But its investment in fraud countermeasures is generally lower than in other sectors with the exception of asset protection and physical security systems, reflecting its focus on loss prevention as the primary approach. Consumer Goods: MODERATE Exposure, MODERATE Response

Consumer goods companies have a relatively narrow set of issues to face: theft of assets and stock, vendor, supplier and procurement fraud, and IP theft, piracy and counterfeiting. But they face the most serious threats of any sector in the first two categories, caused by their extended supply chains. [The sector] has strongly adopted financial controls, IP protection measures and physical asset protection. Travel, Leisure, and Transportation: MODERATE Exposure, MODERATE Response

This diverse sector faces issues with theft of assets, management conflict of interest and (especially) internal financial fraud. Very often, the businesses present complex financial flows and are vulnerable to manipulation. It focuses fraud countermeasures around staff screening, reflecting its role as a people business. Construction, Engineering, and Infrastructure: HIGH Exposure, MODERATE Response

Construction, engineering and infrastructure companies face particular concerns with corruption and bribery, financial mismanagement, regulatory and compliance breaches, and vendor, supplier and procurement fraud. It is an example of an industry with widespread fraud issues caused by its risk profile—its supply chain, but also the nature of its contracts and operations. It invests in a broad range of fraud countermeasures—but at only average levels, for the most part. Source: Kroll Global Fraud Report, Annual Edition, p. 8; http://www.kroll.com/library/fraud/ FraudReport_English-US_Oct09.pdf.


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Most interviews are conducted on site, but what about off-site interviews?

A proper investigation may include the search of key public records and discussions with parties with whom the acquisition candidate has significant relationships. These include customers and suppliers, private lenders, and former key employees, including directors and officers. The acquirer should be sure to interview parties to any standing agreements with the candidate company, both suppliers and customers. The interview may function as a negotiation, asking that the agreements be assigned to the buyer when and if it acquires the business. If the supplier or customer refuses, this may be the basis for a cause of action as an “adverse change” in the affairs of the business between the execution of the acquisition agreement and the closing. (For more on “adverse change,” see Chapter 5.) Note, however, that acquirers should take special care when discussing the seller’s business with third parties. Although these discussions may be the source of valuable information, they may also give rise to tensions between the buyer and the seller. This is particularly true if the seller believes that the discussions may be impairing its ability to carry on its business, or that the buyer will use the information when and if it buys a competitor. The letter of confidentiality and the engagement letter may provide some assurance on these points. (These documents can be found on the Web site for this book.) Nonetheless, acquirers should be especially sensitive on this point. To what extent and how should the acquirer keep a record of interviews?

Before starting the interview process, plan a list of interviews to be conducted, along with a strategy for taking and filing notes. Ask your attorney to identify which notes can and should be kept confidential (invoking the attorney-client privilege) and which notes should remain available for use later to prove due diligence in the event of litigation. It is very important that you learn from counsel what is and is not subject to attorney-client privilege. In the wake of Sarbanes-Oxley, the confidentiality of “privileged” conversations is far less secure.21 The decision to keep notes is a double-edged sword. Through the legal “discovery” process, plaintiffs can use a defendant’s own documents as evi-

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dence against the defendant. On the other hand, if the defendant is using a “due diligence defense,” it will need documentation to prove its case. In general, experts advise erring on the side of inclusion.22 Clearly some records are worth keeping more than others. What records should be kept?

Ideally, if time and funding permit, acquirers should strive to keep notes or memos documenting the dates, participants, and (unless advised otherwise by counsel) substance of the following: ■

■

■

■

■

■

■

Due diligence meetings and interviews, including (as outlined earlier) dates, attendees, scope, and discoveries made Documents reviewed, including summaries or copies as appropriate Visits to facilities, including dates, attendees, and scope of discussion Discussions and interviews with third-party personnel, including dates, attendees, and topics discussed Outlines or checklists used in interviewing issuers and thirdparty personnel Director and officer questionnaires and certificates (both for the candidate company and, if issuing shares, the acquiring company) Reports by investigators or other independent experts engaged to perform parts of the investigation23

Notes should be written bearing in mind that they may be reviewed in court later. How can an acquirer engaging an expert for management and operations review make sure that the expert has the proper credentials? What is the standard for this?

As mentioned in Chapter 1, U.S. federal securities laws have set forth certain standards for expert review. The primary court case for this, cited in


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Chapter 1, is the Daubert standard.24 But standards for assessing expertise go beyond these standards, involving several U.S. Supreme Court cases, as well as federal and state court cases and federal rules. Supreme Court cases include ■ ■

■ ■ ■

Daubert v. Merrell Dow Pharmaceuticals, Inc. (1993) Joiner General Electric Company, et al. v. Robert K. Joiner (1997)25 United States v. Scheffer, 523 U.S. 303 (1998) Kumho Tire v. Carmichael (1999)26 Weisgram v. Marley Co., 528 U.S. 440 (2000)

Federal rules, based on Uniform Rules of Evidence followed by many federal and state courts, deal with the admissibility of testimony by experts. This is covered in Federal Rule of Evidence number 702—admissibility of testimony by experts, as follows: If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.27

Who should keep the files and interview notes gathered in a due diligence investigation?

The files of interviews should ideally be maintained by someone functioning as a “librarian.” The ideal candidate would be a well-trained paralegal with special training for this purpose. The paralegal can manage a data site where electronic records are stored. The site would contain copies of financial statements, interview notes, and other items covering all checklist points. Appendix 3A shows a sample table of contents for an electronic data site.

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How can outside professionals help in a due diligence study of operations and management?

Delegation to outside professionals can be an effective means of not only conducting but also documenting due diligence. Courts have noted that the use of outside professionals is helpful in establishing due care in an investigation. Examples of such professionals that are commonly used include ■

■ ■

An engineer or a certified appraiser to evaluate technology or equipment Industry specialists to evaluate operations A professional investigative firm to investigate the employment and personal backgrounds of key management personnel

IDENTIFYING KEY ASSETS AND ASSESSING RISKS TO THEM Could you give an example of an approach to operations and management analysis?

Certainly. There are two main steps in identifying risks in any company:28 ■ ■

Identifying key assets, tangible and intangible Identifying threats to these assets

The effort put forth to identify threats should be commensurate with the value of the assets at risk. If an asset is not particularly valuable, then identifying threats to that asset may not be important. If an asset is crucial, then it is of utmost importance to identify the threats to that asset. It is important to state here that the most important assets of an enterprise may not be tangible. They may not even appear on the company’s financial statements. Yet it is nonetheless vital to protect them before, during, and after due diligence. Here are some examples of key assets. A company may have more than one.


Brand ■ ■ ■ ■ ■ ■

Reputation Brand name Logo License Trademark Service mark

Cash ■ ■

Positive cash flow Financial surplus (retained earnings)

Culture ■

Ethical standards

Global reach ■

Ability to operate in multiple time zones

Market position ■ ■

Market share Industry leadership

Operations ■ ■

Performance standards Process integrity

People ■ ■

Intellectual capital Key employees

Intellectual property including a proprietary: Product ■ Service ■ Method ■ Technology (See Chapter 9.) ■

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Scale ■ ■

Large number of offices Geographic variety of offices

Each of these assets may face significant risks. The acquisition team, with or without the help of an expert advisor, can look behind the scenes for the story behind the story. There is a twoway flow between the documents and the assets that they describe and guarantee. That is, the acquirer will want to list all of the most important assets on the checklist, and include the most critical of them in the representations and warranties section of the acquisition agreement. As one due diligence advisor firm puts it, Are the representations and warranties that form the basis for the deal accurate and complete?29 This is also true of any statements made about future product launches. (See Box 3.2.)

BOX

3.2

FINDING FINANCIAL FLAWS IN A TAKEOVER TARGET The Problem

A company was interested in acquiring a transportation equipment manufacturer. The target company’s sales volume was projected to grow by 32% in the year following the acquisition based on the launch of new products late in the year. The acquiring company wanted Kroll to determine if those projections were realistic and assess [the manufacturer’s] true financial position. The Kroll Solution

The sales projections hinged on the launch of new products late in the year following the acquisition. Kroll’s analysis of previous project launches determined that achieving significant sales volumes required a longer lead-time than budgeted. The adjusted projections identified 12%—not 32%—as a more realistic figure.


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The Result

The acquisition was completed but restructured to tie a portion of the purchase price to future performance. Both parties agreed that this was a fair approach. Source: Kroll; http://www.kroll.com/services/ifai/case_studies/.

How can an acquirer assess the risks to key assets?

Business threats can come in many different sizes, shapes, and disguises. By their very nature, both routine and nonroutine threats can materialize in unexpected forms or from unanticipated directions. The best way to assess operational risks is to begin by identifying two types of potential risks— with emphasis on the first: ■

■

Regular or routine business threats (such as the threat of frost for a citrus grower) Irregular or nonroutine business threats (such as the threat of fraud)

What are some examples of the routine threats that a particular company faces?

Routine business threats generally fall into the following categories: ■

■

■

Financial threats from events such as normal fluctuations in interest rates, foreign exchange rates, or working capital availability, or from financial reporting errors Operational threats from events such as such noncatastrophic accidents, raw material shortages, product design challenges, technology shifts, labor shortages, distribution blockages, and government regulations Competitive threats from pricing and cost shifts, new product introductions, continuous product and process innovations, new market entrants, personnel recruiting, and consolidations

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What are some examples of nonroutine business threats?

Business irregularities are threats that are not encountered during the normal course of business but that arise under the following general circumstances: ■

■

■

■

■

Intentional illegal and/or hostile action on the part of a company employee, an agent of the company, or a third party such as a competitor. Examples include breach of confidentiality (leaks), economic espionage, fraud, theft, product diversion, product tampering, a hostile competitive action, and violence against staff and/or facilities. Catastrophic accidents involving company property and/or employees. Examples include industrial accidents and plant explosions. Major, unexpected, catastrophic changes in business environment. Causes include an unexpected rise in interest rates (or an unexpected drop, if one is a lender) and major shifts in market preferences. Major lawsuits. As explained in Chapter 4, these can come from a variety of sources, including competitors, customers, employees, suppliers, and the government. Gross mismanagement or negligence. Examples would include business process breakdown, deterioration of service, and weak internal controls. (For more about internal controls, see Chapter 2.)

For a case study showing how Kroll analyzed the assets and threats of a testing company, see Appendix 3B. DUE DILIGENCE IN CONFLICT MANAGEMENT, CULTURE, HUMAN CAPITAL, MARKETING, AND OTHER “SOFT” AREAS Besides threats to assets, what other management areas should the due diligence process cover?

Classic due diligence for management is somewhat limited. It covers only risks arising from the current state and the potential future state of the com-


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pany that is being acquired. Traditional due diligence does not take into account the many issues that can arise from both the companies being combined. Some of these issues are in the “soft” or “gray” area of human feelings and/or values. Consider, for example, interpersonal conflicts between the acquiring and the acquired management. These can prevent postmerger progress. As a result, some acquirers engage the services of specialists in conflict management to ensure a smooth due diligence process.30 There is a lot of talk about “cultural due diligence.” What is this?

Cultural due diligence has been conducted on an informal basis since the beginning of time. When announced deals fail to go through to completion, the failure can often be traced to a sense that the two companies’ cultures will not be compatible. Mitchell Marks, a San Francisco–based consultant who has written extensively on cultural due diligence, notes that approaches to cultural due diligence fall into four general categories: ■

■

■ ■

Integrating cultural criteria into the earliest merger discussions Staffing and preparing the due diligence team with an eye toward cultural criteria Adding cultural criteria to due diligence data collection Using formal tools to assess culture fit31

In recent years, many corporate leaders and advisors have tried to define corporate “culture” and to use this definition in a number of key areas, including due diligence. Perhaps the most extensive work in this area has been done by Hay Management Consultants, which has identified 56 distinct elements of corporate culture. These cultural elements are all expressed as ongoing actions through gerunds (the noun form of verbs). Appendix 3C lists these terms. Yet another cultural diagnostic tool is provided by consultant Ron Ashkenas, managing partner at Robert H. Schaffer & Associates, Stamford, Connecticut. His “cultural assessment worksheet” lists 10 traits, including

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■

■ ■

■

Innovation: using traditional and tested approaches versus looking for and experimenting with innovative ways of getting work done Communication style: formal versus informal Solutions sharing: sharing of ideas originating in one department throughout the organization versus infrequent sharing with other departments in the company Work orientation: emphasis on defined processes and roles versus simply getting measurable bottom-line results

Some cultural diagnostic tools come from the field of individual psychology. For example, the Myers-Briggs assessment for personality types can be used to analyze management teams.32 This well-known test of four pairs yields 16 basic types (2 × 2 × 2 × 2). The four pairs, interpreted for leaders in an organizational culture, are as follows: ■

■

■

■

Favorite world. Do the leaders prefer to focus on the outer world or on their own inner world? This is called Extraversion (E) or Introversion (I). Information. Do they prefer to focus on the basic information they take in, or do they prefer to interpret it and add meaning to it? This is called Sensing (S) or Intuition (N). Decisions. When making decisions, do they prefer to look first at logic and consistency or at the people and special circumstances? This is called Thinking (T) or Feeling (F). Structure. In dealing with the outside world, do they prefer to get things decided, or do they prefer to stay open to new information and options? This is called Judging (J) or Perceiving (P).33

A still shorter list comes from TDF International, founded by Jerry Klarsfeld. This tool for cultural assessment can be used in mergers.34 The dimensions are thinking, decision making, and feeling, and they can manifest themselves in six patterns (3 × 2 × 1). The modes work for organizations as well as individuals. M&A Partners and TDF have combined to create a Culture Fit Analysis based on the TDF system for personality


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assessment. In an article entitled “Cashing in on Culture,” Jim Jeffries notes: “Cultures don’t need to match, but they must mesh. They must be able to interact effectively, or the risk of failure is too great.” Jeffries’s Culture Fit Analysis assesses: ■

■

■

Key cultural values (e.g., stability, innovation, speed, quality, service, production Key cultural practices (e.g., leading, managing, communicating, teaming, selling, producing, talent) Key subcultures (IT, sales, business units, geography, interfaces)35

Do you have any comments on “human capital due diligence”?

Human capital due diligence is the study of a company’s programs for human resources management to determine the effectiveness of the programs. When applied in the merger context, it studies the combination of the two companies’ programs. One documented approach proposed more than a decade ago says that there are five human capital areas to consider: ■ ■ ■ ■ ■

Recruiting, retention, and retirement Performance management and rewards Organizational structure Organizational enablers (legal and accounting) Career development, training, and succession planning

Moreover, there are five phases of review: ■

■

■

Clarification. How do programs in these areas link to the acquiring company’s strategy? All areas should be held up to the strategic light. Assessment. How much do the programs cost, and are they delivering a benefit? Design. If an area is not delivering a benefit, how can it be redesigned?

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■

■

Implementation. How can the newly designed program be implemented after the acquisition? Monitoring. How can the organization ensure the continual relevance and effectiveness of the newly designed program?36

CONCLUDING COMMENTS

The mathematics of due diligence is not pure; it is applied. Although financial statement analysis forms a large part of due diligence, the most important part of due diligence is conducted “live” through interviews and on-site visits. Such interviews should not neglect “soft” information such as conflict and culture. A thorough analysis of operations and management leads naturally to the next stage of due diligence—checking for legal compliance, the subject of our next chapter.


APPENDIX

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3A

Establishing Data Site Security Precautions

When companies use a secure data site, they can take certain precautions, including the following, as listed by BMC, an affiliate of Bowne.37 For greater security, a company can tier access to its files. In the era before virtual data rooms, some companies and advisors used color coding to indicate levels of access. Green meant files could be copied freely, yellow meant to be copied at the discretion of data room personnel, and red meant they could not be copied at all, but were classified as confidential. Electronically, files can be coded in the same manner using a three-level code, such as O for open access, RX for restricted access, and CX for closed access, as the following example shows. A. ACCOUNTING E. ENVIRONMENTAL F. FACILITIES H. HUMAN RESOURCES I. INTERNATIONAL L. LEGAL, GENERAL M. MERGER DOCUMENTATION P. PATENTS R. RESEARCH & DEVELOPMENT T. TRADEMARKS

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NOTES

The following Virtual Data Room Files have been coded as follows: CX: Closed access O: Open to all personnel RX: Restricted access A. ACCOUNTING DATA A.1 Consolidated Balance Sheet Year 1 (RX) A.2 Consolidated Balance Sheet Year 2 (RX) A.3 Consolidated Balance Sheet Year 3 (RX) A.4 Consolidating Balance Sheet Year 4 (RX) E. ENVIRONMENTAL E.1 Facility Overview (O) E.2 Facility Descriptions (CX) E.3 Emissions Data (O) E.4 Accident & Injury Data (CX) E.5 Plant Description (O) E.6 General Information (CX) E.7 Permits (RX) E.8 Audit Report (CX) F. FACILITIES Plant Facilities F.1 Key Facts (O) F.2 Photo (O) F.3 Major Equipment (O) F.4 Production Process (O) F.5 Manufactured Products (O) F.6 Operating Permits Listing (O) H. HUMAN RESOURCES Benefits Information H.1 Long-Term Disability Plan Document (O) H.2 Medical Reimbursement Plan Document (O) H.3 Dependent Reimbursement Plan Document (O) H.4 Retirement Income Plan Document (O)


H.5 Personal Plan Document (O) H.6 Retirement Income Plan for Hourly Employees (RX) H.7 Dental Plan Benefit Summary—Revised Comprehensive Medical Plan (O) I. INTERNATIONAL INDEX France Debt/Credit Arrangements I.1 Debt/Credit Arrangement—Loan Documentation (Loans to Company) (O) I.2 Debt/Credit Arrangement—Guaranties/Comfort Letters/ Promissory Notes/Pledges/Mortgages/Other Liens (O) Taxes I.3 Tax—Taxes Paid Year 4 (O) Employment I.4 Employment Headcount (O) I.5 Employment Total Compensation—Year 4 (by division/function) (O) I.6 Employment Payroll List (showing compensation for management personnel) (O) L. LEGAL L.1 Folder: Product Liability Litigation L.1-a U.S. Product Liability Overview (C) L.1-b U.S. Product Liability History—Legal Fees (C) L.1-c U.S. Pending Litigation Year 5 Legal Fees (C) L.1-d Litigation Expenses Year 4 and Current (Year 5) L.1-e Case Summaries (C) L.1-f Claim Summaries (C) L.1-g Letter of Credit (C) L.2 Folder: Miscellaneous Litigation/Claims (see also related Trademark Folder) L.2-a Bankruptcy Litigation (C) L.2-b Workers’ Compensation Claims Experience Year 1 through Year 5 (Current) (O)

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L.3 Folder: Selected Regulations Affecting Business Operations L.3-a Fair Packaging and Labeling Act (R) L.3-b Federal Hazardous Substances Act (R) L. 4 Folder: Leases, Personalty, and Contracts L.4-a Leases for Equipment (RX) L.4-b Personalty Lease Telephone Equipment (RX) L.4-c Personalty Lease Copiers (RX) Contracts L.5 R&D Contract (O) L.5 Folder: Data Processing (including licenses) Software Licenses L.5-a R&D Contract—List of Confidentiality Agreements (O) L.5-b Software License—Software—Accounts Payable System (O) L.6 Folder: Corporate Records (two volumes: one book of stock certificates and one stock transfer ledger) (RX) L.6-a Corporate Records (RX) M.5: Acquisitions/Merger Documentation M.1 Agreement to Acquire XYZ Company (RX) M.2 Agreement to Acquire ABC Company (RX) M.3 Purchase of Certain Assets of New York Company (RX) M.4 Purchase of Certain Assets of New Jersey Company ((RX) M.5 Certificates of Merger for UV, Inc., and X, Inc. (RX) P. PATENTS P.1 Listing of Patents (CX) R. RESEARCH AND DEVELOPMENT R.1 Folder: Research and Development Overview R.1-a Overview (O) R.1-b Building Facilities (O) R.1-c Product Development Process (O) R.1-d R&D Capabilities (O) R.1-e R&D Organization (O)


T. TRADEMARKS T.1 Folder: World Trademark Registrations T.1-a By marks (CX) T.1-b By owner (CX) T.1-c (Updates (CX) 1. Printout of trademarks T.1-d Pending conflicts to protect trademarks pertaining to products with sales exceeding $10 million (CX) T.1-d Encumbrances on trademarks: exclusive licenses, consents, and agreements (CX)

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APPENDIX

3B

Case Study: Asset/Threat Analysis of a Testing Company

Each company has its own set of assets, and its own set of threats to those assets. Acquirers need to develop an asset/threat mentality when conducting due diligence. The following case study of asset/threat analysis is provided by Kroll Associates. Kroll Associates has had numerous assignments to analyze the risks faced by professional certification testing organizations with global operations. In these cases, Kroll sought to ■ ■ ■

Identify the key asset and threats to the asset. Evaluate the current exam control environment. Recommend ways to strengthen and augment existing controls.

AN EXAMPLE

The following case represents a composite of the work that Kroll did with such organizations. Key Asset/Threats

The key asset in the company was, of course, the exam itself, which must be both high-quality and confidential. The key threats to the exam were


■ ■

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Loss of exam integrity during development Organized cheating and/or theft

The Current Exam Control Environment

Kroll consultants identified several phases in the continuing life cycle of this business, each one exposed to certain risks. The phases were ■

■ ■

■

Exam development. Here managers acknowledged that the main risks were threats to the basic integrity of the exam itself. Exam integrity is lost when there is a breach of confidentiality during exam development through inadvertent or intentional discussion of specific questions and/or exam direction. Exam printing and shipping. Risks here included theft and loss. Exam administration. Here we identified the parties who could steal the exam: ■ Competitors ■ Test takers ■ Staff ■ Volunteers ■ Technology that could be used to steal the exam and communicate results: scanners, video cameras, cell phones, and laptop computers with Internet access Exam grading and reporting. Cheating via changing grades (via hackers, for example) was another identified threat. We also identified security risks—such as destruction of results by flood, fire, or computer software or hardware malfunction.

Kroll also ranked countries by degree of risk, since some countries pose more threats than others because of cultural characteristics, infrastructure differences, and/or the prevalence of violence—from sporadic civil unrest to incidents of terrorism to a sustained state of war. As a result of its risk assessment, Kroll reengineered significant portions of the examination process. Kroll also developed a worldwide crisis management plan and installed an incident reporting hotline system with global coverage.

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APPENDIX

3C

Cultural Due Diligence— A Checklist from Hay Management Consultants

To determine a match of cultures, an acquirer can rate itself and a candidate company on each of the cultural elements given here. For testing purposes, these elements should be presented to evaluators in random order. Note, however, that in their original order, the traits run from left-brain qualities (involving reason) to right-brain qualities (involving intuition). All traits are expressed as positive; any negative trait can be expressed as a low degree of a particular positive. Hay uses numeric ratings of 1 for a small extent, 2 for a moderate extent, and 3 for a great extent. Answers will often form bell curves, with the majority of items receiving a 2, and only a few receiving a 3 or a 1. In the center, one can see the “dominant” culture, often clustering in the same number-range. Asterisks indicate qualities that are highly desirable from a due diligence perspective, since they minimize the chances of postmerger exposure to lawsuits. Conversely, absence of these elements, while completely normal in many cultures, should trigger more energetic due diligence in these areas. Also, due diligence investigators should be aware that incompatible cultures can mean postmerger trouble. A culture that leans in one direction may not be compatible with a culture that leans in the other direction—unless management works on it. 1. Being highly organized. 2. Using proven methods to serve existing markets.


3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39.

Maintaining clear lines of accountability. Limiting the downside of risk.* Minimizing unpredictability of business results.* Providing secure employment. Establishing clear, well-documented work processes. Treating employees fairly and consistently.* Establishing clear job descriptions and requirements. Respecting the chain of command. Being precise. Minimizing human error.* Supporting the decisions of one’s boss. Maintaining customer satisfaction. Providing employees with resources to satisfy customers. Delivering reliably on commitments to customers.* Using limited resources effectively. Participating in training and continuing education. Quality-checking employees’ work. Supporting top management’s initiatives. Being loyal and committed to the company. Achieving budgeted objectives. Demonstrating understanding of the customer’s point of view. Maintaining existing customer accounts. Accepting of strong viewpoints, strongly held. Continuously improving operations. Attracting top talent. Rewarding superior performance. Responding to customer feedback. Encouraging teamwork. Taking initiative Increasing decision-making span. Gaining the confidence of customers. Acquiring cross-functional knowledge and skills. Significantly decreasing cycle time. Sharing successfully. Maintaining a sense of urgency. Applying innovative technology to new situations. Tolerating well-meaning mistakes.

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40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56.

Anticipating changes in the business environment. Encouraging innovation. Adapting quickly to changes in the business environment. Encouraging expression of diverse viewpoints. Developing new products or services. Being flexible and adaptive in thinking and approach. Pioneering new ways of doing things. Capitalizing on creativity and innovation. Organizing jobs around capabilities of individuals. Taking action despite uncertainty. Pushing decision making to the lowest levels. Finding novel ways to capitalize on employees’ assets. Using resources outside the company to get things done. Experimenting with new management techniques. Establishing new ventures or new lines of business. Capitalizing on windows of opportunity. Building strategic alliances with other organizations.

CHAPTER

4

The Legal Compliance Review Are we disposed to be the number of those who, having eyes, see not, and having ears, hear not . . . ? For my part, whatever anguish of spirit it may cost, I am willing to know the whole truth; to know the worst, and to provide for it. —Patrick Henry, Speech at the Virginia Convention, Richmond, March 23, 1775

INTRODUCTION

Legal compliance begins at home, with a responsible due diligence process that uncovers current and potential causes of financial, operational, and legal problems. This process itself can eliminate about a quarter of potential suits against directors and officers. According to past research by Tillinghast Insurance, a unit of Towers Watson, one out of every four lawsuits filed against officers and directors in any 10-year period stems from a merger that has gone bad.1 Plaintiffs allege that the buyer or seller committed errors in the purchase or sale of the company. A responsible due diligence process, well documented, can provide a strong defense against such legal actions. It is somewhat more difficult, however, to anticipate and manage the other causes of lawsuits against corporate officers and directors. These can come from anyone over any issue—and legal claims often come in clusters, involving multiple issues.2 This chapter is about that vast terrain of potential litigation, one that expands whenever an acquirer buys another company. Why? Because the seller’s legal vulnerabilities are usually transferred to the buyer unless the buyer can structure the transaction as an asset sale, which is not always possible. That leaves the acquirer—even one with an excellent due diligence process—with a great deal of work to do, no matter what kind of company

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it is buying. Every sane and decent acquirer tries to select candidates that are free from illegal or unethical activity, but how can a buyer know what lies ahead? First and foremost, buyers need to understand the basic structure of the U.S. legal system. They also need to become familiar with significant business laws and current litigation trends. With respect to the candidate company in particular, an acquirer, working closely with senior legal counsel (internal and/or external), will need to assess all pending litigation, and to determine the strength of the company’s legal compliance programs in general.

THE U.S. LEGAL SYSTEM: AN OVERVIEW In determining the legal profile of a company, it is obviously important to know the applicable law. How can an acquirer develop such an understanding?

The first step is to develop an understanding of the U.S. legal system in general. Such an understanding is based on an understanding of three types of law: common, statutory, and regulatory.3 What is common law?

Common law, also known as case law, is a body of law that is created through court decisions. As mentioned in Chapter 1, this type of law dates back to medieval England. The common law covers right and wrong in a number of areas, including but not limited to contracts. Wrongs done outside of a contractual setting are called torts, and the righting of such wrongs over generations has generated a good deal of the law. Common law also addresses issues of fairness that transcend financial considerations. An equitable action is a case that can be brought “for the purpose of restraining the threatened infliction of wrongs or injuries, and the prevention of threatened illegal action; case in which payment of money damages will not be adequate compensation.”4 Four states in the United States (Delaware, Mississippi, New Jersey, and Tennessee) have separate courts, called chancery courts, that specialize in such matters. In other states, equity cases are heard by the regular state courts.5

CHAPTER 4: The Legal Compliance Review

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Much of the common law has been codified in state law, as well in the following legal models, which have been adopted in various forms by most states and have a tremendous impact on business. ■ ■ ■

Uniform Commercial Code (adopted in all 50 states) Uniform Partnership Act Model Business Corporation Act

What does the Uniform Commercial Code cover?

The Uniform Commercial Code regulates conduct in a vast variety of ordinary business matters. Some of the areas that it covers are ■ ■ ■ ■ ■ ■

■ ■

Sales Leases Commercial paper Bank deposits and collections Bulk transfers and bulk sales Warehouse receipts, bills of lading, and other titles Investment securities Secured transactions

The UCC section that is most relevant to due diligence work is the one on sales, which covers the formation of contracts, construction of contracts, terms of sale, titles and creditors, good faith purchases, performance, acceptance and breach, repudiation, and remedies. What is statutory law?

Statutory law is a series of laws passed by legislatures, then interpreted and enforced by the courts through the judicial process. The statutory law of the United States is passed by Congress, which is composed of the House of Representatives and the Senate. The statutory law of the individual states is passed by state legislatures, which also have two chambers (generally, a state House and Senate). Finally, counties and cities have governments that may pass laws. Federal

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law supersedes state law, and they both supersede local law, subject to limits imposed by the U.S. Constitution. In theory, at both the federal and the state level, there is an equilateral balance of powers among the legislative, executive, and judicial branches in the creation, application, and interpretation of laws, consistent with the U.S. Constitution.6 At the federal level, for example, the legislative branch (Congress) passes laws. The executive branch (led by the president and supported by the Executive Office, executive agencies, and independent agencies) provides guidance to Congress on important matters, issues executive orders, signs or vetoes laws, and applies the laws through regulatory agencies. Finally, the courts interpret and enforce the laws passed by Congress. In recent years in the United States, however, the executive branch has been much more active in determining the content of laws, particularly those involving financial services and health care.7 There are two types of statutory law both for the nation and for the states: criminal law and civil law. The plaintiff in criminal cases is the government (federal or state), representing the people, and the cases are generally tried before a jury. The plaintiff in civil cases is a wronged individual, and the cases are generally tried before a judge, although they may also be tried before a jury. In recent years, business wrongdoing has been increasingly subject to the criminal process. Both civil and criminal laws may be affected by administrative regulations and executive orders from the executive branch of government. All U.S. law, including state and local law, must pass muster under the U.S. Constitution. Any law that does not is deemed “unconstitutional” and is completely unenforceable. You mentioned regulatory law. What is this?

Regulatory law is composed of administrative regulations and executive orders, which are rules set forth by the executive branch of government. They are neither passed by a legislature nor decided by a court, yet they have the force of law. Administrative regulations are created by federal and state agencies, and executive orders are issued by the head of the executive branch of government—the president in the case of the federal government, and the governor in the case of the state.


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Administrative law poses a special challenge to acquirers and all businesses. Not only do agencies have the power to issue regulations that have the force of law, they also have the power to initiate proceedings under those regulations as well as under certain statutes. Furthermore, they have the power to investigate, prosecute, and even decide matters. Not surprisingly, because of their broad scope of power, agencies and their administrative regulations have grown exponentially over the past century.8 States are prohibited from interfering with federal statutory law or with the guidelines promulgated by agencies or other entities established under federal law or by the U.S. Constitution.9 How many agencies or other entities are there, and how can an acquirer keep up with all their rules?

Today, in addition to the four offices of the Executive Office of the President, there are 78 agencies (organized into 15 departments), 30 independent agencies, and 30 boards, commissions, or committees—making 142 executive branch entities in all. Fortunately, not all of these entities engage in rule making; some are merely advisory bodies. Furthermore, of the rule makers, some are focused on a particular industry, such as communications (Federal Communications Commission) or commercial banking (Federal Deposit Insurance Corporation). In fact, less than 10 percent of this vast regulatory machinery regularly applies to business generally. Specifically, there are four executive branch departments (one-third of the 12-member Cabinet) and six entities that generate rules that are potentially applicable to any company. Acquirers should be particularly well aware of this “Big 10”—both the laws that these agencies enforce (statutory law) and the regulations that they generate (administrative regulations). What are the executive branch departments and federal agencies that have the most regulatory effect on business?

Here is a list of the 10 executive branch entities that have power to set and/or enforce business regulations. Au: The following list includes only 10 entities—what is missing?

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Departments (and component agencies) ■

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Department of Commerce (intellectual property and export/import—includes the U.S. Patent and Trademark Office and the International Trade Administration) Department of Justice (law generally—includes the Antitrust Division for competitiveness) Department of Labor (labor law—includes the Occupational Safety and Health Administration, or OSHA) Department of Treasury (financial policy—includes the Internal Revenue Service for taxes)

Independent agencies ■

Environmental Protection Agency (environment)

Boards, commissions, or committees ■ ■

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Consumer Product Safety Commission (for consumer safety) Equal Employment Opportunity Commission (employment fairness) Federal Trade Commission (commercial transactions, supplementing the Department of Justice’s Antitrust Division) National Labor Relations Board Securities and Exchange Commission (securities issues and exchanges)

Going back to the basic sources of law making (common, statutory, and regulatory), how do the U.S. judiciary and the state judiciaries deal with these three different types of law?

The federal judiciary is empowered to hear cases based on both federal and state law. The state judiciary traditionally acts to resolve disputes under state law. For plaintiffs who wish to continue a legal action, there are appeals courts. Each state has appeals courts, plus one supreme court that is the highest court of appeal. The United States courts of appeal are divided into


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12 geographic circuits plus a federal court of appeals. (See the list at the end of this book.) Au: Will this list still appear? If this is the two pages of material that are being picked up, note that it says that there are 12 courts of appeal, not 13. It also has a high court, the U.S. Supreme Court, which typically restricts its review to cases involving substantive and substantial legal issues that require understanding of the U.S. Constitution, from which the Court draws its authority. Clearly, acquirers need to remain current on new legal developments in order to assess liability risks in companies being acquired. How can acquirers accomplish this goal?

This is a tall order. As mentioned, there are laws emanating from legislative bodies, rules coming from regulatory bodies, and judicial interpretations of all of these. Yet the goal is not impossible. Every acquiring company can benefit from having on staff or retaining qualified attorneys with expertise in business law. The most senior attorney (typically called the general counsel) should be familiar with the laws that are most important to the company. Such an attorney is likely to have a solid grounding in the most generally applicable laws, or to have staff members with such a grounding. Furthermore, these attorneys can (and typically do) subscribe to specialized publications that keep them abreast of current developments. For example, many law libraries receive the Federal Register, which gives the full text of all new laws and new regulations promulgated under these laws. These laws and regulations all have a place within the 50-title Code of Federal Regulations (CFR).10 For a list of the 50 parts of the CFR, see Appendix 4A. No attorney, much less manager, is expected to master all 50 parts of the CFR. However, attorneys and others can remain cognizant of federal law in a number of ways. ■

For case law. They can check regularly with various online sources such as westlaw.com to learn about new laws and legal precedents on a daily basis. Furthermore, depending on the area, attorneys and others can consult with a myriad of publications designed to keep them abreast of recent developments (such as Corporate Counsel Weekly and ancillary products11). They can also become active in the American Bar Association (ABA),12 the Association of Corporate Counsel (ACC),13 and

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the Society of Corporate Secretaries and Governance Professionals (Society),14 signing up for task forces in the areas that are of greatest interest to them. For statutory law, federal and state. For any kind of law, one free (donation-supported) online source is the Legal Information Institute at Cornell University,15 which has the following legal material: ■ U.S. Code and Code of Federal Regulations ■ State laws ■ Uniform Commercial Code and other uniform laws This information can also be gleaned online by the patient Internet researcher. For example, by typing Ohio Code (without quotes) into any major search engine, researchers can find the entire legal code of the state of Ohio. For those who prefer hard copies, it is possible to obtain an index to the CFR and then subscribe to services that focus on the parts that are most relevant to a particular business.16 For legal developments generally. Periodicals such as the ABA’s journal The Business Lawyer report regularly on legal developments.17 Also, attorneys can receive continuing education through organizations such as the American Law Institute, the American Bar Association, and the Practicing Law Institute. These organizations have professional practices groups that enable specialists to stay current in various areas of the law. These organizations also hold frequent conferences that are open to their members and to the general public. In some states, attorneys are required to provide proof of such education in order to maintain their professional licenses.

SOURCES OF LITIGATION Clearly, acquirers face exposure to many kinds of lawsuits based on many different sources of law. How can they avoid such lawsuits?

Postacquisition lawsuits stem from two causes, which may coexist in any particular case.


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First, the acquirer may be sued for its own negligence in making the acquisition. For example, the officers and directors of an acquirer might be sued for a failure to fulfill their statutory duty of due care by failing to ask questions that could have uncovered an obvious risk. Such a lawsuit would generally be filed as a private right of action (meaning a nongovernment action) under state law. An acquirer may also be sued under federal securities laws for any faulty disclosures that it made to shareholders or to the public during the course of the acquisition. Lawsuits may allege lack of due diligence, or they may target some technicality that the acquirer missed during due diligence, such as lack of a proper filing. Alternatively (or sometimes in addition), an acquirer may be sued for alleged violations of law by the company it is buying—even if these actions occurred prior to the sale of the company. For example, after buying a restaurant chain, an acquirer might learn of a pattern of racial discrimination that was evident from internal complaints filed prior to the acquisition. Proper due diligence would have uncovered such a problem area and resolved it by settling grievances and instituting appropriate policies prior to the acquisition.

How can an acquirer avoid getting sued for negligence in making the acquisition?

While little can be done to avoid lawsuits, much can be undertaken to prevent their success. As discussed in Chapter 1, an acquirer can show due diligence in making the acquisition. The case law offers guidance here. A famous negative example (which appears in the Landmark Cases appendix) of alleged lack of buyer due diligence is Smith v. Van Gorkom (1985). Conversely, if an acquirer can show that it exercised due care in deciding to acquire a company, its acquisition decision should not be vulnerable to a lawsuit. How can an acquirer minimize the liability exposure it inherits from the seller?

First, it can try to build protections into the acquisition agreement that it cosigns with the seller. Such an agreement can state that the risk of undis-

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closed liabilities will fall on the seller. Beyond this, there are two main things an acquirer can do: ■ ■

Analyze pending litigation, an activity called litigation analysis. Assess legal compliance, an activity called compliance review.

LITIGATION ANALYSIS What is litigation analysis, when is it conducted, and who does it?

Litigation analysis is an examination of existing claims against the company to determine their validity and their potential dollar impact. It may also include a study of litigation trends within the industry, to determine points of vulnerability. Litigation analysis of acquisition candidates is ideally conducted by attorneys who specialize in commercial or corporate litigation and who are familiar with the seller’s industry. This analysis is conducted throughout the M&A process, including the following phases: ■

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Planning and finding. Acquirers may demand a strong compliance system as a requirement for acquisition. Valuation. Acquirers will want to allocate known liabilities in accounting for a transaction, and will want to adjust pricing accordingly. This has become easier to do thanks to a new accounting standard, FASB ASC 805, “Business Combinations,” based on SFAS 141 (R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies,” issued April 1, 2009. (See Chapter 7.)18 Financing. Acquirers will want to satisfy lenders’ requirements with respect to compliance, for example, environmental compliance (see Chapter 11). Structuring. The extent of legal liabilities in a candidate company can influence the decision to structure a transaction as a stock or an asset purchase. Negotiation. As they negotiate the acquisition agreement, acquirers will want to verify the accuracy of representations and warranties with respect to liability issues.


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Closing. Liability exposure analysis must be concluded by closing, and can make or break a transaction.

Senior counsel for the acquirer (typically external counsel) should take the lead in this effort. Counsel should shape the due diligence study according to the direction of senior managers, but should also have a strong measure of discretion and autonomy. The senior counsel should remain in regular communication with others involved in the due diligence review— not only the junior legal associates performing the review but also any other professionals involved. For example, if the acquirer hires professional investigators during the analysis of operational risks, these investigators should report to the general counsel. This hierarchy makes sense, because all risks eventually translate into legal liabilities. How do litigation analysts examine claims for validity and exposure, both current and potential?

The individual who is primarily responsible for the pending litigation review must go through several steps: 1. Determine the parameters of the review, defining what levels of exposure (dollar amounts) would be considered material. 2. Identify the litigation or administrative actions that warrant particular scrutiny. 3. Obtain a schedule of all litigation, pending and threatened. 4. Arrange to receive copies of all relevant pleadings. 5. Arrange to receive copies of all relevant liability insurance policies, including director and officer (D&O) liability insurance. How does counsel determine whether particular litigation is material to the acquiring company in the due diligence context?

Before gathering information through a due diligence request, counsel must determine what litigation is “material.” The materiality determination for litigation, as for other aspects of due diligence, will be relative. A small lawsuit, even if it has merit, may have little significance in the context of a very

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large transaction. But if there are a number of such lawsuits, they can indicate problems that can add up to a crisis.19 In addition, certain types of cases might merit close attention, no matter what the financial exposure might be. For example, a product liability case that looks like it might be the first of many should receive close attention, even if the financial exposure on that one case is insignificant. Consider the history of asbestos litigation, which began with a judgment of $80,000 against three manufacturers but eventually snowballed to bankrupt nine manufacturers (including one of the original defendants).20 Are there any authoritative dollar amount thresholds, and if so, who sets them?

There are no absolute thresholds for U.S. companies. SEC rules, as well as the standards of the Public Company Accounting Oversight Board, use the terms material and significant but do not give numeric definitions of either.21 There are, however, standards that can be applied—both internal and external. Internal standards tend to be tailored to the company’s circumstances. ■

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Any given acquirer may have an internal policy of materiality concerning amounts of money that the board of directors must approve, or so-called authorization limits. It is a good idea to ask the general counsel and/or corporate secretary for a copy of this policy and use it as one way to set an upper limit on what is material. (Lower amounts may also be material, depending.) Common amounts for “authorization limits” and/or “materiality thresholds” in corporate policies range from $5,000 to $150,000, with smaller limits set for smaller companies, and larger limits set for larger ones.22 Percentage-based policies tend to be based on either sales (1⁄ 2 percent, 1 percent, or 2 percent of sales) or earnings (5 to 10 percent). Generally, these amounts are inversely correlated with the size of the company (the larger the company, the smaller the percentage).23 In the United Kingdom, having a dollar amount policy for “matters reserved for the board” is required by law.24


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So, for example, if the acquiring company’s CEO is not allowed to spend more than $5 million without board approval, it is reasonable to assume that the same threshold for materiality would apply to a contingent liability that requires preclosing analysis and disclosure.25

External standards for dollar amount materiality are rare, and typically focus on specific circumstances under regulatory scrutiny: ■

The Securities and Exchange Commission (SEC) has set a bright line of $120,000 for disclosure of related-party transactions, which are transactions involving people who are not independent with respect to a transaction.26

So, to summarize, when assessing materiality, the amount of money that may or may not matter really depends on the size of the company, and will vary by situation. Once the exposure to liability is determined, how can an acquirer assess (and reduce) the cost of legal counsel?

The best way to do this is to ask for an estimate from counsel. Also, in assessing the potential cost of potential litigation, companies should consider the option of settling out of court or, better yet, going to alternative dispute resolution (ADR), where mini-trials bypass or supplement the courts at twice the speed and less than half the cost. This may also yield hidden income, as many companies maintain expensive legal actions that can be replaced by inexpensive ADR processes, with the result that cases can be easily, quickly, and inexpensively settled even during the course of an acquisition negotiation. In examining offers of their current counsel to undertake ADR work, client companies should determine how committed counsel is to this alternative. Begin by asking about counsel’s ADR track record. What information should the litigator review?

In the due diligence request, counsel should seek a summary of all pending or threatened actions that satisfy the materiality standard that has been established. The summaries should include the following:

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Names and addresses of all parties The nature of the proceedings The date of commencement Status, relief sought, and settlements offered Sunk costs and estimated future costs Insurance coverage, if any Any legal opinions rendered concerning those actions

A summary of the following should also be provided: ■ ■ ■

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All civil suits by private individuals or entities Lawsuits or investigations by governmental bodies Criminal actions involving the candidate company or any of its significant employees Tax claims (federal, state, and local) Administrative actions Pending and past governmental and internal investigations

In addition, counsel should request copies of all material correspondence during the past five years with any government agency (for example, any of the Big 11) and any other regulatory agency (city, county, state, or federal) to which the seller is subject, such as the Financial Industry Regulatory Authority for financial services firms. If the firm is subject to the rules of quasi-regulatory bodies such as the New York Stock Exchange or any other exchange, all material correspondence should be gathered. If the candidate company itself has subsidiaries, all relevant information should be requested for the subsidiaries as well. After all this information has been gathered, how is the litigation analysis conducted?

Before the actual analysis begins, the individual in charge of the review must determine who will analyze which claims. Highly specialized claims should be assigned for review to the attorneys with the most knowledge of the area involved. The individual reviewer must arrange to receive pleadings and documents concerning any additional relevant claims and to have access to the


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attorneys representing the seller’s company in those matters. Even in an acquisition characterized by cooperation, obtaining all the relevant pleadings may be difficult. This is particularly true if the company is represented by more than one law firm. The individuals who are responsible for this aspect of the litigation analysis must establish a good working relationship with the attorneys representing the company that is being considered for acquisition. In some instances, communication with outside counsel should be handled gingerly because that firm may see some portion of its legal work disappearing as a result of the acquisition. More often, with larger companies, litigation is being handled by several firms around the country; all those firms will have to be consulted. In some cases, it will be sufficient to review the case file and consult briefly with the seller’s outside counsel. In other cases, outside counsel will have to become more involved in the analytical process. The reviewer should be particularly cautious in accepting the representations made by the seller’s outside counsel that is currently handling the case, as that person may be overly optimistic. Finally, each pending material case should be systematically evaluated and some dollar amount assigned to the pending liability or recovery, including the costs of executives’ time (broken out separately). For litigation that is being handled by outside law firms on the seller’s behalf, the reviewer should evaluate whether the case is being capably handled. Even a meritless case can create significant exposure if it is handled by an inexperienced or incompetent firm or practitioner. What cases should the reviewer consider first?

The reviewer should begin with cases that, if lost, could have an increasingly adverse impact on the defendant company’s business operations, and thus the business operations of the combined company—the “ripple effect.” The investigation should also identify and study other known cases involving other companies in the same industry. For example, suppose a court decides that a business practice of one company in the industry constitutes a deceptive trade practice or some other violation of law. If the seller’s company is in the same industry and engages or might engage in the same practice, this can have a significant impact on the future business of the company, even if it is not a party to the litigation in question.

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What general rules govern the acquirer’s potential liability for the debts and torts of the company it is buying?

The traditional rule is that when one company sells or otherwise transfers all its assets to another company, the successor is not liable for the debts and tort liabilities of the predecessor. The successor may be liable, however, if any one of the following exceptions is established: ■ ■

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The purchaser expressly or implicitly agreed to assume liability. The transaction amounted to a consolidation or de facto merger. The purchasing corporation was a continuation of the selling corporation (as a simple continuation, or by continuing the product, or by continuing the enterprise—types of continuation that some legal scholars believe should be blended into the de facto merger standard).27 The transaction was fraudulently entered into to escape liability, or the transfer was made without adequate consideration and no provisions were made for creditors of the selling corporation.28

The second of these exceptions, the so-called de facto merger doctrine, is based on a principle of fairness (equity) that reasons as follows: An entity should not be permitted to escape its obligations to others through a sham corporate reorganization. If the successor corporation was established merely to continue the former corporation’s operations or to escape the former corporation’s liability, courts have imposed “successor corporation liability.”29 Regarding the last point, if a seller knowingly sells a company that is bordering on insolvency, the transaction—also known as a “conveyance” or “transfer”—may be deemed fraudulent under state laws that adhere to the Uniform Fraudulent Transfer Act of 1984. Under this law, if a debtor makes a transfer to a creditor, this can be deemed a fraud if the debtor did this with actual intent to hinder, delay, or defraud any creditor of the debtor. A transfer also can be deemed fraudulent if the debtor does not receive a reasonably equivalent value in exchange for the transfer, while at the same time being engaged in or planning a business or a transaction for which the


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remaining assets of the debtor were unreasonably small in relation to the business or transaction. Finally, a transfer can be deemed fraudulent if the debtor intended to incur, or believed (or reasonably should have believed) that he would incur debts beyond his ability to pay as they became due.30 An additional exception exists for labor contracts. If the successor buys the predecessor’s assets and keeps its employees, the successor will probably also be required to recognize and bargain with unions that were recognized by the predecessor, and to maintain existing employment terms. Existing contracts may also create successorship problems. State law may vary with respect to the assumption of debts and liabilities, so the reviewer must be cognizant of the specific statutory or case law that will govern the transaction. Faced with an increasingly aggressive plaintiffs bar in search of everdeeper pockets, the courts are increasingly looking to corporate successors for product liability damage awards, including in some instances punitive damages. Product liability is a particularly nettlesome issue because it can be incurred anywhere along the line, from product development to manufacture to sale. Accordingly, the due diligence reviewer must be aware of potential exposure to successor liability for both compensatory and punitive damages all along the product line.

D&O INSURANCE What about insurance policies and cases being handled by insurance companies?

Solid due diligence requires the study of insurance policies covering both the buyer and the seller.31 In general, every insurance policy must be reviewed and matched against any pending claims to see if those claims will be covered. General questions include ■ ■ ■

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What is the deductible? What are the liability limits per occurrence and in total? Are the policies loss-sensitive (having a premium that can be increased or decreased based on losses)? Are punitive damages excluded by the policy or by state law?

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Does the policy contain “regulatory” or other exclusions? What about “merger” exclusions?

Large companies may have overlapping policies, and all policies must be reviewed in light of these questions. This can be subcontracted to firms specializing in the area of insurance-based risk analysis. ■ ■ ■ ■ ■ ■

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Are the policy limits proportionate to the liability risks? Are there any merger/acquisition exclusions or limitations? What is the retroactive date on claims-made policies? Are policies assignable? If so, is the consent of the insurer required? What is the tail exposure—can claims made (including in a joint venture of the acquired firm) come back to haunt an acquirer? What about joint and several liability provisions? Acquirers will prefer “several,” rather than being treated as guilty by association. Who exactly is insured by the underlying insurance—is there an “umbrella”?32 What is the coverage for loss of use/business interruption, waiting period, and contingent exposure, reaching into the supply chain (important for insurance of plant and equipment)? Are there coverage limitations on A-side, B-side, or C-side insurance? ■ A-side insurance covers directors and officers for losses resulting from claims made against them for their wrongful acts committed in their capacity as a director or officer. ■ B-side insurance reimburses the company for the expense of indemnifying its directors or officers as a result of claims made against them. ■ C-side insurance covers a corporation’s losses—separate from directors’ and officers’ losses.

Standard insurance policy language reads: Any organization you newly acquire or form, other than a partnership, joint venture or limited liability company, and over which you maintain owner-


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ship or majority interest, will qualify as a Named Insured if there is no other similar insurance available to that organization. However: a. Coverage under this provision is afforded only until the 90th day after you acquire or form the organization or the end of the policy period, whichever is earlier; b. Coverage A does not apply to “bodily injury” or “property damage” that occurred before you acquired or formed the organization; and c. Coverage B does not apply to “personal and advertising injury” arising out of an offense committed before you acquired or formed the organization.33

Another consideration when reviewing insurance policies is whether the policies are for “claims incurred” or for “claims made.” ■

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Coverage under a claims-incurred policy continues after the cancellation or termination of the policy and includes claims that arose during the period when the insurance coverage was in force, whether or not those claims were reported to the insurance company during that period. Claims-made policies cover only those claims that are actually made to the insurance company during the term of the policy. In addition, under some policies, coverage will continue only if a “tail” is purchased. A “tail” is a special policy purchased to continue coverage that would otherwise be terminated. It is important that the reviewer identify the nature of the seller’s policies and determine any potential problems that may result from a failure to give the insurance company notice of claims during the policy period or from a failure to purchase a tail.

Also, cases that are being handled by insurance companies should be scrutinized. The reviewer should determine the status of the cases. ■

Has the insurer undertaken the representation under a “reservation of rights”? (This means that it agrees to pay for or provide legal representation, but does not abandon its power to deny coverage later.)

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Has the insurer preliminarily denied coverage? Do the damages claimed include punitive or treble damages, and if so, does the insurance policy cover these?34

How can the acquirer be sure about the insurance coverage, and how can it make sure that the coverage will carry over to the new owners?

Before reviewing specific cases, the primary reviewer should ask the management of the selling company which cases it believes are covered by liability insurance, and which cases it believes are not so covered. Then the reviewer should study the insurance policies to determine what cases, if any, are in fact covered. The individual who is responsible for the litigation analysis must have a working knowledge of transactional liability, discussed in the following chapter. This includes the structure of the transaction—for example, whether it is to be a stock or an asset purchase—and the corporate and tort law rules concerning successor liability for debts and torts, especially with regard to compensatory and punitive damages. These are then applied case by case.

COMPLIANCE REVIEW How can an acquirer check a seller’s legal compliance profile?

As a first step, it is wise to find out if the acquirer has an active compliance program. The likelihood of this is fairly high today because of two major developments in D&O liability. ■

One is the Federal Sentencing Guidelines, enacted in 1987 and amended in 1991. These guidelines contain a formula for sentences and penalties that includes mitigating points for companies that have an “effective program to detect and prevent violations of law,” where the company exercises “due diligence in seeking to prevent and detect criminal conduct by its employees and other agents.” In effect, candidate companies


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that have already established such a program expose potential acquirers to less risk. They have, in effect, conducted part of the acquirer’s premerger “due diligence” for it. Another is the landmark Delaware Chancery Court case In re Caremark (1996), effectively upheld by the Delaware Supreme Court in Stone v. Ritter (2006). In this case, Chancellor William T. Allen approved a settlement of a derivative shareholder lawsuit filed against the directors at Caremark, alleging lax conduct in allowing violation of federal Medicare rules by the company. The court based its approval of a settlement on the fact that Caremark had a strong compliance program. Chancellor Allen further stated that failure to ensure the existence of such a program can “render a director liable for losses caused by non-compliance with applicable legal standards.”

As a result of the “carrot” of the Federal Sentencing Act (offering benefits for compliance programs) and the “stick” of Stone v. Ritter (threatening liability exposure in the absence of such programs), many companies today have legal compliance programs. In some industries, such as health care, there is a wealth of excellent models to emulate.35 Obviously, the acquirer cannot check for seller compliance with every single law there is. With literally hundreds of thousands of U.S. federal laws and regulations on the books, not to mention state laws and regulations, this would be impossible. For acquirers, the greatest worry comes from the growth in criminal laws. Since 1980, Congress has created an average of 500 new “crimes” every decade—with 1,500 new ones now on the books. Many of them extend so far into the white-collar area that they risk criminalizing honest mistakes in accounting or reporting.36 The astute acquirer will want to know the likelihood of different types of lawsuits that may occur following an acquisition. These may be brought by private individuals or groups belonging to a particular corporate constituency, or they may be brought by a regulatory body. Anticipating both private and regulatory lawsuits can minimize the chances for problems after the acquisition. If following the checklist shows some areas of difficulty, the acquirer should ask if the company has conducted or would consider conducting an

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investigation into the matter. The legal literature has some very good guides to this activity.37 What are the main constituencies that might file lawsuits against an acquirer?

Any reviewer should have the latest trends in D&O litigation on hand. A leading source for this information is Towers Watson’s Tillinghast insurance division, mentioned earlier.38 Here is a list of groups that commonly sue directors and officers, listed in order of the prevalence of lawsuits based on long-term trends. ■ ■ ■ ■

Employees or unions, current or prospective Shareholders and other investors Customers, suppliers, competitors, and other contractors Government, regulatory, and other third-party claimants

What might all these groups typically sue over?

Here is a list of common issues, with the most common one in each group shown in boldface. ■

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Customers (and also competitors, suppliers, and other contractors) might sue over the following issues:39 Contract disputes Cost or quality of a product or service Debt collection, including foreclosure Deceptive trade practices Dishonesty/fraud Extension or refusal of credit Lender liability Other customer/client issues Restraint of trade (antitrust issues) Employees—including current, past, or prospective employees or unions—might sue over Breach of employment contract


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Defamation Discrimination Employment conditions/safety Failure to hire or promote Harassment or humiliation Pension, welfare, or other employee benefits Retaliation/whistle-blowing Salary, wage, or compensation disputes Wrongful termination Shareholders might sue over Bid or threat by another company to take over the shareholders’ company Bid or threat by the shareholder’s company to take over another company Breach of duty to minority holders Challenge to takeover defense measures Contract disputes (with shareholders) Dishonesty/fraud Divestitures or spin-offs Dividend declaration or change Duties to minority shareholders Executive compensation (such as golden parachutes) Financial performance/bankruptcy Financial transactions (such as derivatives) Fraudulent conveyance General breach of fiduciary duty Inadequate disclosure Inside information use/trading Investment or loan decisions Merger or acquisition when the shareholders’ company is the survivor Merger or acquisition when the other company is the survivor Proxy contests Recapitalization Share repurchase Stock or other public offering

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Competitors, suppliers, and other contractors might sue over Antitrust (in suits brought by suppliers) Business interference Contract disputes Copyright, patent, or trademark infringement Deceptive trade practices Regulators might sue businesses over alleged violations of law involving Antitrust Consumer protection Employee health, safety, and working conditions Environment Securities law Taxes

Other (nonregulatory) constituencies may also sue over these regulatory areas. As indicated earlier, competitors may sue over violations of antitrust law, consumers over consumer protection laws, communities over environmental law, workers over health and safety laws, and shareholders over securities law. The only area that appears to be exclusively a regulatory domain is tax law. In Part 2, we go into all these legal areas in more detail, paying special attention to the regulators that govern them. What are some of the legal issues to be concerned about in a due diligence investigation—ones that a buyer might never think of, but that could hurt the company later?

Here are a few to consider. When government becomes an owner of a company—as when a company receives funds from the Troubled Asset Relief Program or a similar future program—what obligations to the government, and thus indirectly to the taxpayers, may arise? (Some have speculated that this shift may mean that the directors’ focus may shift away from the financial performance of the company to more general social concerns such as the environment or compensation justice.)


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To what extent can the chief executive of a company or the company itself be held accountable for the wrongful acts of subordinates? This “agency” theory is constantly being tested. To what extent can advisors rely on the word of management? To what extent can management rely on advisors? The nature of attorney-client privilege is changing rapidly, with courts demanding more skepticism on both sides. How many times can a company be sued for the same action? Is there a limit to the number of plaintiffs who can ask for punitive damages? What product areas and industries are the trial lawyers targeting? The American Trial Lawyers Association has special groups that study litigation hot spots, and members have expert witnesses lined up to testify.40

We will discuss these and other issues in more detail later in this book. CONCLUDING COMMENTS

Every acquisition brings with it the burden of legal compliance review. This is particularly true in the United States, which lives by the “rule of law”— and boasts a plethora of attorneys to make this possible. Given this condition, any acquirer of a U.S. company needs to become familiar with the nation’s legal infrastructure, particularly with respect to M&A transactions. Acquirers that gain such an insight, and act on it with a thorough compliance review, will help clear the way for financial and management success.

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APPENDIX

4A

The Code of Federal Regulations: A List of Titles

The CFR can be used as a checklist of federal agencies and their regulations. The following list shows all titles of the CFR. (Note that many of the titles fill multiple volumes when printed out.) Asterisks indicate titles and agencies that generate laws that are applicable to business. One asterisk indicates titles and agencies whose laws are applicable to a broad range of industries; two asterisks indicate titles and agencies whose laws apply to a particular industry, such as financial services or utilities. Agencies beginning with the word “Department” (such as Department of Agriculture) have Cabinet status. Title 1, 2: General Provisions Title 3: The President (Executive Orders) Title 4: Accounts (General Accounting Office) Title 5, 6: Administrative Personnel (Office of Personnel Management) Title 7: Agriculture (Department of Agriculture)** Title 8: Aliens and Nationality (Immigration and Naturalization Service) Title 9: Animals and Animal Products (Department of Agriculture) Title 10: Energy (Nuclear Regulatory Commission and the Department of Energy)** Title 11: Federal Elections (Federal Election Commission)


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Title 12: Banks and Banking (Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision, National Credit Union Administration, Farm Credit Administration)** Title 13: Business Credit and Assistance (Small Business Administration) Title 14: Aeronautics and Space (Federal Aviation Administration)** Title 15: Commerce and Foreign Trade (Department of Commerce)* Title 16: Commercial Practices (Federal Trade Commission, Consumer Product Safety Commission)* Title 17: Commodities and Securities Exchanges (Commodity Futures Trading Commission, Securities and Exchange Commission, Department of the Treasury)* Title 18: Conservation of Power and Water Resources (Federal Energy Regulatory Commission, Department of Energy, Tennessee Valley Authority)** Title 19: Customs Duties (United States Customs Service, United States International Trade Commission)* Title 20: Employee Benefits (Office of Workers’ Compensation Programs, Railroad Retirement Board, Social Security, Department of Health and Human Services, Employment and Training Administration)* Title 21: Food and Drugs (Food and Drug Administration, Drug Enforcement Administration)* Title 22: Foreign Relations (Department of State, Peace Corps) Title 23: Highways (Federal Highway Administration)** Title 24: Housing and Urban Development Title 25: Indians (Bureau of Indian Affairs) Title 26: Internal Revenue (Internal Revenue Service)* Title 27: Alcohol, Tobacco Products, and Firearms (Bureau of Alcohol, Tobacco, and Firearms)** Title 28: Judicial Administration (Department of Justice)* Title 29: Labor/OSHA (Department of Labor, National Labor Relations Board)** Title 30: Mineral Resources (Mine Safety and Health Administration, Mineral Management Service Bureau, Surface Mining Reclamation and Enforcement)**

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Title 31: Money and Finance (Treasury) Title 32: National Defense (Department of Defense, Departments of Army, Navy, Air Force)** Title 33: Navigation and Navigable Waters (Coast Guard, Corps of Engineers) Title 34: Education (Department of Education) Title 35: Panama Canal (Panama Canal Commission) Title 36: Parks, Forests, and Public Property (National Park Service, Forest Service) Title 37: Patents, Trademarks, and Copyrights (Patent and Trademark Office, Department of Commerce)* Title 38: Pensions, Bonuses, and Veterans’ Relief (Department of Veterans Affairs) Title 39: Postal Office (United States Postal Services, Postal Rate Commission) Title 40: Environment (Environmental Protection Agency—this title includes 24 parts covering various environmental elements)* Title 41: Public Contracts and Property Management (Government Services Administration) Title 42: Public Health (Department of Health and Human Services) Title 43: Public Lands (Department of the Interior, Reclamation Bureau, Land Management Bureau) Title 44: Emergency Management and Assistance (Federal Emergency Management Agency) Title 45: Public Welfare (Department of Health and Human Services, Commission on Civil Rights) Title 46: Shipping (Coast Guard, Federal Maritime Commission) Title 47: Federal Communications Commission** Title 48: Federal Acquisition Regulations System Title 49: Transportation (Department of Transportation, Federal Highway Administration, National Highway Traffic Administration, Interstate Commerce Commission) Title 50: Wildlife and Fisheries (Fish and Wildlife Management in the Department of Agriculture, National Marine Fisheries and National Ocean and Atmospheric Administration in the Department of Commerce) ________ *Applicable to many business sectors. **Applicable to one business sector.

PA R T

TWO

Transactional Due Diligence

The popular image of due diligence shows advisors counting beans, kicking tires, and looking for skeletons—that is, conducting financial, operational, and legal due diligence, as covered broadly in Part 1 of this book (Chapters 1 through 4). But transactional due diligence—the actual crafting of an acquisition agreement with securities, tax, and accounting issues in mind—is equally important. Part 2 delves into the details of paperwork and red tape—a needed focus. Many due diligence investigators think of risk in terms of the ongoing business risks discussed in the previous chapters of this book. But an equally important area is transactional risk—structural factors that can jeopardize a deal with even the most solvent, well-managed, and litigation-resistant company. In this part of the book, we take a closer look at due diligence from the point of view of the all-important transactional work. In Chapter 5, we examine the acquisition agreement and closing memoranda. Chapters 6 and 7 cover securities and tax law and related accounting regulations. This material may seem to you to be the province of “other experts” that you can hire, but we urge you to give it your full personal attention. The technical knowledge presented here—combined with the even more important ingredient of common sense—will help you practice the art of M&A due diligence with uncommon skill.

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CHAPTER

5

The Documentation and Transaction Review Delay is preferable to error. —Thomas Jefferson, Letter to George Washington, May 16, 1792

INTRODUCTION

In addition to examining the financial, operational, and legal risks, managers must focus on the risks that arise from the transaction itself—risks that can be mitigated through the effective negotiation of the acquisition agreement and through proper closing procedures. We call the work involved here “transactional due diligence,” as distinguished from the types of due diligence discussed in the previous three chapters. Those chapters offered guidance on how to measure the risks inherent in the business being acquired, either before or potentially after the acquisition. This chapter discusses the risks inherent in deal making itself—the negotiating and “red tape” aspects, if you will. Unfortunately, transactional due diligence is all too foreign to many corporate executives. Whereas most executives know how to read a financial statement, evaluate corporate operations, and avoid violations of wellknown laws, few are familiar with the details of contract negotiations, which can be critical to postmerger value. Furthermore, many executives overlook the “paperwork”—or, more precisely, the electronic document management—that is necessary to structure and close an actual transaction. As a result, managers often delegate these matters to professionals. Such delegation is appropriate, but managers should monitor developments closely. This chapter provides some practical guidance.

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PART 2: Transactional Due Diligence

KEY POINTS IN THE ACQUISITION AGREEMENT What is the purpose of the acquisition agreement?

The acquisition agreement sets forth the legal understandings of the buyer and seller about the transaction. Ideally, it accomplishes five basic goals: ■ ■

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It sets forth the structure and terms of the transaction. It discloses all the important legal issues that affect the company being acquired, as well as key financial issues and other pertinent information about the buyer and the seller. It obligates both parties to do their best to complete the transaction. It obligates the seller not to change its company in any significant way before the deal closes. It governs what happens if, before or after the closing, the parties discover problems that should have been disclosed either in the agreement or before the closing but were not properly disclosed.

Unlike the typical letter of intent, which may or may not be binding, depending on how it is written,1 an acquisition agreement is a legally binding agreement. Once it is signed, a party that fails to consummate the transaction without a legally acceptable excuse can be liable for damages. In some cases, even an unwritten agreement can trigger such liabilities.2 The negotiation of the agreement is, in large part, an effort by the buyer and seller of a company to allocate the risk of major economic loss attributable to defects in the company that surface after the signing of the acquisition agreement, both before and after the closing. What if something goes wrong at the target company after the buyer and seller sign the acquisition agreement?

Both parties should be aware that the value of the acquisition candidate may improve or deteriorate between the signing of the agreement and the closing. Therefore, the acquisition agreement often includes provisions that state the parties’ right to cancel the transaction or change the price in the

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event of “unforeseen events of a material nature.” (For more about materiality, see the discussion later in this chapter.) One of the typical conditions to closing for the buyer is that there has been no “material adverse change,” or MAC, in the financial condition of the seller. The buyer naturally wants to protect itself against events that might lower the value of the candidate company. Such conditions include a new lawsuit against the candidate company or a burdensome new law affecting the candidate’s industry. The buyer wants the right to lower or withdraw its offer if such events occur. Can a target include exceptions to these MAC clauses?

Yes. These exceptions are called MAC carveouts. A typical MAC carveout might say something like In no event shall any of the following, in and of itself, be considered a Material Adverse Change or Material Adverse Effect: (a) any change in the market price or trading volume of such entity’s outstanding securities or the de-listing thereof from the Nasdaq listing or any litigation relating thereto; (b) any failure to meet internal projections or forecasts or published revenue or earnings predictions for any period ending (or for which revenues or earnings are released) on or after the date hereof; (c) any adverse change to the extent attributable to the announcement or pendency of the Merger, including any cancellations of or delay in customer orders, any reduction in sales or revenues, any disruption in supplier, distributor, partner or similar relations or any loss of employees; (d) any adverse change attributable to conditions affecting the industries in which the Company or Parent participates, the U.S. economy as a whole or foreign economies in any locations where the Company, Parent or any of their respective subsidiaries has material operations or sales except, in any such case, as the case may be, to the extent such effect on either Parent or Company, as the case may be, is materially disproportionate; (e) the pendency of any litigation instituted by a third party other than a Governmental Entity that challenges, or that may have the effect of preventing, delaying or otherwise interfering with the Merger or any of the transactions contemplated by this Agreement; (f) any adverse change arising from or relating to any change in accounting requirements or prin-

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ciples or any change in applicable laws, rules or regulations or the interpretation thereof.3

How can a seller minimize the impact of a MAC clause?

To prevent a MAC clause from ruining a deal, a seller can “carve out” factors that will not be considered MACs, such as general economic, regulatory, or political conditions or changes; financial market fluctuations; and general changes in its industry. A seller can also carve out changes that “would not have or reasonably be expected to have, individually or in the aggregate, a . . . material adverse effect.” This is what Frontier did in the case of Frontier Oil v. Holly Corp (2004).4 By doing so, Frontier, the seller, was not held responsible for adverse postclosing changes that were normal events in its industry. This kind of “reasonable expectations” language helps to insulate agreements against MAC factors. It certainly helped in the case of In Re: IBP, Inc., Shareholders Litigation (2001).5 In this case, the acquirer, Tyson Foods, claimed that the target, IBP, had suffered a MAC because IBP’s earnings for the first quarter of 2001 were 64 percent lower than its earnings for the first quarter of 2000. But the Delaware Court of Chancery took a futuristic view, saying that the drop in earnings did not necessarily affect the target company in the long term. So Tyson Foods was obligated to complete its purchase of IBP.6 After the Tyson and Frontier Oil decisions, which prevented buyers from invoking a MAC clause to exit a deal, buyers began defining “material change” more precisely, such as “a drop in revenues of 10 percent or more,” so that they would have an ironclad reason to back out of a deal. Conversely, however, sellers are coming up with new kinds of MAC carveouts, such as “general economic, financial, regulatory, or market conditions,” unless they have affected a target in a “materially disproportionate manner” as compared to other companies in the target’s industry.7 CORRECTING BUYER BIAS IN THE AGREEMENT

The seller who accepts a MAC clause in the agreement may note the lack of parallel. After all, the seller typically has no right to back out of the sale


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in the event of a positive event that raises the value of its company. The company that is selling may obtain a long-awaited legal decision or settlement, or make a valuable new discovery. In this case, the seller might want the right to retain ownership of the company. Yet agreements rarely afford sellers this right. To correct the buyer bias in an agreement, a seller may ask for ■ ■ ■

A deposit A liquidated damages provision Transfer of risk to the buyer as of the date of signing, not the date of closing

In what circumstances might a seller ask for a deposit?

The seller should receive a deposit in situations where it would not be able to collect damages in the event of a breach of contract. For example, a buyer may transact a deal through a shell company with no assets, set up specifically and solely for the purpose of the acquisition. In such a case, the seller may have no economically meaningful remedy in the event that the buyer breaches the agreement. The seller may win the lawsuit, but will not be able to collect damages. In such circumstances, sellers often insist upon a cash deposit, much as a seller does in the sale of a home. Alternatives include a cash escrow or a letter of credit that can serve as security for the buyer’s obligations. It is hard for most buyers to argue their way out of such a requirement. This is particularly true where the seller has several creditworthy suitors, and where signing with the buyer will cause the other potential buyers to lose interest in the deal. However, if the buyer has a proven track record of closing deals and the price is right, it may be able to talk the seller out of a deposit or to delay posting the deposit until some period of time after the signing. For example, the buyer may agree to post a deposit only if the deal hasn’t closed by a specified date, or if the buyer has not obtained financing commitments. At the very least, a seller should make a strong effort to get a deposit large enough to cover all of its expenses and to limit the time given to close the contract so that the company is not off the market too long.

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Also, as mentioned earlier, if the buyer has the flexibility to walk away from the deal because of negative events, the seller should also have this flexibility with regard to positive events—or even better offers. But there should be financial sanctions against parties that “walk” from near-completed deals without substantial cause. When is a liquidated damages clause appropriate?

A buyer may back out for a reason that is beyond the control of the seller. If the seller fears this, it might add a liquidated damages clause. This is a clause promising the payment of damages to the seller if the buyer backs out for a reason that is beyond the control of the seller. The parties must approach this problem by crafting a solution that is carefully tailored to the specific concerns of the parties. The buyer and seller can compromise by adjusting the deadline by which financing commitments must be provided and/or the consequences of the buyer’s failure to finance the transaction. How does risk transfer work for a seller?

Normally, risk transfers from the seller to the buyer at closing. Some sellers try to shift the date of this transfer to the date the acquisition agreement is signed, rather than the closing date. Their theory is that the buyer has to accept a balanced economic deal—as mentioned, it gets both the good and the bad events that occur after the signing. They reason that the buyer is getting what it bargained for, as long as the representations and warranties as of the signing date are accurate on the closing date and the seller does not breach its covenants concerning the conduct of the business pending closing. What are the buyer and seller really concerned about when they are negotiating the acquisition document?

Once they have agreed to the key substantive aspects of the transaction (price and terms), the seller and buyer have different concerns. In fact, their concerns are mirror opposites.


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The seller wants to be as certain as possible of at least two things: (1) that the closing will occur as soon as possible after the agreement is signed, and (2) that no postclosing events will require a refund of any of the purchase price. Conversely, the buyer wants certainty (1) that it will have as much time as possible to conduct due diligence after the agreement is signed, and (2) that it will be able to get some or all of its purchase price back if negative events occur after the closing. The buyer would like the flexibility to abandon the transaction in the event that it discovers any financial, operational, or legal defects in the candidate company. Also, after paying the seller at closing what the buyer feels is a fair price, the buyer would like to know that it will be compensated for any economic loss resulting from legal or financial problems that it did not expect. This is not to be confused with the business risk of operating the company after the closing. General economic downturns, new competition, and failures of management after the closing are pure business risks that any sensible buyer knows it is assuming when it buys a business. But the buyer will seek to protect itself against hidden flaws in the business—flaws that exist beneath the surface at the time of the closing and show up later, after the company has already been purchased. Ideally, the buyer would like to obtain protection against major problems such as profit deterioration leading to losses, poor morale leading to top management turnover, and illegal practices leading to legal exposure— the kinds of risks outlined in previous chapters. Unfortunately, the seller is unlikely to agree to provide a blanket guarantee against the occurrence of any of these events. Instead, the seller will more typically guarantee only that it has disclosed all debts incurred, lawsuits filed, and fines payable as of a particular date. The buyer will typically try to include clauses that enable it to withdraw from the transaction before the closing. However, if there is too much flexibility, the agreement is simply an option to acquire, not a legally binding promise to do so. If the buyer really wants to buy the company, it should be willing to be legally obligated, within reason, to do so. On the other hand, the seller can never be completely certain that the transaction will close, simply because there are too many conditions that

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are beyond the control of both the buyer and the seller that must be satisfied before any transaction can close. Who should bear the risk of loss associated with undisclosed legal defects in the company discovered after the closing—the buyer, the seller, or both?

The real issue is, What is a fair price for the company? The answer hinges on the assumptions that the buyer and seller made when they first agreed to the transaction. Any buyer has two choices. It can ■

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Determine a price based upon assuming the risk—that is, an “as is” deal—which presumably will be less than the price that the buyer would pay if the seller retained some or all of the risk. Determine a higher price premised on the seller’s retention of some part of the risk.

Although sellers usually want to sell their company on an as is basis, buyers should resist this type of deal, as it affords them little or no protection after the closing. This alternative is a gamble, but it may be acceptable to a buyer that knows its candidate, or that is buying in an industry with a low risk profile. The vast majority of private companies are not sold as is. Most buyers rightly insist that the seller absorb some of the risk of undisclosed problems. Without such shared risk, the seller has less of an incentive to cooperate in the due diligence effort. Thus, the seller will typically give the buyer at least some protection in the event that the company is not what the seller said it was. In fact, it is the rule in most sales of private companies that the seller will bear a significant portion of the risk of company defects, and the deal will be priced accordingly. The seller, however, does not have to be pestered incessantly about descriptions that prove inaccurate or incomplete. Everyone going into an acquisition knows that no company is perfect, and that, in due course, blemishes on its legal and financial record will undoubtedly surface.


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So it is customary to hold the seller accountable for these problems, but only during a defined time period. (See the discussion of the indemnity section and Article XII in the model acquisition agreement, which can be found on the Web site for this book.) This customary practice makes sense for three reasons. ■

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First, if it is unlikely that a problem will be discovered, then an as is transaction with reduced pricing forces the seller to accept less money needlessly. Second, if a problem is discovered before the closing, it probably would result in a lower price anyway, even in an as is deal. Third, a sharing of the risk between buyer and seller will provide both with a strong incentive to try to discover problems before the agreement is signed or the deal is closed. Thorough investigation by both parties who have a stake in the outcome reduces the likelihood that a claim will arise.

This does not mean that every seller should cave in on this issue. In the case of a deal-hungry buyer or a buyer that has confidence in its assessment of the risk of loss attributable to breaches of representations and warranties, the seller may get the best of both worlds—a high price with little or no postclosing risk. This is especially true in a competitive bidding situation. In the end, the allocation of risk will depend more on the bargaining power and negotiating skills of the parties than on the niceties of pricing theories. COMPONENTS OF THE AGREEMENT How are the general concerns of the buyer and seller reflected in the acquisition agreement?

The major concerns of the parties are focused on in two sections of the agreement: the conditions to closing section and the indemnification section. The conditions section lists the conditions that must be satisfied before the parties become obligated to close the transaction, and thus controls whether the buyer or the seller can “walk” from the deal with impunity. The

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indemnification section establishes the liability, if any, of each party to the other for problems discovered after the closing. Both sections are generally keyed to two earlier parts of the agreement: the representations and warranties section and the covenants section—basically a “saying” section and a “doing” section. In the representations (“reps”) and warranties section, the parties make statements about the legal and financial state of affairs, as of the date of the signing, of the candidate company, the seller, and the buyer, including the legal and financial ability of each party to enter into and consummate the transaction. In a typical agreement, a buyer or a seller will be able to back out of the agreement if it discovers that the representations or warranties of the other party are untrue to any significant extent. Also, the seller must indemnify the buyer for problems that surface after the closing. The representations must be true at the time they are made and continually until closing, or be amended at closing to reflect any changes. After that, the representations expire. The covenants section contains the parties’ agreement to take no action that would change the state of affairs described in the representations and warranties section. Of course, changes resulting from the ordinary operation of business, actions that are necessary to complete the transaction (such as seeking government approvals and other third-party consents), and changes that are contemplated by the acquisition agreement (such as certain corporate reorganizations) are permitted under the covenants. Reps, warranties, and covenants are extremely important. The most significant conditions to closing are that the representations and warranties are true on the closing date, and that the parties have not breached the covenants. Liabilities under the indemnity section, in turn, arise from breaches of representations, warranties, and covenants. The goal for both parties should be to avoid unnecessary or unclear reps, warranties, or covenants. A short, clear list can lower the risk of cancellation and reduce the seller’s exposure to legal liability. For these reasons, a great deal of the negotiation of the agreement centers on the scope and meaning of the representations, warranties, and covenants. A typical negotiation process is divided into two parts. In the first part, the parties haggle over how much the seller will say about the candidate company in the reps and warranties section and how much it will agree to do (or not to do) in the covenants section. This is an important


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process because the risk of loss from any areas not covered by the seller’s statements or covenants falls on the buyer. In the second stage, the parties agree on the consequences if the representations and warranties that the seller agrees to make and the covenants that it undertakes turn out to be untrue or breached, before or after the closing. What are the major parts of the agreement?

The major segments of a typical agreement are as follows: ■ ■ ■ ■ ■ ■ ■ ■

Introductory matter Price and mechanics of the transfer Representations and warranties of the buyer and seller Covenants of the buyer and seller Conditions to closing Indemnification Termination procedures and remedies Legal miscellany

INTRODUCTORY MATTER AND PRICE AND MECHANICS What is covered in the introductory matter?

Introductory matter sets the stage for the deal. Contracts often begin by describing the intentions of each of the parties to the agreement. This practice can clarify the meaning of the agreement in the event of a dispute. Therefore, it has become customary to introduce the agreement with a series of “recitals” that set forth the purpose of, and parties to, the agreement. The legal significance of the introductory matter is usually not great, however. What is the significance of the section on the price and mechanics of a transfer?

This section identifies the structure of the transaction. It identifies the transaction as a stock disposition, an asset disposition, or a merger. It also

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describes the mechanics to be used to transfer the property from seller to buyer. This is often the place where the parties will provide for a buyer’s deposit (as mentioned) or some other security required prior to closing. In the case of a stock acquisition or a merger, this section includes the dollar amount per share to be received by the shareholders, as well as all of the other terms of the transaction. Merger terms often include the identity of the surviving corporation, the articles of incorporation and bylaws governing the surviving corporation, the composition of the surviving corporation’s board of directors, and the names of its officers. In the case of an asset acquisition, this section identifies exactly which assets are to be conveyed to the buyer and which of the seller’s liabilities the buyer will assume. For both stock and asset purchases, this section will, of course, also identify the nature of the consideration to be received by the seller and the timing of its payment. Also, this section may contain provisions regarding intercompany liabilities and how they must be satisfied by the surviving company or forgiven by the seller and capitalized as additional equity in the transaction.8

How does due diligence differ for stock and asset transactions?

As mentioned earlier (in Chapter 1), in all stock sales, and in all asset sales that are structured as mergers, acquirers assume the seller’s debts unless the seller agrees otherwise. By contrast, if a transaction is structured as an asset sale, the acquirer will not assume the seller’s debts and liabilities unless the acquirer agrees otherwise. Asset sales are less common than stock sales for two reasons. First of all, sellers prefer stock sales, so that they can unload their debts and legal liabilities onto the acquirer. Second, acquirers sometimes prefer stock sales because asset sales ■

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Require a separate transfer of each asset—an onerous feature in the purchase of companies with numerous contracts, deeds, or licenses. Generally impose a higher tax cost than (generally tax-free) exchanges of securities.9


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Require third-party consent for the transfer of some assets, such as certain intangibles and leases. Can trigger the need to comply with certain provisions of the Uniform Commercial Code, such as the bulk sales law.10

If an acquirer purchasing a company through an asset sale overcomes these hurdles, will it then be free of responsibility for the seller’s debts and legal liabilities?

Not necessarily. As mentioned earlier, there are exceptions: ■

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If an acquirer fails to comply with the bulk sales law (mentioned earlier), it may have to assume responsibility for some of the seller’s debts. If an asset sale is deemed to be a fraudulent conveyance (defined in Chapter 4), the seller’s liabilities are automatically transferred to the acquirer. Under the laws of some states, a buyer of a manufacturing business, even in asset purchases, automatically assumes legal liabilities for faulty products manufactured by the seller prior to the acquisition. (See Chapter 10.) Under federal law, acquirers must honor debts under union contracts, such as pension fund obligations. (See Chapter 12.) Finally, in some states, if a buyer purchases an entire business, and the shareholders of the seller become the shareholders of the buyer, courts can apply the de facto merger doctrine, treating the transaction as a merger rather than as an acquisition.

REPRESENTATIONS AND WARRANTIES What is the purpose of the representations and warranties section of the agreement?

In this section of the agreement, the seller makes detailed statements about the legal and financial condition of the company, the property (assets and/or

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stock) to be conveyed, and the ability of the seller to consummate the transaction. The representations and warranties reflect the situation as of the date of the signing of the agreement and, together with the exhibits or schedules, are intended to disclose important legal, operational, and financial aspects of the business to the buyer. The seller also gives assurances that the transaction itself will not have adverse effects upon the property to be conveyed. Some of the representations and warranties are not related to the legal condition of the company, but serve to provide the buyer with information. For example, the seller might list all the major contracts of the company it is selling, and the buyer might make similar representations and warranties about its legal and financial ability to buy the company. The buyer must be quite assertive in obtaining the information that it needs for this section, as much is at stake. Lenders providing acquisition financing will require the buyer to make extensive representations and warranties about the company being acquired as a condition to funding. If the acquisition agreement lacks comparable representations from the seller, with appropriate recourse in the event of a breach, the buyer will take on the dual risk of a loan default and any direct losses caused by the seller’s breach. In some cases, it may be more difficult to obtain adequate financing if there are insufficient representations and warranties about the business. The buyer should make every effort to anticipate the representations and warranties that the lenders will require and attempt to include language in the acquisition agreement that covers these areas. What is the role of exhibits or disclosure schedules?

The exhibits are an integral part of the representations and warranties. Usually each exhibit is keyed to a specific representation or warranty, and sets forth any exceptions to the statements made in the representation. For example, a representation might provide that there are no undisclosed liabilities of the company “except as set forth in Exhibit A,” or state that there is no litigation that might have an adverse effect on the company “except as set forth in Exhibit B.” Another representation might state that “except as set forth in Schedule C,” there are no contracts of a “material nature,” or there are no contracts involving amounts in excess of a fixed sum, say, $100,000. Schedule C would contain a list of all the contracts that meet the criteria in


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the representation, that is, contracts that either are material or involve dollar amounts above the threshold. (For more about materiality, see the following discussion.) By design, then, the exhibits list all of the items that the buyer needs to investigate in its due diligence effort in anticipation of pricing and financing the deal. The exhibits are a critical part of that due diligence because they require the seller to make statements about all of the pertinent aspects of a company. Thus, they create a succinct financial, operational, and legal synopsis of the company. The use of exceptions to create exhibits might seem odd, but it is merely a practical drafting device. The alternative would be to incorporate each of the candidate company’s documents in the acquisition agreement, which would make the agreement unwieldy. To ease compliance, the representations and exhibits requested by the buyer should run parallel to the due diligence checklist that the buyer gives the seller early in the process (see the sample checklist at the end of this book). Furthermore, the agreement should provide that the information in the exhibits is part of the representations and warranties. As far as acceptance of risk goes, the default goes to the buyer. That is, the risk of loss attributable to anything disclosed to the buyer in an exhibit will be assumed to be accepted by the buyer, unless the parties specifically agree otherwise. For this reason, the exhibits and all of the documents or matters that they reference must be reviewed carefully by attorneys and managers who are knowledgeable about the matters covered. It is a major mistake to delegate review to the most junior person on the project, unless this junior reviewer has been carefully trained and will be closely monitored. In fact, in the classic case of Escott v. BarChris Construction Corp. (1968), the court based its finding against one individual in part on his having relied on work by a very junior associate. Here perhaps more than anywhere, “haste maketh waste.” The buyer’s advisors should check each pending litigation matter and each contract. If necessary, they should request additional documents to substantiate what is being said or promised. Because the review of an agreement is time-consuming, it should not be left until the day before signing. The review process can be greatly facilitated if, as suggested previously, the due diligence checklist parallels the order and content of the representations and warranties that are to appear in the agreement.

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If the seller needs time to prepare lengthy exhibits, it will often use this as an argument for reducing the scope of the representations and warranties. When the seller has prepared the agreement, it will have prepared its exhibits, usually skipping representations and warranties. If there is a need to sign quickly, the buyer may feel pressure, asking its lawyers, “Is all this red tape really necessary?” The lawyers should be sensitive to time pressures, but be ready to defend the relative importance of the various requests. What does the term material mean when it appears in representations and warranties?

It is often said that materiality is in the eyes of the beholder. As mentioned in Chapter 1 (at note 21), the SEC has recently issued Staff Accounting Memorandum 99 on materiality. The memorandum makes it clear that under securities laws generally, material means important to an average, reasonable investor in determining whether to make a given investment. In many contracts, the parties agree that a “material” fact must be material to the business of the candidate company and any subsidiaries taken as a whole. This ensures that the importance of the fact relates to the entire enterprise acquired and not solely to the parent corporation or to a single subsidiary. In order to reduce the opportunity for disagreement, the parties often set a dollar threshold that defines materiality in particular circumstances. For example, rather than asking for representations about “material contracts,” the buyer will substitute a request for disclosure about all contracts involving payments above a specified dollar amount. Similarly, the buyer may request disclosure of all liabilities greater than a certain sum. Use of numbers tends to fine-tune the disclosures, and in many ways provides protection for the seller as well. If there is a dollar threshold of, say, $100,000 for liabilities, the seller can be assured that a $95,000 undisclosed liability will not be deemed “material” in a later dispute. Many companies already have a policy defining the amounts that they consider material in various circumstances. For example, a company may have a capital expenditure policy in an accounts payable manual. The


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policy would show the limits of capital expenditures that can be approved at various levels. For a company of substantial size, for example, the limits may range from $10,000 for a department manager to $100,000 for a division president to $1 million for the CEO.11 In setting a dollar limit for materiality, the acquirer could base the limit on one of these existing thresholds. However, due diligence investigators should go beyond the numbers as evidence dictates. All parties should bear in mind the true meaning of “materiality,” as suggested by regulators and courts. Should exhibits be used if the candidate company is, or will become, a public company?

No. If the candidate is a public company, or if the buyer intends to take it public, it is better for the buyer to spell everything out on a disclosure statement. A disclosure statement, required under SEC Rule 15c2-11, is a separate document that sets forth all of the items that otherwise would be listed in exhibits or schedules to the acquisition agreement.12 How can a seller narrow the scope of its representations and warranties?

The seller can use one of two basic strategies to reduce its exposure attributable to representations and warranties. It can refuse to make any representations or warranties about specific items—for example, accounts receivable or the financial condition or liabilities of certain subsidiaries. Alternatively, it can refuse to make representations and warranties about matters that are not “material” to the transaction, or it may attempt to make representations and warranties only to the “best of its knowledge.” To protect itself further, the seller can seek to insert the word material, or phrases with the same effect, in every one of its representations. For example, it can state that it is disclosing only “material liabilities” or “material litigation,” or that it knows of no violations of law by the company that will have a “material adverse effect” on the company.

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How and to what degree can the buyer resist the narrowing of the scope of the representations and warranties?

Generally speaking, it is in the buyer’s interest to have the broadest possible representations and warranties. However, unreasonable requests for disclosure can threaten a deal. Pressuring the seller of a large, complex company to make comprehensive disclosures may cause the seller to fear that it will inadvertently fail to disclose minor matters, jeopardizing the transaction or leading to unfair liabilities after the closing. Moreover, anyone who is buying a business must recognize that no business is more perfect than the human beings who conduct it. Therefore, there are bound to be a variety of problems in connection with the operation or ownership of the business, including litigation, liabilities, or violations of law, that the buyer must accept as part of the package of owning the business. As a result, in most transactions, the buyer will permit the seller to limit the scope of the matters that are being represented to those things that are material, individually or in the aggregate, but where appropriate will negotiate dollar threshold amounts to require more, rather than less, disclosure. What different motivations might a seller have for narrowing representations and warranties?

For negotiation purposes, it is important for the buyer to understand the seller’s real concerns. The seller may simply be concerned about the time and expense required to uncover a lot of detailed information that, in its view, shouldn’t matter to a buyer, or that, given the time pressure of the deal, just can’t be obtained. Or the seller may be far more concerned about making representations and warranties that will increase the risk that the buyer will be able to back out of the transaction. Alternatively, the seller’s most significant concern may be with postclosing liabilities for breaches of representations, warranties, and covenants in the agreement. How can a buyer address these different motivations?

Concern about time and expense is legitimate only to the extent that the buyer is asking for truly inconsequential or irrelevant representations or


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warranties. Remember that the seller’s negotiator on these points is likely to be an in-house lawyer or technician who is focused more on details than on the broad scope of the deal. Where time is truly a critical factor (as opposed to a negotiating point for the parties), the buyer’s lawyer should exercise care and use good judgment in paring down the more burdensome, yet noncritical, representations and warranties. The buyer should, however, address the most legitimate concerns of the seller. The buyer can explain to the seller that it wants in-depth disclosure of a broad range of items so that the buyer can determine on its own what is material. Most buyers prefer to determine the materiality of information themselves rather than leaving it up to the officers or advisors of the seller. Lawyers in particular may have a narrower view of materiality, and may not be aware of the buyer’s specific concerns about certain legal or financial aspects of the company or the assets to be acquired. The buyer should assure the seller that extensive disclosures will not threaten the deal or increase the seller’s postclosing liability. To ease the seller’s concerns, the buyer can state in the agreement that although disclosures may affect the price, they will not lead to termination or require indemnification unless there are material breaches of representations, warranties, or covenants. To summarize, the buyer must look through the stated position of the seller, determine its real interests, and deal creatively with the seller’s concerns, rather than simply viewing negotiations as an argument over whether or not the word material is going to modify a particular representation or warranty.

What is the purpose of the ordinary course of business phrase that is often found in representations and warranties?

This phrase is simply a way for the parties to narrow the scope of the seller’s representations and warranties. The phrase ordinary course of business is usually used in representations and warranties to exclude certain things from the representations. For example, the seller may not be required to disclose supply contracts entered into in the ordinary course of business, or may not be required to disclose liabilities accrued in the ordinary course of business.

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The definition of ordinary course of business will depend upon the normal practices of the specific business that is being acquired and the industry of which it is a part, including the normal character and size of routine transactions. It can be generally defined as not including business activities that the seller does not engage in on a regular and consistent basis. For greater clarification, the parties could enumerate the seller’s ordinary practices in the acquisition agreement. An important point is that any transactions that are extraordinary in nature, price, or size will be included in the representations and warranties. What is the function of the phrase best of knowledge ?

The phrase best of knowledge serves a similar function. A seller may ask that its representation concerning litigation be limited to the litigation about which it has knowledge, so that it will not be required to represent and warrant absolutely that there is no material litigation. The seller often argues that the phrase should also modify other representations and warranties. At each juncture, the buyer should ask whether the “best of knowledge” modification is appropriate. Usually it is not, but it is often agreed to with respect to the existence of threatened litigation and infringements of copyrights and patents by third parties. Beyond those few customary areas, the buyer should resist efforts to base the representations solely on the knowledge of the seller. Because such a representation and warranty tells the buyer only that the seller is unaware of any problems, it protects the buyer only if problems that are known to the seller are not disclosed. Thus, “best of knowledge” representations have the effect of allocating to the buyer all the risk of defects that no one knows about. “Best of knowledge” qualifiers may be presented as a compromise to a seller who adamantly refuses to indemnify the buyer for breaches discovered after closing. At the very least, an indemnity should be forthcoming with respect to problems that the seller knew about but didn’t disclose. There are other issues in connection with the phrase. First, whose knowledge are we talking about? Careful sellers will attempt to limit the knowledge to a narrow group of people in the company that they are selling, such as senior officers. Certainly, a large organization ought to be careful about making representations about what “the corporation” knows.


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Consequently, a buyer who accepts a “best of knowledge” representation will often permit the seller to limit the persons whose knowledge will be tested. The buyer ought to be certain that everyone who has material information about the company is included in the selected group of officers. This will force the seller to quiz the officers whose knowledge will be pertinent for purposes of the agreement. Another issue is whether the phrase best of knowledge implies any obligation on the part of the seller to look into the matter—that is, does it assume that the knowledge is based upon a reasonable effort to ascertain the existence of any problems? The general answer is that the seller’s inquiry would be limited to information that is already in the seller’s possession. A buyer who wishes to impose upon the seller a duty to make reasonable investigations into the matters represented to the buyer should augment the best of knowledge phrase with the words after due inquiry. What if the seller claims to have no knowledge, or ability to get knowledge, about an area that is the subject of a representation or warranty?

In this era of rapidly changing ownership of companies through merger, acquisition, buyout, and restructuring, the seller often has not had a chance to become acquainted with all the details of the business it is selling. This may seem reasonable from the seller’s perspective, but the buyer should not give the argument much weight. As noted earlier, if the buyer must absorb a loss resulting from a breach of a rep or warranty, the buyer is in effect paying an increased purchase price. One veteran in deal making suggests that the buyer respond as follows: The real issue is, Who should absorb the risk in the event that there are undisclosed material defects in the business? We have different views, of course, of who should bear the risk, but let’s really talk about what matters, not about what each of us knows about the company right now. The agreement between us ought to be structured to provide incentives for both of us to do the best job possible to unearth problems, and to increase our knowledge of the company now, before we close, rather than wait for problems to surface afterward. Then, if something does surface later, either after we sign or after we close, we need to decide where the risk should reside.13

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This response addresses the real interests of the parties and will prevent digressions into who knows the most about the company or who can know the most about the company. Sometimes the seller is leery of making legally important statements without being absolutely certain of their truth. It is important for both sides to recognize that the representations and warranties are not a test of the integrity of the parties making them. A party cannot properly be accused of dishonesty if it makes a representation about which it is not certain (provided, of course, that it has no knowledge that the representation is in fact untrue). In order to reduce legal exposure, however, it makes sense to try to verify the accuracy of the representations and warranties as much as possible. There will always be some degree of uncertainty. However, if the parties recognize that the representations are not a test of integrity, but a legal device for allocating risk, the process becomes more manageable. How do reps and warranties work in a management buyout (MBO)?

The seller should be just as cautious about reps and warranties when selling to managers as when selling to an unknown buyer. Managers who are buying the company know more about the strengths and weaknesses of the company than the typical buyer. But they may want to bring more negative than positive factors to light in order to reduce the price they are paying for the company. This is certainly good for the management team that is buying the company, and for the promoter, investment bank, or lenders that will also end up owning equity, but it is not good for the seller. Are some representations and warranties more important than others?

Yes. The representations regarding financial statements, litigation, undisclosed liabilities, and taxes are usually the most important. If a buyer is pressed to get indemnities only for what it absolutely needs, it should, at a minimum, argue hard for solid representations and warranties on these points. Protection against breaches of the representations on the financials should be the last point the buyer concedes; the buyer should make this con-


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cession only if it is fully apprised of, and is committed to taking, the associated risk. In general, the audited financial statements represent the best picture of the company as a whole. If material problems arise, triggering a restatement, then the buyer may argue that the seller violated its representation in this regard and may prevail. Again, this is not necessarily a test of the seller’s integrity. Most restatements stem from honest errors in accounting rather than from any intent to defraud. If a seller is concerned that a future restatement may trigger a contract violation, it may want to narrow this to restatements resulting from fraud rather than all restatements. The model here could be the narrow language used in the Sarbanes-Oxley Act of 2002,14 rather than the broad language used in the Emergency Economic Stabilization Act of 2008.15 Of course, the buyer would want to use the broad language found in the 2008 law.

COVENANTS What is the major purpose of the covenants section of an agreement?

The covenants section of the agreement defines the obligations of the parties with respect to their conduct during the period between the signing of the agreement and the closing. For negotiation purposes, the most significant covenant relates to the obligation of the candidate company to continue conducting business as usual between signing and closing, except as noted in the agreement or approved later by the buyer. For example, an agreement involving a multinational manufacturer might state that the company must continue to own and operate all its factories, but has permission to divest one of its factories through a pending sale that is known to the acquirer. In the representations and warranties, the seller assures the buyer of the legal characteristics of the company as of the date of the signing of the agreement. In the covenants section, the seller in essence agrees not to do anything to change that picture in any material way, except as necessary in the normal operations of the business. Under appropriate circumstances, it is often necessary to limit this restriction by requiring the buyer not to “withhold consent unreasonably.”

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This limitation should be used sparingly to ensure that it achieves its limited purpose. That is, in narrow circumstances, the seller may be required to take certain actions in order to preserve the business—for example, restructure a loan, make a capital investment, or sell an asset—and the buyer should not be allowed to prevent these actions unless they will have a material impact on the transaction. DOCUMENT FLOW

In Chapter 1, we mentioned virtual data rooms. We will elaborate on this topic here, in the context of transactional due diligence. Today, many deals have gone virtual. The tradition of having a physical closing binder and a physical closing room, with all documents and parties present in one place, has given way to a flow of documents via e-mail. This can lead to decentralization of data, with the attendant risks of data loss and corruption. For strong transactional due diligence, key data need to be ■ ■

Identified and listed in the acquisition agreement. Then obtained and managed over the course of the transaction.16

How can an acquirer obtain and manage the data it needs?

A comprehensive acquisition agreement can help. It will state that the acquirer should have access to all target company documents that are reasonably required for the conduct of due diligence, and it will specify which data are needed at a minimum (for example, the most recent audited financial statements). Acquirers can ask for clear language giving the acquirer the right to obtain and store records in their original electronic formats, as opposed to having the target place documents on backup media. (Backup storage may not reflect the acquirer’s preferred way of tagging and organizing the documents—not to mention vulnerability to file corruption.17) The agreement would list the kinds of data required. (See the sample closing memoranda found on the Web site for this book.)


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It may be wise to include language that asserts a good faith intention to comply with Sections 802 and 1102 of the Sarbanes-Oxley Act of 2002.18 These provisions set penalties for tampering with evidence or obstructing justice. In keeping with the trend to criminalize matters that used to be up to the civil courts, these provisions impose substantial criminal penalties on any person or entity—public or private—for destruction of evidence or obstruction of justice regarding any actual or “contemplated” federal investigation, matter, or official proceeding. As for managing the data, most acquirers use outside counsel to gather documents for an electronic document room, either in-house or with a thirdparty vendor. ■

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In the in-house approach, the acquirer’s requests are sent from a custom-built site housed in the acquiring company or with the company’s law firm. The target is then sent an e-mail with a link to the requests, each of which has an associated field for uploading responsive documents in electronic form. If documents exist only in paper format, the target scans and uploads them. During this process, counsel needs to direct what documents are being collected and how they are being stored. In the third-party vendor approach, counsel will transmit a list of documents required; the target then locates the requested documents, often in hard-copy form, and provides copies to the acquirer. The acquirer sends them on to the vendor, which scans them into the appropriate electronic format and then either populates the extranet with them or returns them to the acquirer for coding, according to the diligence request list, followed by upload to the extranet. This takes longer, but it is a viable alternative for companies that do not have their own virtual data rooms.

Whichever approach is taken, it is very important to treat the documentation for the deal as an important knowledge management process. At the very least, the law firm advising the acquirer should have a records retention policy (as well as any separate litigation hold policy) that requires the information technology team at the law firm to check with counsel before overwriting any data. The standard data retention policy

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may have a clause that requires automatic destruction of data after a set period of time. Such automatic policies may have to be suspended for the purposes of document management in a due diligence project, for the reasons outlined previously. CONDITIONS TO CLOSING What is the “conditions to closing” part of the agreement, and how does it affect the key concerns of the buyer and the seller?

The “conditions to closing” section is an important part of the agreement. It lists conditions that must be fulfilled if the transaction is to close. If the conditions are not fulfilled, then either party, depending on the circumstance, may avoid completing the transaction. The most significant condition is the so-called bringdown provision. This typically states that the buyer will not be required to close if ■ ■

The seller has breached any of its covenants. Any of the representations and warranties of the seller and the candidate company were not true when they were made— or were true when they were made, but are not true on the closing date.

These events can occur as a result of changes outside the control of the seller and the candidate company. For example, the seller may state that its company is waiting to receive word on a Food and Drug Administration approval of a new drug in which the company has invested $20 million in the expectation of an appropriate return. If the FDA declines to approve the drug, then the statement about waiting is no longer true. This condition triggers an activity known as bringdown due diligence, described in Chapter 1. To recap, this means continued due diligence activities through additional meetings, conference calls, reexamination of disclosure items, and updating seller warranties and representations. Bringdown due diligence can protect a buyer against a claim that it should have uncovered some late-breaking development that was not included in representations and warrantees.


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Could you give an example of how the conditions to closing works?

The following example will illustrate the process. On the day that both parties sign the acquisition agreement (but on a day prior to closing), the seller states in writing that there is no “material” litigation involving the company being sold. The acquisition agreement contains a condition to closing stating that the representations and warranties must be true as of the date the acquisition agreement was signed. If they were not true (that is, if the seller failed to disclose pending lawsuits), then the buyer may abandon the transaction if it discovers that material litigation existed on the signing date. What if a lawsuit arises after the signing? Does the conditions to closing clause protect the acquirer against that as well?

No—and that is why it is so important to conduct a liability exposure analysis prior to closing, and to continue bringdown due diligence right up to the last minute. In our example, the seller guaranteed only that no lawsuits existed as of the date of the acquisition agreement. Since the representation was true when it was made, there is no breach of the litigation representation as a result of events between signing and closing. However, a bringdown condition will obligate the seller to make the same representation as of the closing date. On the basis of such a condition, the buyer will be able to terminate the agreement if interim events such as new litigation, liabilities, or other postsigning occurrences reduce the value or viability of the company. In a typical representation, the seller warrants that the financial statements of the company being sold represent a true and accurate picture of the company as of the date of the financial statements—for example, at the end of the previous quarter. But this representation does not cover the possibility that there has been a change between the time of the financial statements and the time of the signing. To cover that possibility, the buyer can ask the seller to state that there has been no material adverse change in the financial condition, operations, or prospects of the company between the date of the financial statements and the date of signing.

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The effect of this bringdown condition is to assure the buyer that, on the closing date, the company it is acquiring will be the same company, from a financial, operational, and legal perspective, that it bargained for in the contract. Because the buyer is not required to close the transaction if any part of the bringdown condition is not satisfied, the condition allocates to the seller the risk of loss attributable to any adverse change during the period between signing and closing. Interim losses may reduce the value of the company, so the bringdown condition may allow the buyer to renegotiate a lower price reflecting the changes. Do reps and warranties have to be restated as of the closing date?

No. In fact, the typical bringdown clause states that representations and warranties need not be restated as of the closing date. But be careful! Occasionally a seller will attempt to limit the applicability of a representation (for example, an assurance that it is not “currently” involved in material litigation) by adding language like “As of the date . . . ” Such a qualifier may deprive the buyer of the right to claim breach of promise and walk away from the deal. How can a buyer make sure that it will have legal recourse in the event of a breach of a representation?

Some assurance can come from an “officer’s certificate.” This is a statement (typically within the conditions to closing part of the acquisition agreement) by an officer of the company being sold certifying that the representations and warranties are accurate in all material respects as of the closing date. Providing this certificate is in effect a restatement of all the representations and warranties as of the closing date. (An example can be found on the Web site for this book.) In the absence of an officer’s certificate, a buyer might be unprotected against certain adverse events that could occur between signing and closing. For example, if a material liability arises and is discovered before closing, a closing condition will be unsatisfied, and the buyer can walk away from the deal. But if it is not discovered, the parties may close because, to their knowledge, each closing condition—including the condition that the


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representation and warranty about undisclosed liabilities is true—was satisfied. If the certificate is inaccurate, the inaccuracy will constitute a breach of a representation or warranty and may give rise to liability from buyer to seller under the indemnification section of the agreement. For the officer’s protection, the officer’s certificate should be made solely on behalf of the corporation and should not be a personal affidavit. Otherwise, the officer might be personally liable to the buyer if the certificate is proved untrue, irrespective of whether he or she is at fault. Who bears the risk of a general economic downturn affecting the seller’s industry?

In all fairness, both parties should bear this risk, but it is usually the seller that does so. If significant problems arise between the two events, the buyer can terminate or renegotiate the acquisition. But, as mentioned, the seller has no right to keep the business if positive developments occur. Some sellers try to get buyers to “lock in” their promise to buy, even in the face of general or industry-specific economic reversals that may affect the seller. Buyers are usually successful in resisting the attempt, but sellers cannot be blamed for trying. After all, in the typical agreement, as mentioned earlier, the buyer clearly gets the upside of unanticipated positive movements (since the seller must close, no matter what). To be fair, an agreement could protect the seller against the downside of unanticipated negative movements in the same manner. The buyer cannot be expected to assume the risk of other postsigning adverse changes, such as new lawsuits, major undisclosed liabilities, or major uninsured casualty losses. In any event, the buyer must resist this attempt by the seller, because the buyer may not be able to close its financing in the face of negative events. It does not seem fair to tag the buyer with damages for failing to close in this situation, particularly if the seller knows that it is selling in a highly leveraged transaction and if the buyer has obtained financing commitments in advance. Many sellers may try to shift the date for the transfer of risk from the seller to the buyer to the date the acquisition agreement is signed, rather than waiting until the date of closing. Their theory is that the buyer has to accept a balanced economic deal—it gets both the good and the bad that may occur after the signing. The seller says that as long as (1) the repre-

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sentations and warranties as of the signing date are accurate on the closing date and (2) the seller does not breach its covenants concerning the conduct of the business pending closing, the buyer is getting what it bargained for. The seller’s argument has logical appeal, particularly if there will be a great deal of time between the signing and closing, perhaps because of the need for regulatory approvals. If the seller is going to push this point, it must also be willing to give up any earnings during the interim period. Tradition is on the buyer’s side, so the seller can expect to give up something significant to win this point. If the time span between signing and closing is less than 60 days, it may not be worth the fight. In order to govern events that occur before closing that will harm the financial condition of the company afterward, the conditions to closing section of the acquisition agreement should require that there be no material adverse change in the “prospects” of the company. In the absence of such a provision, the buyer would be obligated to close under these circumstances. The seller often argues that the word prospects is too vague. The proper response is to be more specific, but without shifting the entire risk to the buyer. Do buyers ever close even if they know the seller has breached a representation or warranty— and if so, what happens?

This does happen—usually when the buyer either has negotiated an appropriate price reduction or considers the breach unimportant. If the buyer does close while knowing of the breach, it cannot sue the seller for it later. DUE DILIGENCE IN CLOSING What are the main phases of closing?

The main phases of closing are the preclosing, closing, and postclosing. What is a preclosing?

The preclosing, also called a preclosing drill, is a dress rehearsal for the closing, preferably held no earlier than three days prior to closing and no


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later than the night prior to closing. Counsel for the parties conduct the preclosing; their clients and other persons will be present as needed. Each party puts all of its closing documents out on the closing room table so that the other appropriate parties can satisfy themselves that the conditions to closing embodied in those documents have been met. To the extent feasible, the parties will execute as many documents as possible in order to save time on the closing day and thereby ensure that all conditions to closing will be satisfied early enough in the day to allow any wire transfer of funds or investment of sale proceeds to be completed on the closing day. After review of the closing documents and the closing checklist, the parties will identify tasks that must be completed before, legally and logistically, closing can be effected. However, it is not unusual to generate a schedule of minor uncompleted items and agree that they will be resolved postclosing. In transactions involving third-party financing, lenders and lenders’ counsel may require two or more preclosings—that is, one involving their own financing, one involving review of the corporate side of the transaction, and, if applicable, others involving the other financing pieces of the transaction.

What happens on the closing day itself?

Assuming that the parties have conducted a preclosing, three things will happen. First, the parties and their counsel will review any documents that have been revised or were newly generated, the parties will execute any previously unexecuted documents, all undated documents will be dated, any required meetings of the board of directors that have not previously been held will be held, and any changed documents or signature pages that must be submitted to local counsel prior to their release of their opinions will be transmitted to them. Second, the parties will recheck all the documents lined up on the closing table against the closing checklists. Then, when all counsel are satisfied that all conditions to closing have been either satisfied or waived, they will instruct their clients’ respective agents to wire funds or to file or record documents (simultaneously or in such order as they have agreed), as applicable, and will deem all the docu-

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ments on the closing table to have been delivered in the sequence set forth in the closing checklist and other governing agreements. In the case of a transaction involving third-party financing, what part of the deal closes first?

Typically, all transactions are deemed to take place simultaneously. Practically speaking, the lenders usually will not release the loan proceeds until they receive confirmation that the corporate portion of the transaction has been completed, that is, that stock certificates or bills of sale have been delivered or merger certificates have been filed, and that security and title documents have been properly recorded. What are some of the most common logistical snafus that can derail a closing?

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Unavailability of key businesspeople Failure to have local counsel on standby to review last-minute document changes Failure to provide local counsel with copies of documents or other items that are conditions to the release of their opinions Failure to have precleared the Articles of Merger with appropriate jurisdictions Failure to have persons on standby to file or record documents, including merger documents, UCC-1 forms (required under the Uniform Commercial Code), mortgages, and terminations of UCC-1s required to be removed off record19 Failure to have adequate support staff to make last-minute revisions in documents Failure to have conducted the preclosing, including the execution of all documents that are not subject to change Failure to have adequate legal staff at closing headquarters to negotiate the final documents, including local counsel legal opinions Failure to obtain proper wiring instructions for funds transfers


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Failure to ascertain the time periods by which wires must be sent or to make arrangements to have banks hold their wires open past normal hours Failure to consummate any preclosing corporate reorganizations (such as mergers of subsidiaries into parent companies, dissolution of defunct subsidiaries, or filing of charter amendments) in a timely fashion Failure to have tax counsel review the final terms and documentation to ensure that tax planning objectives have not been adversely affected by last-minute restructuring or drafting Failure to obtain the required bringdown good standing certificates or other certified documents from appropriate jurisdictions

Proper advance planning can prevent most, if not all, of these failures. What are typical postclosing activities?

Postclosing tasks typically fall into one of two categories: document distribution and cleanup. Why is document distribution necessary? Can’t all the documents go to everybody?

Document distribution requires planning. Although each of the parties to a closing generally wants a complete collection of closing documents for its records, this is usually impractical. First, each party has different requirements for closing documents. Some parties should not receive documents that other parties will receive, and some parties need original hard-copy documents, whereas others need only photocopies. Further, some documents may be available via a secure data site. Each participant is entitled to a certain set of documents. Shortly after closing, each should receive his or her complete set. In some transactions, the initial distribution of originals and copies is followed by the production of a real or virtual “closing binder” containing a complete indexed set of documents in one or more volumes or files.

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The final document assembly and distribution effort will be much easier if counsel has prepared a good closing document checklist. When completed and updated, the checklist may be turned into a closing memorandum, which may double as an index to the closing document binders. (Examples of closing memoranda are available on the Web site for this book.) The memorandum may include a brief narrative chronology of the transactions taken prior to, at, and following the closing to complete the transaction. A single closing memorandum can be used even if the acquisition and financing closings occurred at different offices. What is involved in postclosing cleanup?

In the cleanup phase, participants complete tasks and documents that were not or could not have been completed at or prior to closing. This may include the following actions: ■ ■

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Corrections or amendments to ancillary documents Receipt of consents and approvals that were not obtainable by closing Completion and documentation of a closing date audit for balance sheet pricing adjustment purposes Receipt of title insurance commitments or policies as of the closing date from jurisdictions with filing delays

In addition, when many real estate parcels in multiple jurisdictions must be mortgaged, or when collateral is located in foreign countries, completion of the recording of mortgages and perfection of security interests is commonly put aside as a postclosing matter, with a deadline for completion of several months after the closing date. Other cleanup activities might include urgent changes in compensation arrangements, such as restructuring of pension plans. In all cases, the individuals who are responsible for postclosing efforts should strive to complete their tasks as soon as possible, before the pressure of other matters and the passage of time make the wrapping up of these loose ends more difficult than it would otherwise have been. Acquirers should create a postclosing checklist keyed to their closing memorandum.


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CONCLUDING COMMENTS

Transactional due diligence demands energy and attention. To some executives, this may seem like so much wheeling and dealing, far removed from the loftier concerns of market share and product launches. Yet transactional due diligence plays a vital role in setting the stage for postacquisition success.


CHAPTER

6

Detecting Legal Exposure under Securities Law The stock market is but a mirror which . . . provides an image of an underlying economic situation. —John Kenneth Galbraith, The Great Crash (1955)

INTRODUCTION

Knowledge of securities law is imperative in any transaction involving one or more public companies—whether as a buyer, a seller, or both. We define a public company as one that is registered with the appropriate securities regulator to sell shares to the public. In the United States, this means companies registered under Section 12 of the Securities Exchange Act of 1933, described later in this chapter. This knowledge may also be helpful in transactions involving only private companies if those companies have issued or bought securities in a manner that brings them under the control of the securities laws in their jurisdiction. A security, after all, is a common element of corporate life. All companies have securities of some form on their balance sheets—including equity and, generally, debt. And many companies use securities to make acquisitions. Equity securities, also called shares, are, by definition, owned by shareholders—an important fact in itself. As mentioned in Chapter 4, a substantial percentage of lawsuits against directors and officers come from shareholders.1 Based on long-term trends in settlement amounts, the most common allegation in shareholder lawsuits against directors and officers is inadequate disclosure. Other issues motivating suits include 161

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Business decisions: divestitures or spin-offs, recapitalizations, investment or loan decisions Other business issues: contract disputes (with shareholders), dishonesty or fraud, executive compensation (such as golden parachutes), and fraudulent conveyance Fiduciary issues: general breach of fiduciary duty and breach of duty to minority holders Financial or financing issues: dividend declaration, changes in financial performance or bankruptcy, financial transactions (such as derivatives), share repurchases, and stock or other public offerings Insider trading issues: trading on the basis of undisclosed information Change of control issues: challenging a company’s takeover bid or its response to a bid from another company, and proxy contests2

Clearly, the sweep of securities law is broad. To maximize its usefulness, this chapter will focus on the last topic, change of control issues. By mastering the basics of securities law pertaining to changes of control, acquirers will improve their ability to perform a litigation analysis of a candidate company and to reduce the chances of securities law violations before, during, and after their merger transaction. OVERVIEW OF SECURITIES LAW What precisely are corporate securities?

Corporate securities are a type of financial instrument—one that is “secured” by the value of an operating company. These securities can be issued as equity securities (such as shares of company stock) or as debt securities (such as company bonds, certificates, notes, or paper).3 Equity represents ownership, whereas debt represents a promise to repay a certain sum, with interest, at a definite time. The distinction between equity and debt securities is important, because the two instruments require different tax and accounting treatment.

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Furthermore, the holders of equity and debt instruments may have different priorities as corporate stakeholders. Although, under state law, directors and officers have the fiduciary duties of care and loyalty to both equity and debt holders, there are times when holders’ interests may conflict. In those cases, the directors’ duties may shift, based on the financial condition of the company. Normally directors owe their primary duty to shareholders, but if a company becomes insolvent, directors must place the interests of debt holders above those of equity holders.4 What is the purpose of the federal securities laws?

The federal securities laws require that the issuers of securities make certain disclosures at certain times. These disclosure rules ensure that anyone who buys or sells securities has the basic information necessary to determine their value. The laws also ensure that all shareholders have equal access to information, as those who have access to nonpublic information are restricted from trading. All these laws are enforced by the Securities and Exchange Commission (SEC), which was established under the Securities Act of 1933 and the Securities Exchange Act of 1934 as an independent, nonpartisan, quasi-judicial regulatory agency charged with administering federal securities laws. The SEC also regulates firms engaged in the purchase or sale of securities, people who provide investment advice, and investment companies such as mutual funds. What are the primary federal securities laws?

The primary securities laws (to recap and expand the description in Chapter 1) are as follows: ■

Securities Act of 1933. This law requires that investors receive financial and other information concerning securities that are being offered for public sale. It has led to the promulgation of hundreds of rules and regulations related to the registration of securities and the publication of information related to registration.

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Securities Exchange Act of 1934. This law requires that investors have access to current financial and other information regarding the securities of publicly held corporations, particularly those that trade on the national exchanges or over the counter. The 1934 Act has led to the promulgation of hundreds of rules and regulations concerning the operation of the markets and the actions of participants, including proxy solicitations by companies and shareholders, tender offers, and buying securities on credit (so-called margin purchases). Investment Company Act of 1940. This law governs the activities of companies, including mutual funds, that are engaged primarily in investing, reinvesting, and trading in securities and that offer their own securities to the investing public. Under this law, investment companies are subject to certain statutory prohibitions and to regulation by the SEC. Public offerings of investment company securities must be registered under the Securities Act of 1933. Investment Advisor Act of 1940. This law contains provisions similar to those in the Securities Exchange Act of 1934 governing the conduct of securities brokers and dealers. It requires that persons or firms who are compensated for advising others about securities investment must register with the SEC and conform to statutory standards designed to protect investors. Trust Indenture Act of 1939. This law applies to debt securities, including debentures and notes, that are offered for public sale. Even though such securities may be registered under the Securities Act of 1933, they may not be offered for sale to the public unless a formal agreement between the issuer of the bonds and the bondholder, known as a trust indenture, conforms to the statutory standards of this law. This law was revised substantially in 2009, following the global financial crisis of the preceding three years.5 Public Utility Holding Company Act of 1935. This law covers interstate holding companies engaged, through subsidiaries, in


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the electric utility business or in retail distribution of natural or manufactured gas. This is clearly a broad array of laws for the SEC to enforce—especially given the commission’s relatively small size. To extend its reach, the commission relies on what it calls a “public-private partnership.” That is, the commission sets standards for the issuance and trading of securities, but much of the direct, day-to-day regulation of the securities market participants is done under SEC oversight by the so-called self-regulatory organizations—stock exchanges. In addition, the investing public itself has the remedy of “private ordering” and/or “private action.”6

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Private ordering refers to mechanisms that enable shareholders and others to propose and adopt changes that are suited to their situations, rather than conforming to a law that sets a single standard. Private right of action refers to the right to sue in court based on the language or implications of a law.

What is the role of state securities laws?

State securities laws, commonly known as blue sky laws, set forth registration requirements for brokers and dealers, registration requirements for securities to be sold within the state, and prohibitions against fraud in the sale of securities. A majority of states, with the notable exception of New York and California, have adopted the Uniform Securities Act (USA) of 1956, which is frequently updated.7 In addition, there are state corporate statutes governing corporate existence, charters, and bylaws. These establish the rights of the holders of securities. Corporate statutes vary from state to state, but there is some uniformity, thanks to the influence of Delaware corporate law (which is often used as a prototype for state corporate statutes) and the Model Business Corporation Act, which was first created in 1946 and is regularly

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updated under the auspices of a committee of the Business Law Section of the American Bar Association (ABA).8 FEDERAL SECURITIES LAW PERTAINING TO PUBLIC COMPANIES What are the most important federal laws to consider when conducting due diligence on an acquisition involving a public company?

At the federal level, securities laws are encompassed in two of the laws mentioned earlier: the Securities Act of 1933 (commonly referred to as the 1933 Act or the Securities Act), which sets forth registration requirements for companies seeking to sell securities to the public, and the more extensive Securities Exchange Act of 1934 (commonly called the 1934 Act or the Exchange Act), which sets the disclosure and filing requirements. In general,9 Au: Text needed for this note. Securities Act rules are numbered from 100 on up, based on when they were approved, while Exchange Act rules are numbered from 01 on up, after sections. Thus, for example, under Section 10(b), there are rules from 10b-1 on up (to 10b-21 now). Regulations and forms are also named in accordance with sections. The basic text of these laws has been amended and expanded over time, and now includes hundreds of related rules. Rules of the Securities Act and the Securities Exchange Act have undergone many amendments and additions. Could you give an overview of all the Securities Act and Exchange Act rules pertaining to mergers or acquisitions?

M&A transactions are complex and situation-specific, so any given transaction could require knowledge of one or more of hundreds of securities laws. In any transaction involving a public company, it will be important to engage the services of an experienced securities lawyer, whether as inside or outside counsel or both. This said, here is a brief list of the Securities Act and Exchange Act rules that are most relevant to M&A.10


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Key Securities Act rules for M&A include the following: ■

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Rule 144 provides an exemption from registering with the SEC for certain securities sales where there are a small number of buyers who meet certain requirements. Rule 145 rescinds a previous exemption by including reclassification of securities, mergers, consolidations, and acquisitions of assets as events requiring registration with the SEC.11

Key Exchange Act rules for M&A include the following: ■

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10b-1 to 10b-21 ban “manipulative and deceptive devices and contrivances.” 13d-1 to 13f-1 under Regulation 13(d) require disclosure [on Form 13(g)] of beneficial ownership of 5 percent or more within 10 days. 14a-1 to 14b-2 under Regulation 14(a) cover the solicitation of proxies (used to achieve a change of control by getting shareholders to cast proxy votes for a dissident slate). 14d-1 to 14d-11 under Regulation 14(d) pertain to tender offers (used to achieve a change of control by getting shareholders to sell or “tender” their shares to the entity making the tender offer). 14e-1 to 14e-8 under Regulation 14(e) deal with unlawful tender offer practices, such as short tendering. 16b-1 through 16b-8 deal with the timing of sales (curbing illegal insider trading by banning “short-swing” trades by insiders within six months of obtaining shares); Rule 16b-7 exempts mergers, consolidations, and recapitalizations from this rule.

Many of these rules are described further later in this chapter. Beyond these rules, there are more than a dozen additional regulations with their own numbering systems. Some of these are very general, such as Regulation S-K, which provides additional rules pertaining to securities registration, and Regulation S-X, which gives additional guidance on financial statements. The regulation pertaining specifically to

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M&A is called Regulation M-A, and it requires the filing of a Schedule TO for tender offers.12 Regulation M-A added Items 1000 to 1016 under the Securities Act and the Securities Exchange Act, effective January 24, 2000. This regulation (created entirely by the SEC, not by Congress) is applicable to takeover transactions, including tender offers, mergers, acquisitions, and similar extraordinary transactions.13 The revised rules permit increased communication with security holders and the markets. The amendments aimed to ■ ■ ■

Balance the treatment of cash versus stock tender offers. Simplify and centralize disclosure requirements. Eliminate inconsistencies in the treatment of tender offers versus mergers.14

What exactly is a tender offer?

A tender offer is a public invitation to a corporation’s shareholders to purchase their stock for a specified consideration.15 More than 30 years ago, the SEC provided a comprehensive definition within a proposed rule (which was never adopted but never withdrawn): The term “tender offer” includes a “request or invitation for tenders” and means one or more offers to purchase or solicitations of offers to sell securities of a single class, whether or not all or any portion of the securities sought are purchased, which (i) during any 45-day period are directed to more than 10 persons and seek the acquisition of more than 5 percent of the class of securities, except that offers by a broker (and its customer) or by a dealer made on a national securities exchange at the then current market or made in the over-the-counter market at the then current market shall be excluded if in connection with such offers neither the person making the offers nor such broker or dealer solicits or arranges for the solicitation of any order to sell such securities and such broker or dealer performs only the customary functions of a broker or dealer and receives no more than the broker’s usual and customary commission or the dealer’s usual and customary mark-up; or (ii) are not otherwise a tender offer under [clause (i)] of this section, but which (A) are disseminated in a widespread manner, (B) provide for a price


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which represents a premium in excess of the greater of 5 percent of or $2 above the current market price and (C) do not provide for a meaningful opportunity to negotiate the price and terms.16

A short, somewhat tautological definition of a tender offer appears in Exchange Act Rule 13e-4(a)(2). In that rule, the term “issuer tender offer” is defined as “a tender offer for, or a request or invitation for tenders of, any class of equity security, made by the issuer of such class of equity security or by an affiliate of such an issuer.”17 In a tender offer, the acquirer sends an “offer to purchase” that sets forth the material terms of the offer, and a “letter of transmittal” that the shareholder sends back to accept the offer. By accepting the offer, the shareholder sells or “tenders” its shares to the acquirer. A tender offer typically occurs within a 20-day period.18 Most tender offers involve a general, publicized bid by an individual or group to buy the shares of a publicly owned company at a price above or at a premium19 to the current market price. During a tender offer, the offeror may not directly or indirectly purchase or arrange to purchase, other than pursuant to the tender offer, securities that are the subject of that offer until the end of the offer (Rule 10b-13). This prohibition also includes privately negotiated purchases. Some purchases made before a public announcement may be permissible, even if the purchaser has made the decision to make the tender offer, but purchase agreements that are scheduled to close during the offering period are illegal no matter when they were or are made. What does Regulation M-A require of companies engaged in tender offers and mergers?

Under Regulation M-A, acquiring companies (referred to as “filing persons”) must provide security holders with a summary term sheet, written in plain English, that describes in bullet points the most material terms of the proposed transaction. The summary term sheet must provide security holders with sufficient information to understand the essential features and significance of the proposed transaction. The bullet points must cross-reference more detailed disclosures found in Schedule TO, the disclosure document disseminated to security holders. Items in the term sheet include

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Subject company information. This includes name and address, securities now trading, trading market and place, dividends, prior public offerings, and prior stock purchases. This is basic information about the company whose securities may be acquired. Identity and background of the filing person. This includes name and address, business background of entities, business background of natural persons, tender offer and class of securities to which the offer relates, and Internet contact, if any. Terms of the transaction. This includes material terms, purchases from insiders, differing terms for shareholders, appraisal rights, provisions for unaffiliated security holders, and eligibility for listing or trading. Past contacts, transactions, negotiations, and agreements. This includes details on past transactions between the subject company and the filing person; significant corporate events involving the two, such as a merger, consolidation, acquisition, tender offer, election of a director to the board of the subject company, or sale or transfer of a material amount of assets of the subject company; name of the person who initiated contacts or negotiations; conflicts of interest; and agreements involving the subject company’s securities. Purpose of the transaction and plans or proposals. This includes purposes, use of securities, and subject company negotiations. Source and amount of funds or other consideration. This includes the source of funds, conditions, and expenses. The filer may request confidentiality regarding the source of borrowed funds. Interest in the securities of the subject company. This includes securities ownership and securities transactions. Persons and/or assets retained, employed, compensated, or used. This includes solicitations or recommendations, employees, and/or corporate assets. Financial statements. This includes financial information, pro forma information, and summary information.


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Reports, opinions, appraisals, or negotiations. This includes a description of the report and its preparer.

Regulation M-A also has a section on going-private transactions. Prior to Regulation M-A, individuals who were interested in understanding a transaction had to go to many different reports to get information. The Regulation M-A term sheet provided a way for anyone to see “at a glance” all the material aspects of a merger or acquisition transaction. Are all securities lawsuits brought under the Securities Act and Exchange Act or related regulations?

No. Other laws may be applied in securities cases. For example, RICO has been applied. What is RICO and how could it pertain to M&A?

The Racketeer Influenced and Corrupt Organizations Act, or RICO, was passed in 1970 as part of broad anticrime legislation. RICO sets steep penalties, which include asset freezes, treble damages, and up to 20 years in jail, for organizations that engage in a “pattern” of crime. It was first applied in securities fraud cases in the late 1980s in the Southern District of New York under then-U.S. Attorney Rudolph Giuliani. Since that time, the U.S. Supreme Court has clarified some aspects of the law. Since the 1980s, application of RICO in securities matters has been rare, in part because of judicial interpretations narrowing the application of the statute. In Holmes v. Securities Corp. (1992), the high court ruled that RICO plaintiffs must prove that the alleged wrongdoing did direct harm to the plaintiffs. In Boyle v. United States (2009),20 the court affirmed that to be charged under RICO, an entity must have a “structure,” defining that to mean, at the very least, “a purpose, relationships among the associates, and longevity sufficient to permit the associates to pursue the enterprise’s purpose.” These conditions have made it more difficult for the government to accuse merger planners of any kind of racketeering. Still, for anyone involved in the planning of any merger transaction, this statute could be a sleeping tiger to watch—if managers or advisors find themselves involved in some sort of plot that seems unethical, it may be illegal as well.

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How do securities laws influence transactional due diligence for buying a publicly held company versus a privately held company?

The negotiation of a public transaction involves fiduciary and disclosure considerations that are normally inapplicable to a private setting. The board of directors of a public company that is being acquired via a tender offer— often called a target, reflecting the involuntary nature of its involvement— must be mindful of its fiduciary responsibilities under state corporate law. Traditionally, under state law, as represented by Delaware law and the Model Business Corporation Act, the directors’ primary fiduciary duty is to shareholders. In the landmark case of Revlon Inc. v. MacAndrews & Forbes Holdings (1986), the court described the role of the board of directors as that of a price-oriented “neutral auctioneer” once a decision to sell the company has been made. Obviously, this interpretation constrains decisions in a way that would not apply to most sales of private companies. (But note that boards have some decision-making discretion under state “constituency” statutes as well as under the business judgment rule, discussed later in this chapter.) Furthermore, the structure, timing, financing, and negotiation of a public company sale are greatly affected by federal and state securities laws. Because of these laws, most material aspects of the transaction quickly become public knowledge. For example, even before public companies reach an agreement on price and structure, they may find themselves subject to certain disclosure obligations. They may be placed in a position in which they must disclose their activities. If questioned, they may be permitted to say nothing, but they must refrain from untruthful denial, as shown in Basic, Inc. v. Levinson (1986), discussed later in this chapter. Moreover, in a public company deal, statutory and practical delays provide ample opportunity for a new bidder to arrive on the scene. As a result of the publicity surrounding its offer, the buyer may become a “stalking horse” for the seller in order to attract other bidders. Unfortunately for such a buyer, it will have incurred substantial transaction expenses, such as legal and accounting fees, and it may have laid out significant sums as commitment fees to lenders to arrange for financing. The buyer may also have passed up other investment opportunities while pursuing the acquisition of the target. These considerations may cause the buyer to focus on tactical issues at the expense of due diligence.


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What form does a public company acquisition usually take?

A public company acquisition can be accomplished through either a onestep or a two-step transaction. In the one-step acquisition, the buyer organizes an acquisition subsidiary that will merge into the target. Upon consummation of the merger, the stockholders of the target receive cash and, perhaps, other property such as notes, and the stockholders of the acquisition subsidiary receive all the stock of the target. The merger will require the approval of the target’s stockholders; the exact percentage of stockholder approval required will depend on the articles of incorporation of the target and could be as low as a majority of the voting power of the common stock. To effect the approval, the target must solicit proxies from the stockholders and vote those proxies at a stockholder meeting called for the purpose of voting on the transaction. The proxy solicitation must comply with federal securities law. A two-step acquisition involves a tender offer followed by a merger: 1. The buyer organizes an acquisition subsidiary that makes a tender offer for the shares of the target. Usually, the offer is conditioned upon enough shares being tendered to give the buyer sufficient voting power to ensure that the second-step merger will be approved. For example, if approval by a majority of the voting stock of the target is required, the offer is conditioned on the buyer’s obtaining at least a majority of the target stock in the tender offer. 2. The buyer obtains stockholder approval, the acquisition subsidiary is merged into the target, the stockholders of the acquisition subsidiary become stockholders of the target, and the original stockholders of the target who did not tender their shares receive cash. If the buyer obtains sufficient stock of the target (90 percent in Delaware), the merger will not require the approval of the target’s remaining stockholders (a so-called short-form merger).21 In any event, the acquiring company must make certain disclosures in its proxy statement—a document that informs shareholders of material facts, so that they can vote by “proxy” rather than attend a meeting of shareholders. If the shareholder meeting is being held in connection with any

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merger, consolidation, acquisition, or similar matter, the issuer must disclose certain information in the proxy statement as set forth in Regulation 14A, supplemented by others as described earlier. How does the M&A process in a hostile transaction differ from due diligence in a friendly transaction?

The due diligence process in a hostile deal is very different from due diligence in a friendly deal. A friendly acquirer will typically conduct most of its due diligence after approaching its candidate company, and with the cooperation of the candidate company. By contrast, a hostile acquirer—that is, a company targeting another company for takeover via a tender offer, proxy fight, or other such procedure—must conduct its due diligence in advance of approaching the target. What kind of due diligence, if any, can be conducted before a tender offer?

The acquirer in a tender offer will typically form a team that includes some or all of the following: ■

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A financial advisor to review the target company’s financials (which are already publicly disclosed, since the target in any tender offer is by definition public) and advise the purchaser as to the desirability and feasibility of the proposed transaction. A deal may be more or less desirable and completable depending on the technicalities of federal and state securities laws as they apply to the transaction. (For more about due diligence at this early stage, see Chapter 1.) A dealer-manager to lead communications with (and, if needed and permitted, to buy from) major shareholders. An attorney (or team of attorneys) who is familiar with securities law and litigation and is able to obtain additional expertise in any other pertinent areas of the law, such as antitrust. A shareholder solicitation firm that will arrange for the delivery of tender offer materials and will contact shareholders to solicit their shares.


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A depository bank that will receive and pay for tendered securities. A forwarding agent that will receive shares as an agent for tendering stockholders. A financial printer with the ability to prepare tender offer documents quickly and confidentially.

In a public transaction, must the stock be acquired only through a tender offer or a merger?

No. Before the tender offer, the buyer may make ordinary market purchases or may acquire, or enter into arrangements to acquire, stock from the target or from some of its major stockholders (lockup arrangements).22 The timing and method of such purchases must conform to federal securities laws, which may preclude certain transactions after a tender offer begins and may characterize certain open market purchases as tender offers. The laws may also require disclosure of purchases made prior to the tender offer. For example, there is a requirement to disclose any beneficial ownership of more than 5 percent of a company’s shares. What is a beneficial owner, and why does it matter?

A beneficial owner of equity is a person or group of persons possessing “voting power” or “investment power” over a security as defined in Rule 13d-3 of the Exchange Act. Thus, shares that are beneficially owned include not only shares that are directly owned, but also all shares with respect to which a person has or shares direct or indirect power to vote or sell. For instance, all shares subject to a shareholders’ voting agreement become beneficially owned by each person who is a party to the agreement. The concept of beneficial ownership is especially important in view of the 5 percent threshold in the filing requirements. Thus, if each member of a “group” of five persons owns 1 percent of the shares of a class of a company, that group must make the necessary filings23 if the group has agreed to vote or dispose of those securities as a block. These schedules require the filing person or group to disclose certain information about the transaction: ■

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The number of shares of the company to be acquired that it beneficially owns Its purpose in acquiring those shares, and any plans or proposals to acquire or dispose of shares of the target company Any plans for an extraordinary corporate transaction (such as a merger, reorganization, or liquidation) affecting the target company or any of its subsidiaries Any proposed change in the target’s directors or management, in the target’s capitalization or dividend policy, or in its business or corporate structure Any past involvement of the individual or group members in a violation of state or federal securities laws; the source and amount of funds; or other considerations for the acquisition Any contracts, arrangements, understandings, or relationships that the filer has with any other person concerning the shares of the company to be acquired

A person is deemed to own beneficially any security that he or she, directly or indirectly, has the right to acquire within 60 days, whether such acquisition is pursuant to a purchase contract, exercise of a warrant or option, or conversion of a convertible security (Rule 13d-3). ■

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Also, once a tender offeror becomes a beneficial owner of 10 percent of the target’s securities, it is an insider for purposes of Section 16 of the Exchange Act and must file a Form 3 with the SEC within 10 days of becoming an insider. The amount and type of ownership interest of the offeror must be disclosed on Form 3. An offeror must file a Form 4 upon any subsequent change in its beneficial ownership of the target’s securities. The Form 4 must be filed within 10 days after the end of any month in which a change in beneficial ownership occurred.

Forms 3 and 4 must be filed with the SEC and each exchange on which the target securities are traded.24 Under Rule 16b-7, an insider is exempt from liability under Section 16(b) if it acquires or disposes of shares pursuant to a merger or consolidation of companies and one of the companies owns 85 percent or more of


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the combined assets of the other. Rule 16b-7 usually applies to second-step mergers after completion of a partial tender offer. Also, a transaction that does not follow a typical sale-purchase or purchase-sale sequence may be exempt from the liability provisions of Section 16(b).25 What exactly is a “group” under federal securities law?

Acquirers of less than 5 percent of a target company’s stock may be part of a group and not realize it. Here are salient points about a group for the purposes of Schedules 13D and 13G rules: ■

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The existence of a written agreement is not required; circumstantial evidence of an agreement in itself may be enough [Section 13(d)1(E)3]. A group can be formed as soon as the members of the group reach an agreement, even if the agreement is merely preliminary. Managers of an acquired company may be considered a group if they act as such to acquire shares and if collectively they own more than 5 percent of the company. A written agreement to acquire additional shares may not be necessary to define a group. If shareowners who collectively hold a total of 5 percent or more of a class of voting stock agree to act together in the future to further the group’s purpose, this agreement may be enough to form a group, regardless of whether acts to carry out the agreement (such as voting and acquiring stock) occur after the date of the agreement.

You mentioned earlier that the acquirer must disclose “any proposed change in the target’s . . . business or corporate structure.” Suppose one of the changes involves a confidential strategic plan or a trade secret. Must it be disclosed?

It is possible to avoid the public disclosure of certain material if it can be demonstrated that such disclosure would be detrimental to the operations of the company, and that disclosure of the material is unnecessary for the pro-

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tection of investors. A company that wishes to avoid the public disclosure of such information must seek an Order of Confidential Treatment from the SEC. Generally, if appropriate grounds for relief are asserted, the SEC will grant confidential treatment of such information for a limited period of time. What rules constrain the behavior of sellers in a tender offer?

There are rules against “short tendering.” This occurs when a shareholder in a partial tender offer tenders more shares than he or she actually owns in the hope of increasing the number of shares that the bidder will actually accept pro rata. A person is prohibited from tendering a security unless that person, or the person on whose behalf he or she is tendering, owns the security (or an equivalent security) at the time of the tender and at the end of the probation period. A person is deemed to own a security only to the extent that he or she already has a net long position in that security. That is, the person must have a long position that exceeds any short position. Individuals who hold options contracts may have additional restrictions.26 MERGER DISCLOSURE ISSUES If a company’s board is discussing the possibility of a merger, does the company have to disclose this?

No. Consider Jackvony v. IHT Financial Corporation (1989), a lawsuit brought by a shareholder who earlier had sold his stock in a company without knowing that the company would eventually be sold at a premium. The court found that at the time of the shareholder’s decision, the company had no obligation to make disclosures about its merger discussions, as the merger plans were only speculative and had not yet reached a material phase. The evidence shows no more than the type of concern about possible acquisitions that many large companies frequently express; it reveals no concrete offers, specific discussions, or anything more than vague expressions of interest. It provides no reason to believe in the existence of any preliminary negotiation of the sort mentioned in Basic,27 a case in which the Supreme Court found that specific “meetings and telephone conversations” among “officers


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and directors” of the relevant firm might, or might not, prove material, depending on the probability that the transaction will be consummated. Any reasonably sophisticated investor buying shares in a large corporation would expect that from time to time, other corporations might express an interest in buying, or that the large corporation’s directors might discuss what it should do if it obtains such offers. For large corporations to make public announcements any time directors discuss any such matter in terms as vague as those presented in this evidence or receive “tentative feelers” of the general sort revealed in this evidence would confuse rather than inform the marketplace.28

What if the company has entered into negotiations?

If the company is asked about the negotiations, it may not deny them, but it can say “no comment.” That was the gist of the Supreme Court’s 1988 decision in Basic, Inc. v. Levinson.29 In this landmark case, the Court said that outright denial of negotiations is improper even if the negotiations in question are discussions that have not yet resulted in an agreement on the price and structure of a transaction. The appropriate response to inquiries about such a matter is either “no comment” or a disclosure that negotiations are, in fact, taking place. Prior to the Basic decision, the U.S. Court of Appeals for the Third Circuit had implied that merger proposals and negotiations were not “material,” and thus actionable, until the parties had reached a firm agreement in principle on the price and structure of a transaction. In Basic, the Supreme Court rejected this test of materiality, often called a “bright line” test because it set forth a fairly clear dividing line between material and nonmaterial discussions. The high court held that the materiality of untrue statements about merger negotiations must be evaluated on a case-by-case basis after considering all relevant facts and circumstances. When does a company have a duty to disclose merger negotiations?

Generally, the timing of the disclosure of material information is at the discretion of the company and will be protected by the business judgment rule, described in the next section. Nevertheless, a company that is the subject of takeover speculation or whose stock is trading erratically typically finds itself

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pressured by brokers, news services, stock exchange officials, securities analysts, and others to disclose merger proposals and negotiations. The Basic decision has accelerated the trend toward voluntary disclosures in these circumstances, although it is still acceptable under certain circumstances for a company to adopt a policy of silence or state that “no comment” will be the response to any questions concerning merger proposals or rumors. However, a company may not remain silent when (1) there is an affirmative disclosure rule (such as the tender offer regulations), (2) the company is about to purchase its own shares in the public market, (3) a prior public disclosure made by the company is no longer accurate (such as when a company has publicly denied that merger negotiations with a party were occurring), or (4) rumors that have been circulating concerning the proposed transactions are attributable to a leak from the company. Disclosure may also be appropriate when it is apparent that a leak has occurred, even if the leak is not from the company. In such a situation, consideration should be given to a variety of factors, including the requirements of any agreement with a stock exchange, the effect of wide price fluctuations on shareholders generally, and the benefits to the market provided by broad dissemination of accurate information. If the company does elect to disclose either the existence or the substance of negotiations, it must take care that its disclosures are neither false nor materially misleading.

“DUE DILIGENCE” UNDER STATE CORPORATE LAW: DIRECTORS’ DUTIES What are the primary responsibilities of a corporate board of directors upon receipt of a takeover bid?

The board of directors’ primary responsibility in the event of an offer to acquire the company is to evaluate the offer and recommend what action the company should take. The directors’ conduct in this and other contexts is typically evaluated under the business judgment rule. What is the business judgment rule?

The business judgment rule is a judicial doctrine applied by courts in cases where shareholders have sued directors for violating their fiduciary duty of


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care in making a particular business decision. The rule is that the board of directors’ business decision will be protected from liability unless the shareholders can prove that in making that decision, a director did not act with good faith, informed judgment, and the rational belief that the decision was in the corporation’s best interest. The business judgment rule protects directors from liability if they act in a manner consistent with its requirements in making a particular decision. A thorough due diligence process can satisfy the second prong of the business judgment rule—that is, informed judgment. What is a director’s duty of due care?

For a director, exercising due care means acting on behalf of the company’s stockholders in good faith and with the amount of care that similarly situated reasonable directors would exercise. In practice, this means, in conjunction with the business judgment rule, making informed decisions after obtaining all reasonably available information required to make an intelligent decision and after evaluating all relevant circumstances. Under this standard, the director’s duty is not merely to make the best possible decision, in the director’s judgment, for the corporation, but to make that decision only after careful, informed deliberation. It is the process of decision making that the courts take into consideration in evaluating whether a director acted with due care. If such a process is not shown, then the results of that decision may be reviewed by the court. As mentioned in Chapter 4, a famous example of alleged lack of due care—and, more specifically, lack of seller due diligence—is Smith v. Van Gorkom (1985). Since Van Gorkom, the application of the business judgment rule has been discussed in a series of landmark cases— notably Hanson Trust (1986), Time Inc. (1990), and Paramount (1994). (See the “Landmark and Recent Due Diligence Cases” in the back of the book.) There are literally dozens of landmark cases in this area, which is extremely complex.30 What is a director’s duty of loyalty?

A director of a corporation owes a duty of loyalty to the corporation and its shareholders. As such, the director is prohibited from acting with fraud, bad

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faith, or in the director’s self-interest, to the detriment of the corporation and its shareholders. Normally plaintiffs alleging a violation of the duty of loyalty have the burden of proof, but if it can be shown that a director has a personal interest in a transaction, then a court will shift the burden of proof to the director to show that the transaction is fair and that it serves the best interests of the corporation and its shareholders. Why are the board’s duties of loyalty and due care so important?

First, these rules affect timing—the need for the board to act with due care will restrict its ability to act quickly on a friendly offer. At the very least, a fairness opinion must be obtained, and the investment banker will need several days, at a minimum, to complete the task. The loyalty rules are particularly important in the case of a management buyout. The rules also restrict the board’s ability to take action that eliminates the possibility of a competing bid—so-called lockups or other arrangements (bust-up and topping fees31 and “no shop” clauses32) that are designed (in part) to frustrate the efforts of other bidders. These arrangements are among the most negotiated provisions of the public deal. For the reasons outlined earlier, the buyer will seek to minimize the risk of a successful competing bid and will seek to ensure that it is compensated if it loses to another bidder. The next several questions deal with these issues in the context of the board’s fiduciary responsibilities to the shareholders. USE OF A SPECIAL COMMITTEE When is it appropriate for a selling company to appoint a special committee of its board of directors to review a proposed transaction?

When a majority of board members have a personal interest in the proposed merger (i.e., when management directors predominate and will obtain benefits from the merger), an independent special committee of the board should be appointed to handle the negotiation and recommendation of any proposed transaction. A special committee is also appropriate when a pro-


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posed transaction is complex enough to require careful study if the board is to act responsibly. Having a special committee with adequate authority over the transaction may shift to a plaintiff the burden of showing that the transaction is unfair. This could make it more difficult for a shareholder to obtain an injunction against a proposed merger. What steps should a special committee take to ensure that it is acting responsibly?

The special committee should examine all information about the proposed transaction. This examination must be thorough, and members of the special committee should question the persons supplying such information carefully to be sure that the information is complete and accurate. The committee should also take care not to act hastily and should make sure that it documents its deliberations. Recent judicial decisions have indicated that directors who make decisions without adequate deliberation may have difficulty establishing that they acted with the care necessary to engage the protection of the business judgment rule. In the context of mergers and acquisitions, the special committee of a board of directors should retain independent legal counsel and financial advisors. Should a special committee obtain a fairness opinion?

Yes, but the opinion must be from a qualified, independent source, such as an investment banking firm, a commercial bank, or a professional services firm. In rendering such an opinion, the advisor limits its evaluation to the adequacy of the consideration or the fairness of the exchange, not the strategic merits of the transaction. However, an opinion regarding financial fairness can be developed only after considering the entire context of the transaction. What purpose does a fairness opinion serve?

A fairness opinion can be a useful tool in determining whether to complete a transaction and in obtaining the protection of the business judgment rule.

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However, it is not an assurance that the best possible price was achieved. In addition, a fairness opinion alone does not suffice as proof of the exercise of due care. Instead, a fairness opinion is one component (albeit a very important component) of the fiduciary’s decision-making process and must be supplemented by management presentations, advice of legal counsel, and the deliberations of a board of directors or an independent special committee appointed by the board. When are fairness opinions necessary?

Fairness opinions are necessary when there is a clear conflict of interest, when minority shareholders are being bought out, when a transaction will result in a significant structural change, or for any material transaction in which the fiduciary wants an independent advisor to support its actions. What criteria should be employed to assess the providers of fairness opinions?

In considering potential advisors, a fiduciary should consider the following factors: ■

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Can the advisor be perceived as having a conflict of interest? For example, does the advisor have significant transaction fees that are contingent on the closing of the transaction in question? Can the advisor be regarded as having the best interests of the client in mind? Does the advisor demonstrate the requisite technical, industry, and transaction experience? Does the advisor have the appropriate policies and procedures in place to ensure a thorough review of the transaction and a completely impartial conclusion?

What should the fairness opinions say?

The fairness opinion should first clearly define the terms of the transaction on which it is opining. It should also describe the process that the advisor used in making its determination that a proposed transaction is fair and


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should indicate what matters have been investigated and independently verified, and what matters the advisor has not verified. Finally, the opinion should also describe the fees being paid and all possible conflicts of interest. To ensure impartiality, compensation for a fairness opinion should not be contingent upon the closing of a transaction. Does the fairness opinion ensure the fairness of the transaction?

No. Because the opinion is an expert judgment and not a statement of fact, the opinion letter does not guarantee the fairness of the transaction. In addition to providing the opinion, the advisor should make a presentation to the fiduciary giving detailed information regarding the procedures performed during the engagement, data considered, judgments made, analytical methodologies employed, and all other relevant considerations connected to its conclusion that the transaction is fair. The fiduciary has a duty to question the advisor to determine that it has a reasonable basis for its opinion and is free from conflicts of interest. Ultimately, the burden is on the fiduciary, not the advisor, to accept or reject a transaction.

SELLER DUE DILIGENCE IN THE SALE OF A CONTROL BLOCK What concerns will a seller have in the sale of a control block?

State corporation laws would suggest an expanded duty for the seller of a controlling block of stock. When a controlling block of stock is sold but other shareholders remain, the selling stockholder has a duty to conduct a reasonable investigation of the potential purchaser. The courts have imposed liability on a controlling stockholder in circumstances in which such stockholder could reasonably foresee that the person acquiring the shares would engage in activities that were clearly damaging to the corporation, such as looting, fraud, or gross mismanagement of the corporation. In planning a sale, a potential seller should fully investigate the potential purchaser’s motive, resources, reputation, track record, conflicts of interest, and any other material items relevant to the transaction and

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the corporation. Note also that in certain circumstances, selling shareholders may be deemed underwriters for the purpose of Rule 145 of the Securities Act.33 A second consideration is the duty of loyalty that a controlling stockholder owes to the minority stockholders. This duty generally arises when a controlling stockholder is selling shares at a premium. For example, if a corporation owns a large quantity of a product that is in short supply and could be sold at above-market rates, a controlling stockholder may have a fiduciary obligation to refrain from selling shares at a premium, on the theory that the shareholder’s receipt of the premium would constitute a misappropriation of a corporate opportunity (i.e., the stockholder would be appropriating a certain amount of the corporate goodwill). In addition, some have suggested the imposition of a requirement of “equal opportunity” on a controlling stockholder. Under this requirement, a controlling stockholder must offer all the other stockholders an opportunity to sell the same proportion of their shares as the controlling stockholder. Generally, the courts have refused to apply this unwieldy principle. Accordingly, if a block purchase is challenged, the courts will review the particular facts surrounding the purchase to determine its fairness. In addition to all the areas already covered, are there any other aspects of federal and state securities laws that may be relevant to mergers?

Insider trading laws are a source of potential liability for insiders of buying and selling companies alike. Since many individuals obtain knowledge of a target company during the time it is being considered for purchase— for example, during the due diligence phase—it is important to ensure that all parties involved have a good sense of insider trading law.

INSIDER TRADING What exactly is insider trading?

Traditionally, insider trading was trading in a company’s securities by an insider of the company on the basis of undisclosed material information. Such trading today is prohibited and illegal.


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An insider has been defined as an officer, a director, or a principal shareholder (generally, any beneficial owner of more than 10 percent of the company’s equity securities). Also subject to the prohibition on insider trading is any employee who, in the course of his or her employment, acquires material nonpublic information about a publicly traded corporation. Such an individual owes a fiduciary duty to the employer not to appropriate this information for his or her own use and then trade on this information prior to its release and absorption by the market. In addition, certain “outsiders” may become “temporary insiders” if they are given information by the subject corporation in confidence solely for a corporate purpose. Attorneys, accountants, consultants, and investment bankers are examples of “temporary insiders” who are involved in a merger or acquisition. Trading on inside information concerning mergers and acquisitions may be closely scrutinized by the SEC and may result in criminal prosecutions and very substantial civil penalties. What laws prohibit insider trading?

Most insider trading cases are covered by three well-known rules promulgated by the SEC under the authority of the Exchange Act: ■

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Rule 10b-5 prohibits fraudulent or manipulative conduct in connection with the purchase or sale of securities. (For the full text of Rule 10b-5, see Chapter 1.) Rule 14e-3 prohibits trading on the basis of inside information in the context of a tender offer, whether as an insider, as the “tippee” of an insider, or as anyone who is merely in possession of the inside information. Section 16(b) of the Exchange Act prohibits any officer or director, or any shareholder owning more than 10 percent of the issuer’s stock, from profiting from a purchase and sale or a sale and purchase (a short sale) of securities of the issuer within a six-month period. This is known as the short-swing profit rule. Any profits from such a purchase-sale or sale-purchase must be paid to the issuer. The short-swing profit rule

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applies whether or not that person was in possession of material inside information. Various laws have set penalties for different types of insider trading.34 The U.S. Congress is continually proposing bills that outlaw some aspect of insider trading.35 Suppose an insider does have material nonpublic information about a security, and wants to buy or sell the security. What can he or she do? First, the insider must consider whether the trade would violate any regulation (such as the rule against short-swing trading) or duty (such as the duty of loyalty). If there is no problem there, then the individual must “disclose or abstain.” That is, the individual must, as the U.S. Court of Appeals for the Second Circuit in New York ruled in the famous 1968 Texas Gulf Sulfur case, the first federal insider trading prosecution, either disclose that information to the market (and trade if desired) or keep the information confidential and refrain from trading. In practical terms, the “disclose or abstain” rule means abstain. To be effective, disclosure of a material development affecting a security must result in broad enough dissemination to inform the entire public trading in that security. Most individuals cannot adequately disseminate such information themselves, and disclosure itself may constitute a breach of fiduciary duty. If the inside information is incomplete or inaccurate, disclosure could be misleading to other investors and result in separate liability under other SEC disclosure rules. Is it ever acceptable to use nonpublic material information to benefit from a stock trade?

No. In general, that is called misappropriation, and it is illegal. The misappropriation theory of liability holds that an individual violates the securities laws when he or she secretly converts information received for legitimate business or commercial purposes by trading on the information for personal benefit. The U.S. Supreme Court upheld the misappropriation theory in United States v. O’Hagan (1997), when it found an attorney guilty for buying call options in a company (Pillsbury Co.) when he knew that another firm (Grand Metropolitan PLC) was planning to make a hostile bid for it. The court said:


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Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law. An investor’s informational disadvantage vis à vis a misappropriator with material, nonpublic information stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill.36

What if the recipient of a tip has no fiduciary relationship to the source of confidential information? Can this individual still be charged with insider trading?

First, let us define some basic terms. ■

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Tipping is the selective disclosure of material nonpublic information for trading or other personal purposes. A tipper is a person who, in return for some direct or indirect benefit, provides material nonpublic information about a security to another person, who then trades in that security. A tippee is a person who receives material nonpublic information about a security and then trades in that security. Note that a tippee may also become a tipper if he or she divulges the information to another person (who becomes a second- or third-level tippee).

If the tippee knows or should have known of the tipper’s breach of duty and participates in the violation through silence or inaction, the tippee becomes liable as an aider and abettor if he or she then trades or divulges the information to one who trades. Under Rule 10b-5, a tippee is liable for fraud only if he or she knew that the information received was material nonpublic information. That is, Section 10(b) has a scienter requirement. This means that to be found liable for violating Rule 10b-5, an insider must either have “actual knowledge” of the fraud or omission or have acted with “recklessness and disregard of the truth.” Furthermore, judicial interpretation of Rule 10b-5 has often centered on the issue of the fiduciary duty of the tipper to the issuer of the securities or some other party. Courts have interpreted Rule 10b-5 to prohibit tipping

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if the tipper has made a disclosure that breached a fiduciary or fiduciary-like duty that he or she owed to another, including the issuer or some other party. That duty is breached when the tipper, traditionally an insider, but also potentially a misappropriator, receives a personal benefit, directly or indirectly, from the disclosure. But another key insider trading rule, Rule 14e-3, does not contain such a requirement. Rule 14e-3(a) simply prohibits an individual from trading while he or she possesses material nonpublic information concerning a tender offer if the individual knows or has reason to know that such information is nonpublic and has been obtained, directly or indirectly, from any of the following: the entity making the tender offer, the corporation that is the subject of the tender offer, any persons affiliated with these entities, or any person acting on behalf of either entity. The transfer of such information from a tipper to a tippee violates this rule. Rule 14e-3 makes it unlawful for certain persons to “communicate material, non-public information relating to a tender offer . . . under circumstances in which it is reasonably foreseeable that such communication is likely to result in [improper trading or tipping].” This portion of the rule expressly excludes communications “made in good faith to certain individuals.” Rule 14e-3 is triggered when any person has taken a “substantial step” to commence a tender offer, even if the offer never actually begins. A “substantial step” includes the offeror’s formulating a plan to make an offer, having its directors vote on a resolution with respect to the tender offer, arranging financing for a tender offer, authorizing negotiations for a tender offer, and directing that tender offer materials be prepared. CONCLUDING COMMENTS

As acquirers study the financial, operational, legal, and transactional aspects of a candidate company, they must be mindful of securities law— particularly federal securities laws pertaining to mergers, acquisitions, and tender offers. In this chapter, we have attempted to provide an overview of such laws. Having mastered these, an acquirer will be in a stronger position to continue checking for legal compliance in a full range of other areas—as explained in the next six chapters.

CHAPTER

7

Detecting Exposure under Tax Law and Accounting Regulations Render therefore unto Caesar the things which are Caesar’s . . . —Matthew 22:21

INTRODUCTION

A century after it gained its power to tax corporate income,1 Congress is still finding new ways to do it—and affecting M&A due diligence in the process. Buyers, sellers, and their advisors invariably consult the Internal Revenue Code (Title 26 of the U.S. Code)2 when structuring their transactions. They know that it is important to ensure compliance with the tax code sooner rather than later. During the due diligence stage, buyers and sellers can benefit from understanding the tax and accounting aspects of transaction structure.3 The previous chapter (Chapter 6) offered guidance on securities laws pertaining to mergers in order to minimize the chances of postmerger litigation from shareholders. In this chapter, we will continue the transactionoriented discussion by advising readers of major tax law and accounting regulations that are relevant to M&A, and therefore to due diligence. After all, the aim of due diligence is to reduce postmerger exposure to insolvency or liability—and knowing tax law and accounting regulations can help in this regard. In this chapter, we define basic tax terms, then go on to explain the tax consequences of transaction structure, choice of entity, and financing.

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In closing, we explain some postmerger tax issues, as well as other issues of general interest. We have intentionally taken a superficial approach here, touching on only the most general tax topics. We have refrained from providing details on particular sections of the tax code or on the many pronouncements of the Financial Accounting Standards Board (FASB). Our aim is to provide a high-level overview. Adding too many details only distracts from that purpose. (We urge readers to consult the Web sites irs.gov for taxes and fasb.org and iasb.org for accounting rules.) Taxes and accounting are both extremely complex areas. ■

Regarding taxes, in the past quarter century alone, there have been more than 8,500 changes to the U.S. tax code—nearly one per day.4

Accounting, too, is an ever-changing arena. ■

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On June 30, 2009, the FASB released Financial Accounting Standards Board (FASB) Statement No. 168, The FASB Accounting Standards Codification, effective September 15, 2009. This superseded all existing accounting standard documents. Any accounting literature that is not included in the codification is nonauthoritative unless it is grandfathered. This chapter cites only authoritative and grandfathered literature, and includes the latest updates. Adding further complexity, many of the newly codified U.S. accounting standards are undergoing further change as they are brought into convergence with international standards, with the FASB working with its global counterpart, the International Accounting Standards Board (IASB), to achieve one global accounting standard by 2014.

Given this high rate of change, even the specialists cannot hope to have complete knowledge in this area. We have made every attempt to be accurate here, but always consult with qualified M&A tax and accounting professionals. If you are dealing with a major accounting firm or law firm, remember that nearly every local office has M&A specialists. Use them! Your due diligence efforts will improve as a result.

CHAPTER 7: Detecting Exposure under Tax Law and Accounting Regulations

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TAX BASICS What is the principal U.S. regulator of the taxation of companies involved in mergers and acquisitions?

The chief regulator here is the Internal Revenue Service (IRS), which is part of the U.S. Treasury Department. The IRS’s mission is to “provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.”5 The IRS does not get involved in transactions. Unlike federal agencies such as the Federal Communications Commission and the Federal Trade Commission, the IRS does not need to give advance approval of a transaction. In fact, the IRS will not ordinarily have occasion to review a transaction unless and until an agent audits the tax return of one of the participants. One exception to this rule is that the parties to a transaction can often obtain a private letter ruling issued by the National Office of the IRS. Such a ruling states the agency’s position with respect to the issues raised and is generally binding upon the IRS. Requesting such a ruling is a serious business and should never be undertaken without expert legal help. What are the principal goals of tax planning for a merger, acquisition, or divestiture?

From the acquirer’s point of view, the principal goal of tax planning is to minimize, in present value terms, the total tax costs of not only acquiring but also operating and even selling another corporation or its assets. In addition, effective tax planning provides various safeguards to protect the parties from the risks of potential changes in circumstances or in the tax laws. Moreover, the acquirer should attempt to minimize the tax costs of the transaction to the seller in order to gain advantage as a bidder. From the seller’s point of view, the principal goal of tax planning is to maximize, in present value terms, the after-tax proceeds from the sale of the corporation or its assets. This tax planning includes, among other things, determining the structure of the transaction and the entities involved in it, developing techniques to provide tax benefits to a potential buyer at little or no tax cost to the seller, and structuring the seller’s receipt of tax-deferred consideration from the buyer.

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More often than not, the tax plan that is the most advantageous for the buyer is the least advantageous for the seller. For example, the tax benefit of a high valuation of the assets of the acquired corporation may be available to the acquirer only at a significant tax cost to the seller. But buyers rarely, if ever, pursue tax benefits at the seller’s expense, because the immediate and prospective tax costs of a transaction are likely to affect the price. Generally, the parties will structure the transaction to minimize the aggregate tax costs of the seller and the buyer, and will allocate the tax burden between them through an adjustment in the price. What tax issues typically arise in an acquisition or divestiture?

There is no definitive checklist of tax issues that may arise in every acquisition or divestiture. The specific tax considerations for a transaction depend upon the facts and circumstances of that particular deal. However, certain tax terms and issues, many of which are interrelated, are far more common than others. To engage in any useful discussion of tax matters, participants in any transaction must grasp the definitions of basic tax terms used in M&A. ■

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A primary issue is the structure of the transaction: whether the transfer is effected through a stock acquisition, an asset acquisition, or a merger. The optimal structure is generally that which maximizes the aggregate tax benefits and minimizes the aggregate tax costs of the transaction to the acquired corporation, the seller, and the buyer. Key issues include net operating loss, credit carrybacks and carryforwards, amortization of goodwill, and the alternative minimum tax. Another initial question to be resolved in many acquisitions is the choice of entity issue: whether the operating entity will be a C corporation, an S corporation, or a general or limited partnership. The tax implications of the financing arrangement must also be analyzed. Two key issues are the distinction between debt and equity and the effect of the original issue discount rules. Managers and advisors should also give attention to other tax matters, including the effects of state tax laws, the tax conse-


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quences of future distributions of the acquired company’s earnings, and the ultimate disposition of the acquired corporation or its assets. Finally, deal makers should be aware of accounting issues related to taxation.

After defining some basic tax terms, this chapter will cover each of these issues in order.

DEFINITIONS OF TAX TERMS What are earnings and profits?

Earnings and profits is a term of art in the Internal Revenue Code. The amount of a corporation’s earnings and profits is roughly equivalent to the corporation’s net income and retained earnings for financial reporting purposes, as distinguished from its current or accumulated taxable income. The primary purpose of the earnings and profits concept is to measure the capacity of a corporation to distribute a taxable dividend. If the IRS believes that a corporation, by virtue of its current and accumulated earnings and profits, can pay a taxable dividend, it may view certain corporate distributions—namely, nonliquidating distributions—as dividends and tax them as such. What is a distribution?

A corporate distribution means an actual or constructive transfer of cash or other property (with certain exceptions) by a corporation to a shareholder acting in the capacity of a shareholder.6 What is a liquidating distribution?

A liquidating distribution is generally a distribution (or one of a series of distributions) made by a liquidating corporation in accordance with a plan of complete liquidation. Corporate liquidation occurs when a corporation ceases to be a going concern. At this point, its actions are limited to winding up its affairs, pay-

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ing its debts, and distributing its remaining assets to its shareholders. A liquidation for tax purposes may be completed prior to the actual dissolution of the corporation under state law. What is a nonliquidating distribution?

A nonliquidating distribution is any corporate distribution to shareholders that is not a liquidating distribution. A nonliquidating distribution is generally either a dividend or a distribution involving the redemption of some (but not all) of the corporation’s outstanding stock. What are the tax consequences to corporations of distributions to their shareholders?

The taxation of corporate distributions involves myriad complex rules, many of which have exceptions and qualifications. In general, however, the tax consequences of corporate distributions depend upon three factors: ■

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Whether the property distributed is cash or property other than cash Whether the recipient shareholder is an affiliated corporation (see the next question) Whether the distribution is a liquidating or a nonliquidating distribution

Distributions of cash, both liquidating and nonliquidating, generally have no tax consequences for the distributing corporation, except that the amount distributed reduces the corporation’s earnings and profits. Distributions of appreciated property, both liquidating and nonliquidating, generally trigger the recognition of gain to the distributing corporation to the extent of the appreciation in the asset. What is an affiliated corporation?

An affiliated corporation is one of a group of corporations consisting of two or more “member” corporations where the “parent” corporation controls, directly or indirectly, the stock of each of the “subsidiary” corpora-


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tions. More precisely, the parent corporation must generally own a certain percentage (usually 80 percent) of the voting power and equity value of at least one of the subsidiary corporations. (Tax law may provide that an entity may elect to determine taxable gain or loss on the liquidation of an 80-percent-or-more-owned subsidiary by reference to the tax basis of the subsidiary’s net assets rather than by reference to the parent entity’s tax basis in the stock of that subsidiary.7 Note also that certain corporations, such as foreign corporations, are not permitted to be members of an affiliated group.8 What is a consolidated federal income tax return?

A consolidated return is a single federal income tax return filed by an affiliated group of corporations in lieu of a separate return for each member of the group.9 Not every multiparty entity qualifies for a consolidated return, so acquirers must consult with a tax professional.10 What are the advantages of filing a consolidated federal income tax return?

The principal advantages of a consolidated return are as follows: ■

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Losses incurred by one member of the group may be used to offset the taxable income of another member. The tax consequences of many intragroup transactions are either deferred or wholly eliminated. Earnings of a subsidiary corporation are reflected in the parent’s financial reports, so that such earnings are not taxed again on the sale of such stock by the parent.

Is there such a thing as a consolidated state income tax return?

Yes, but not all states allow an affiliated group of corporations to file a combined (consolidated) tax return. Some states do not allow combined returns at all; others allow them only in limited circumstances.

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What is a tax year?

Every individual and entity that is required to file a tax return must report the results for an annual accounting period. For individuals, the annual accounting period is almost always the calendar year. For other entities, however, the tax accounting period may be either a calendar year or a fiscal year ending on the last day of a month other than December. An entity’s tax year need not coincide with its fiscal year for purposes of financial accounting. Extensive rules govern the selection of tax years other than calendar years by C corporations, S corporations, partnerships, and trusts. (These entities are discussed later in the chapter in the section on choice of entity.) What is the current U.S. federal income tax rate structure?

As we go to press in 2010: ■ ■

Marginal income tax rates range from 10 percent to 35 percent. Capital gains tax differs according to how long one has held an asset. As of 2010, if one has held an asset for less than one year before selling it, the tax rate is the same as the regular marginal income tax rate. If one has held an asset for more than one year, the rate is from 0 percent to 15 percent.

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Marginal income tax rates will rise, and will range from 15 percent to 39.6 percent. Capital gains tax will also rise, with three categories: ■ Held less than one year: same as marginal income tax rate. ■ Held one to five years: will range from 10 percent to 20 percent. ■ Held more than five years: will range from 10 percent to 20 percent, but with some exceptions.11

Is the distinction between capital gains and ordinary income still relevant in tax planning?

Yes. In its most recent tax bills, Congress retained the myriad rules and complexities in the Internal Revenue Code that pertain to capital gains and losses.


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More important for tax planning is that the tax code retains various limitations on the use of capital losses to offset ordinary income. Thus, M&A planners must still pay attention to the characterization of income or loss as capital or ordinary. What is the significance of the relationship between the corporate and individual tax rates?

Corporations can be used to accumulate profits when the tax rate on the income of corporations is less than the tax rate on the income of individuals. (Offsetting this benefit is the “double tax” on corporate earnings—tax is paid once by the company and then by the stockholders when they receive the company’s dividends.) Conversely, noncorporate “pass-through” entities can be used to store profits when the tax rate on the income of corporations is greater than the tax rate on the income of individuals. How does the capital gains tax fit in?

A shareholder’s tax on the sale or liquidation of his or her interest in the corporation is determined at preferential capital gains rates. How does the double tax on corporate earnings work?

The Internal Revenue Code sets forth a dual system of taxation with respect to the earnings of corporations. Under this system, a corporation is taxed as a separate entity, unaffected by the tax characteristics of its shareholders. The corporation’s shareholders are then subject to tax on their income from the corporation if and when corporate earnings are distributed to them in any form. What are the practical consequences of the dual system of corporate taxation?

The primary consequence of the dual system of taxation is that corporate earnings are generally taxed twice—first at the corporate level and then again at the shareholder level. The shareholder-level tax may be deferred but not eliminated when the corporation retains its earnings rather than pay-

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ing them out in dividends. The shareholders will pay a tax a second time when they sell their interests in the corporation. How can leverage reduce the effects of double taxation?

A leveraged company’s capital structure is tilted toward debt instead of equity. Leverage reduces or eliminates the negative effect of double taxation of corporations in two ways. First, unlike dividend payments to shareholders, which are generally taxable,12 debt repayments to lenders generally are not taxable to the recipient. Second, in most cases, interest payments are tax-deductible to the corporation making them. (An issuer of debt can deduct the interest that it pays, but an issuer of equity may not deduct dividend payments that it makes.) It is very important to remember, however, that the Internal Revenue Service may take the position that a purported debt is actually equity, thus eliminating the benefit of leverage. What is the alternative minimum tax, or AMT?

Congress enacted the alternative minimum tax in 1969 to curb the exploitation of deductions and preferences by certain high-income individuals and corporations. In later tax legislation, Congress amended the minimum tax provisions and created a rather severe regime of alternative minimum tax, particularly for corporations. The alternative minimum tax for both individuals and corporations is determined by computing taxable income under the regular method (with certain adjustments), then adding back certain deductions or “preferences” to obtain the alternative minimum taxable income. The alternative minimum tax rate for individuals or for corporations is applied to this amount. The taxpayer is required to pay the greater of the regular tax or the alternative minimum tax.13

BASIC STRUCTURE OF THE TRANSACTION What are the various forms that a transaction can take?

There are three general forms used for the acquisition of a business: (1) a purchase of the assets of the business, (2) a purchase of the stock of the


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company owning the assets, and (3) a statutory merger of the buyer (or an affiliate) with the asset-owning company. It is possible to combine several forms so that, for example, some assets of the business are purchased separately from the stock of the company that owns the rest of the assets, and a merger between the buyer and the acquired company occurs immediately thereafter. Or a transaction may involve the purchase of the assets of one corporation and the stock of another, where both corporations are owned by the same seller. What happens in an asset transaction, and what are the reasons for this type of deal?

In an asset transaction, the seller transfers all the assets used in the business that is the subject of the sale. These include real estate, equipment, and inventory, and also “intangible” assets such as contract rights, leases, patents, and trademarks. These may be all or only part of the assets owned by the selling company. The seller executes the specific kinds of documents (e.g., deeds, bills of sale, and assignment) needed to transfer the assets in question. Many times, the choice of an asset transaction is dictated by the fact that the sale involves only part of the business owned by the selling corporation. Asset sales are the only way to go in the sale of a product line that has not been run as a subsidiary corporation with its own set of books and records. In other cases, an asset deal is not necessary, but is chosen because of its special advantages. ■

An asset sale is preferable when the seller will realize a taxable gain from the sale—that is, when the tax basis of the assets of the acquired company is lower than the selling price. A taxpayer’s basis in an asset is the value at which the taxpayer carries that asset on its tax balance sheet. When this value is lower than the selling price, the buyer generally will obtain significant tax savings from structuring the transaction as an asset deal, thus “stepping up” the asset basis to the purchase price. Conversely, if the seller will realize a tax loss, the buyer is generally better off inheriting the tax history of the business by doing a stock transaction, and thus keeping the old high basis.

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In an asset sale, with some exceptions (explained in Chapter 5), the buyer generally assumes only the financial liabilities that it specifically agrees to assume.

What happens in a stock transaction, and what are the reasons for this type of arrangement?

In a stock transaction, the seller transfers its shares in a corporation to the buyer in exchange for an agreed-upon payment. Usually all shares are transferred, although there are some exceptions to this. (Exceptions include a tender offer for a public company, since not all shareholders will necessarily tender, and a management buyout type of deal, in which managers will retain some stock.) A stock transaction is appropriate whenever the tax costs or other problems in an asset transaction make the transaction undesirable. As mentioned in Chapter 5, asset transfers may have a high tax cost and can impose the administrative hassle of obtaining third-party consents for the asset transfer (which are often unnecessary in a stock deal). Do review third-party documents for “change of control” provisions. Contracts, leases, or permits involving real estate, for example, may require consent if there is a change in the control of the tenant. There are two major disadvantages to a simple stock deal, however. First, if there are a number of stockholders, it may be more difficult to consummate the transaction. Assuming that the buyer wants to acquire 100 percent of the company, it must enter into a contract with each of the selling stockholders, and any one of them might refuse to enter into the transaction or might refuse to close. The entire deal may hinge on one stockholder. As will be shown later in this chapter, the parties can achieve the same result as a stock transfer through a merger transaction and avoid the need for 100 percent agreement among the stockholders. Second, the stock transaction may result in tax disadvantages after the acquisition—disadvantages that can be avoided by choosing an asset transaction. Under Section 338 of the Internal Revenue Code, however, it is possible to have most stock transactions treated as asset acquisitions for federal income tax purposes. Under a so-called Section 338 election, the tax benefits can be achieved while avoiding the nontax pitfalls of an asset transaction.14


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What happens in a merger transaction, and what are the reasons for this kind of deal?

A merger is a transaction in which one corporation is legally absorbed into another, and the surviving corporation succeeds to all the assets and liabilities of the absorbed corporation. There are no separate transfers of the assets or liabilities; the entire transfer occurs by operation of law when the certificate of merger is filed with the appropriate authorities of the state. In a reverse merger, the buyer is absorbed by the company that it is buying. The shareholders of the buyer get stock in the company, and the shareholders of the acquired company receive the consideration agreed to. For example, in an all-cash deal, the shareholders of the acquired company will exchange their shares in the company for cash. At the end of the day, the old shareholders of the acquired company are no longer shareholders, and the shareholders of the buyer own the company. For federal tax purposes, a reverse merger is often treated essentially like a stock deal. In a forward merger, the acquired firm is merged into the acquirer’s company, and the acquired company’s shareholders exchange their stock for the agreed-upon purchase price. When the dust settles, the buyer has succeeded to all the assets and liabilities of the acquired firm. For federal income tax purposes, such a transaction is treated as if the acquired firm had sold its assets for the purchase price, then liquidated and distributed the sales proceeds to its shareholders as a liquidation distribution.15 In a subsidiary merger, the buyer corporation simply incorporates an acquisition subsidiary that merges with the acquired company. Such a transaction must be approved by a majority of shareholders of the firm owning the subsidiary, and by the board of directors (not the shareholders) of the successor firm. In a forward subsidiary merger, the acquired company is merged into the acquisition subsidiary, which may function as a holding company.16 In a reverse subsidiary merger, the acquisition subsidiary merges into the acquired company. This allows the owner of the successor firm to avoid asset transfer problems, while still treating the transaction as an asset deal for taxation purposes, thanks to Section 338. The agreement between buyer and seller in the case of any merger is essentially the same as in a stock or asset deal, except that the means of transferring the business will be a statutory merger as opposed to an asset

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or stock transfer. Thus, a merger helps buyers avoid the inconveniences of asset or stock transfers—and the permissions that each entails. To effect a statutory merger, the board of directors of each corporation that is a party to the merger must adopt a resolution approving an agreement of merger. Shareholders owning a majority of the stock must also approve the transaction.17 In some cases, the corporate charter may require a higher percentage of shareholders to approve (a “supermajority,” such as 75 percent of the shares). The merger becomes effective upon the filing of a certificate of merger. How can a stock acquisition be combined with a merger?

This is the two-step transaction described in Chapter 6. To recap, the first step is an acquisition of part of the stock (usually at least a statutorily sufficient majority) of the acquired company; the second step is a merger. As explained in Chapter 6, two-step transactions are very common in acquisitions of public companies, where the first step is the acquisition of a control block through a tender offer and the second step is a merger in which the minority is bought out. How does an asset acquisition differ from a stock acquisition with respect to taxes?

The primary tax distinction between an asset acquisition and a stock acquisition concerns the acquirer’s basis in the assets acquired. As mentioned, an asset’s basis is initially its historical cost to the taxpayer. This initial basis is subsequently increased by capital expenditures and decreased by depreciation, amortization, and other charges, becoming the taxpayer’s adjusted basis in the asset. Upon the sale or exchange of the asset, gain or loss for tax purposes is measured by the difference between the amount realized for the asset and its adjusted basis. The basis of the asset represents, in effect, the amount at which the cost of the asset may be recovered free of tax through depreciation, deductions, and adjustments to gain or loss upon disposition. When an acquirer acquires the assets of a corporation directly, and the corporation is subject to tax on the sale or exchange of the assets, the


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basis of the assets for the acquirer is their cost. This is called cost basis. When an acquirer acquires a corporation’s assets indirectly through the acquisition of stock, the basis of the assets in the possession of the acquired corporation is generally not affected. This is called carryover basis because the basis of an asset in the acquired corporation “carries over” upon the change of stock ownership. A cost-basis transaction is often referred to as an “asset acquisition,” and a carryover-basis transaction is often referred to as a “stock acquisition.” Neither of these terms necessarily reflects the actual structure of the transaction. Are there any other significant tax differences between a cost-basis, or “asset,” transaction and a carryover-basis, or “stock,” transaction?

Yes. In a carryover-basis transaction, the acquirer acquires, by operation of law, the corporation’s tax attributes (net operating loss carryovers, business credit carryovers, earnings and profits, accounting methods, and others), each of which may be either beneficial or detrimental to the acquirer. The most beneficial tax attributes, however, are generally subject to various limitations that are triggered upon a significant change of stock ownership of the acquired corporation. In all cost-basis transactions, the acquirer acquires the assets of a corporation without the corporation’s tax attributes. What types of transactions are carryover-basis, or “stock,” transactions?

As a rule, a carryover-basis, or stock, acquisition includes any transaction in which the stock or assets of a corporation are acquired by the acquirer and the bases of the assets of the corporation are not increased or decreased as a result of the change of ownership. There are several types of carryoverbasis transactions. The direct purchase of the corporation’s stock in exchange for cash and debt is the most straightforward stock acquisition. Another transaction that is treated as a sale of stock for tax purposes is the merger of the acquiring corporation into the acquired corporation (a reverse merger), in which the shareholders of the corporation relinquish their shares in exchange for cash or debt in a fully taxable transaction. Another com-

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mon stock transaction is the acquisition of the stock or assets of a corporation in a transaction that is free of tax to its exchanging shareholders.

What types of transactions are cost-basis, or “asset,” transactions?

As a rule, a cost-basis, or asset, acquisition includes any transaction in which the preacquisition gains and losses inherent in the assets acquired are triggered and recognized by the acquired corporation. There are several types of cost-basis transactions. The direct purchase of the assets from the acquired corporation in exchange for cash or indebtedness is the quintessential asset acquisition. Another common type of asset transaction is the statutory merger of the acquired corporation into an acquiring corporation (a forward cash merger), in which the shareholders of the acquired corporation exchange their shares for cash or other property in a fully taxable transaction. In certain circumstances, a corporation may acquire the stock of another corporation and elect under Section 338 of the tax code to treat the stock acquisition, for tax purposes, as an asset acquisition.

What is the significance to the acquirer of the basis of the assets in an acquired corporation?

The basis of the assets in an acquired corporation may have a significant and continuing effect on the tax liabilities, and therefore the cash flow, of either the acquirer or the acquired corporation. The basis of an asset represents the extent to which the asset may be depreciated or amortized (if at all), thereby generating noncash reductions of taxable income. Basis also represents the extent to which the consideration received in a taxable sale or exchange of an asset may be received by the seller free of tax.

What is the prospective cost basis of an asset to the acquirer?

The prospective cost basis of an asset to the acquirer is the price that it will pay for the asset, directly or indirectly, which is presumed to be its fair market value.


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What is the prospective carryover basis of an asset to the acquirer?

The prospective carryover basis of an asset to the acquirer is simply the “adjusted basis” of the asset in the possession of the acquired corporation prior to its acquisition. As explained earlier, the adjusted basis of an asset is generally its historical or initial cost, reduced or “adjusted” by subsequent depreciation or amortization deductions. You mentioned earlier that a “step-up” might be necessary in an asset purchase. What is this about?

When the basis of an asset is increased from the acquired corporation’s lower initial basis (or adjusted basis, if different) to a basis determined by an acquirer’s cost or fair market value, the basis of the asset is said to have been “stepped up.” The term may refer, however, to any transaction in which the basis of an asset is increased. In most asset, or cost-basis, transactions, the basis of the assets of the acquired corporation is stepped up to the acquirer’s cost. An acquisition in which the basis of the assets of the acquired corporation is increased is referred to as a step-up transaction. Who benefits from a step-up?

Generally, the buyer. A high tax basis in an asset is always more beneficial to its owner than a low basis. The higher the basis, the greater the depreciation or amortization deductions (if allowable), and the less the gain (or the greater the loss) on the subsequent disposition of the asset. An increase in these deductions and losses will reduce the tax liabilities of the acquirer or the acquired corporation during the holding period of the assets, thereby increasing after-tax cash flow. Will an acquirer’s cost basis in an asset generally be greater than its carryover basis?

Yes. When an asset has appreciated in value, or when the economic depreciation of an asset is less than the depreciation or amortization deductions allowed for tax purposes, an acquirer’s prospective cost basis in the asset

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will exceed its prospective carryover basis. The depreciation and amortization deductions allowed for tax purposes for most types of property are designed to exceed the actual economic depreciation of the property. As a result, the fair market value of most assets, which represents the prospective cost basis of the asset to an acquirer, generally exceeds the adjusted tax basis. The aggregate difference between the acquirer’s prospective cost and the carryover basis of the acquired corporation’s assets is often substantial.

Will an acquirer generally receive greater tax benefits by acquiring a corporation through a cost-basis transaction than by acquiring it through a carryoverbasis transaction?

Yes. An acquirer in a cost-basis acquisition of a corporation will generally acquire a basis in the corporation’s assets that is higher than the basis in a carryover-basis transaction. This is because the cost or fair market value of the corporation’s assets is generally greater than the adjusted basis of the assets prior to the acquisition. In that circumstance, a cost-basis transaction will “step up” the basis of the assets of the acquired corporation. The amount of the increase in basis—the excess of cost basis over carryover basis—is referred to as the step-up amount.

What are loss carryovers and carrybacks?

If a taxpayer has an excess of tax deductions over its taxable income in a given year, this excess becomes a net operating loss (NOL) for the taxpayer. Section 172 of the tax code allows that taxpayer to use its NOL to offset taxable income in subsequent years (a carryover or carryforward) or to offset taxable income in previous years (a carryback). For most taxpayers, an NOL may be carried back for up to two tax years and may be carried forward for up to twenty tax years.18 A new tax code provision, enacted as part of the American Recovery and Reinvestment Act of 2009, enables small businesses with an NOL in 2008 to elect to offset the loss against income earned in up to five prior years.19 Generally speaking, each state has its own NOL carryback and carryforward rules, which may not necessarily match the federal rules.


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What role do loss carryovers play in mergers and acquisitions?

As stated earlier, a potential advantage of carryover-basis acquisitions— both taxable stock purchases and tax-free reorganizations—is the carryover to the buyer of basis and of favorable tax attributes. To the extent that a buyer can purchase an acquired corporation and retain favorable NOL carryovers, it can increase the after-tax cash flow generated by the activities of the acquired corporation and, to some extent, use those losses to offset the tax liability generated by the buyer’s own operations. What is the accounting treatment of net operating losses?

ASC 740, incorporating SFAS 109, issued by the Financial Accounting Standards Board (FASB), mandates recognition of the tax consequences of a transaction or an event in the same period in which the transaction or event is recognized in the enterprise’s financial statements. Under ASC 740, “Accounting for Income Taxes,” an enterprise may execute a statutory merger whereby a subsidiary is merged into the parent company, the noncontrolling shareholders receive stock in the parent, the subsidiary’s stock is cancelled, and no taxable gain or loss results if the continuity of ownership, continuity of business, and certain other tax requirements are met.20 Also under ASC 740, for example, deferred tax liabilities for future taxable amounts are recognized, deferred tax assets for future deductions and operating loss and tax credit carryforwards are recognized, and the liabilities and assets are then measured using the applicable tax rate. The parallel standard under the International Accounting Standards Board (IASB) is IAS 12.21 Do all asset, or cost-basis, transactions step up the basis of the acquired firm’s assets?

No. When the purchase price of the assets of the acquired corporation, which is presumed to equal their fair market value, is less than the carryover basis of the assets, a cost-basis, or asset, transaction will result in a net

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reduction of basis. In such cases, the transaction should generally be structured as a carryover-basis, or stock, acquisition. In what circumstances are carryover-basis transactions more beneficial to an acquirer, from a tax standpoint, than cost-basis transactions?

There are two situations in which a carryover-basis, or stock, transaction may be more beneficial to the acquirer than a cost-basis, or asset, acquisition. In the first situation, the carryover basis of the acquired corporation’s assets to the acquirer exceeds their cost basis. This excess represents potential tax benefits to the acquirer—noncash depreciation deductions or taxable losses— without a corresponding economic loss. That is, the tax deductions or losses from owning the assets may exceed the price paid for those assets. In the second situation, the acquired corporation possesses valuable tax attributes—net operating loss carryovers, business tax credit carryovers, or accounting methods, for example—that would inure to the benefit of the acquirer. Situations in which carryover-basis transactions are more favorable to the acquirer than cost-basis transactions, however, are more the exception than the rule. What are the tax consequences of a cost-basis, or asset, acquisition for the acquired corporation?

The general rule is that the basis of an asset in the possession of an acquired corporation may not be stepped up to cost or fair market value without the recognition of a taxable gain to the corporation. In a cost-basis transaction, the acquired company will generally be subject to an immediate tax on an amount equal to the aggregate step-up in the bases of the assets. In addition, the sale or exchange of an asset may trigger the recapture of investment or business tax credits that were previously taken by the acquired corporation when it acquired the asset. What are the tax consequences of a cost-basis, or asset, acquisition to the shareholders of the acquired corporation?

The shareholders of the acquired corporation will be subject to tax upon the receipt of the asset sales proceeds (net of the corporate-level tax) from


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the acquired corporation. This is so whether the proceeds are distributed in the form of a dividend, through redemption of the shareholders’ stock in the acquired company, or through complete liquidation of the acquired corporation. If the asset sales proceeds are retained by the acquired corporation, then the value of those proceeds is indirectly taxed to the shareholders upon the sale or exchange of the stock of the acquired corporation. In what circumstances will an acquired corporation and its shareholders be subject to double taxation on a cost-basis, or asset, acquisition?

The corporation and its shareholders will typically be subject to double taxation when (1) the acquired corporation sells its assets to the acquirer in a taxable transaction, (2) the shareholders of the acquired corporation will ultimately receive the proceeds of the sale, and (3) the receipt of the proceeds by the shareholders of the acquired corporation will be taxable to them. In these circumstances, the cost-basis transaction generally causes the proceeds of the sale to be taxed twice, first to the corporation and then again to its shareholders.22 On balance, which type of structure is preferable: a stock acquisition or an asset acquisition?

Generally, a stock, or carryover-basis, acquisition is preferable to an asset, or cost-basis, acquisition. The immediate tax cost to the acquired corporation and its shareholders on the basis step-up amount in an asset acquisition is generally greater than the present value of the tax benefits to the acquirer. In what circumstances does a cost-basis, or asset, acquisition transaction make better sense for tax purposes?

A cost-basis, or asset, transaction is generally advisable for tax purposes in situations where the double tax burden to the seller can be partially or wholly avoided and in situations where double taxation is inevitable regardless of the structure. When double taxation is unavoidable, the seller can postpone the recognition of gain via an installment sale or via a tax-free or partially tax-free acquisition.

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What is an installment sale?

An installment sale is a sale of property at a gain where at least one payment is to be received after the tax year in which the sale occurs.23 The taxpayer is required to report the sale under the installment method unless the taxpayer “elects out” on or before the due date for filing a tax return (including extensions) for the year of the sale. If the taxpayer elects out, it must report all the gain as income in the year of the sale. Installment sale rules do not apply to losses, or to gains from the sale of inventory or of stocks and securities traded on an established securities market. Under the installment method, the taxpayer includes in income each year only part of the gain that it receives. Gain is generally the amount by which the proceeds received from the sale, not counting interest, exceed the adjusted basis in the property sold.24 For example, if A sells property to B for a note with a principal amount of $100 and A’s basis in the property was $60, A realizes a gain of $40. Since the ratio of the gain recognized ($40) to the total amount realized ($100) is 40, this percentage of each principal payment received by A will be treated as taxable gain. The other $60 will be treated as a nontaxable return of capital.

What kinds of transactions are eligible for installment sale treatment?

The installment method is generally available for sales of any property other than installment obligations held by a seller, and other than inventory and property sold by dealers in the subject property. Subject to certain exceptions, installment treatment is generally available to a shareholder who sells his or her stock or to a corporation or to another entity that sells its assets. Installment treatment is not available for sales of stock or securities that are traded on an established securities market.

What are the tax consequences of a typical tax-free reorganization?

In a classic tax-free acquisition, the Parks own all the stock of Mom and Pop Grocery, Inc. (Grocery), which is acquired by Supermarkets, Inc.


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(Supermarkets). In the transaction, the Parks surrender all their stock in Grocery to Supermarkets, solely in exchange for voting stock of Supermarkets. This is a fully tax-free B reorganization (defined later in this chapter), in which the Parks recognize no immediate gain or loss. The corollaries to tax-free treatment, here as elsewhere, are carryover and substituted basis and holding period. In other words, the Parks obtain a basis in their Supermarkets stock that is equal to their basis in the Grocery stock that they surrendered (substituted basis) and continue their old holding period in the stock. Similarly, Supermarkets obtains a basis in the Grocery stock that it acquired that is equal to the Parks’ basis (carryover basis), and also picks up the Parks’ holding period. What are the advantages of tax-free transactions to sellers and buyers?

By participating in a tax-free transaction, the seller is given the opportunity to exchange its own company’s stock for the buyer’s stock without the immediate recognition of gain. Because the seller will have a basis in the buyer’s stock that is the same as the seller’s old basis in the acquired corporation’s stock (a substituted basis), tax is deferred until the stock of the acquiring corporation is ultimately sold. When the acquired corporation is closely held and the buyer is publicly held, the seller may obtain greatly enhanced liquidity without a current tax. For the buyer, there are two principal advantages to a tax-free acquisition. First, when the buyer is able to use its stock in the transaction, the corporation can be acquired without the incurrence of significant debt. When equity financing in general is attractive from a buyer’s point of view, it will often make sense to use it in a business acquisition. Second, although subject to certain limitations, the acquired corporation’s tax attributes (including net operating loss carryovers) will remain usable after the acquisition. What kinds of transactions may qualify for tax-free treatment?

Every transaction involving an exchange of property is taxable unless otherwise specified in the Internal Revenue Code. Thus, corporate acquisitions

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are generally taxable to the seller of stock or assets. However, several types of acquisition transactions may be tax-free to the seller, but only to the extent that the seller receives stock in the acquiring corporation (or in certain corporations that are closely affiliated with the acquiring corporation). In general, tax-free acquisitions fall into three categories: statutory mergers, exchanges of stock for stock, and exchanges of assets for stock. Most available tax-free acquisition transactions are provided under Section 368 of the tax code. In all, considering the various permutations of its provisions, Section 368 ultimately sets forth more than a dozen different varieties of acquisition reorganizations. The most commonly used forms are the A, B, C, and D reorganizations. (Others are F and G reorganizations and various hybrids.) ■

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An A reorganization (named, of course, after its alphabetic place in Section 368) is, very simply, a “statutory merger or consolidation.”25 This type of reorganization has other, more complex names, such as a reorganization not solely for voting stock, as distinct from a B reorganization, which is solely for voting stock (see below). It is also referred to as a tax-free forward merger, as opposed to the taxable forward merger and taxable reverse merger forms discussed earlier (there is no tax-free reverse merger). A B reorganization is a stock-for-stock exchange in which one company buys the stock of another company using only (“solely”) its own stock. A C reorganization is a transaction in which one company buys the assets of another company using only its own stock. A D reorganization is a transaction in which a company transfers its assets down into a subsidiary. This kind of transaction would usually disqualify a company from meeting the requirements of Section 355 of the tax code, which provides for a taxfree “spin-off ” (distribution) of a subsidiary’s stock to shareholders.

To qualify as tax-free reorganizations under Section 368, all acquisition reorganizations must meet three nonstatutory requirements.


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First, the reorganization must have a business purpose. Second, the acquiring corporation must satisfy the continuity of business enterprise requirement, which involves the continuation of a significant business of the acquired corporation or the use of a significant portion of the acquired corporation’s business assets. Third, and probably most burdensome, the reorganization must satisfy the continuity of interest requirement.

What would be an example of the use of Sections 355 and 386?

A good example would be the Heinz-Del Monte transaction of 2003.26 Heinz borrowed against SKF Foods and then spun it off to itself (“Heinz Public”). Del Monte then “acquired” SKF Foods from Heinz Public for 74.5 percent of Del Monte Stock. ■

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Heinz distributed 100 percent of the stock of SKF Foods to Heinz Public tax-free under Section 355. Del Monte then merged into SKF Foods and issued 74.5 percent of its stock to Heinz Public in a Section 368 transaction. SKF Foods became a wholly owned subsidiary of Del Monte, with Heinz Public owning 74.5 percent of Del Monte.

You said, “Most available tax-free acquisition transactions are provided under Section 368 of the tax code.” What is the exception?

The one exception is a Section 351 transaction. Section 351 of the tax code provides nonrecognition treatment on the transfer of property to a corporation by one or more parties in exchange for stock or stock and securities of the transferee corporation, provided that the transferors possess 80 percent control of the transferee corporation immediately after the transaction. (See Exhibit 7-1.)

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EXHIBIT

7-1

SECTION 351: TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR Issue

Whether a transfer of assets to a corporation (the “first corporation”) in exchange for an amount of stock in the first corporation constituting control satisfies the control requirement of § 351 of the Internal Revenue Code if, pursuant to a binding agreement entered into by the transferor with a third party prior to the exchange, the transferor transfers the stock of the first corporation to another corporation (the “second corporation”) simultaneously with the transfer of assets by the third party to the second corporation, and immediately thereafter, the transferor and the third party are in control of the second corporation. Facts

Corporation W, a domestic corporation, engages in businesses A, B, and C. The fair market values of businesses A, B, and C are $40x, $30x, and $30x, respectively. X, a domestic corporation unrelated to W, also engages in business A through its wholly owned domestic subsidiary, Y. The fair market value of X’s Y stock is $30x. W and X desire to consolidate their business A operations within a new corporation in a holding company structure. Pursuant to a prearranged binding agreement with X, W forms a domestic corporation, Z, by transferring all of its business A assets to Z in exchange for all of the stock of Z (the “first transfer”). Immediately thereafter, W contributes all of its Z stock to Y in exchange for stock of Y (the “second transfer”). Simultaneous with the second transfer, X contributes $30x to Y to meet the capital needs of business A after the restructuring in exchange for additional stock of Y (the “third transfer”). After the second and third transfers, Y transfers the $30x and its business A assets to Z (the “fourth transfer”). After the second and third transfers, W and X own 40 percent and 60 percent, respectively, of the outstand-


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ing stock of Y. Viewed separately, each of the first transfer, the combined second and third transfers, and fourth transfer qualifies as a transfer described in § 351. Law

Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in § 368(c)) of the corporation. Source: 26 CFR 1.351-1: Transfer to Corporation Controlled by Transferor. Rev. Rul. 2003-51; http://www.irs.gov/pub/irs-drop/rr-03-51.pdf.

What is the continuity of interest requirement?

As noted previously, tax-free treatment is generally available to an acquired corporation’s stockholders only to the extent that they either retain their stock or exchange it for stock in the acquiring entity or group. Continuity of interest requires that this qualifying stock consideration constitute a substantial portion of the total consideration received by the acquired corporation’s shareholders in the overall transaction. For this purpose, a substantial portion is at least 40 percent; if a private ruling from the Internal Revenue Service is desired, the stock consideration must be at least 50 percent of the total.

TAX AND ACCOUNTING ISSUES IN CHOICE OF ENTITY What types of entities may operate the business of an acquired company?

Four types of entities may be used to acquire and operate the business of the acquired corporation: (1) a C corporation, (2) an S corporation, (3) a partnership, either general or limited, and (4) a limited liability company

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(LLC). The LLC offers the legal insulation of a corporation and the preferred tax treatment of a limited partnership. What are the primary differences among the four types of business entities?

A regular, or C, corporation is a separate taxpaying entity. Therefore, its earnings are taxed to the corporation when they are earned and again to its shareholders upon distribution. Partnerships and S corporations (and presumably LLCs), in contrast, are generally not separate taxpaying entities. The earnings of partnerships and S corporations are taxed directly to the partners or shareholders, whether or not earnings are distributed or otherwise made available to such persons. Moreover, partnerships and S corporations may generally distribute their earnings to the equity owners free of tax. Because S corporations and partnerships are generally exempt from tax, but pass the tax liability with respect to such earnings directly through to their owners, these entities are commonly referred to as pass-through entities. What are pass-through entities?

Pass-through entities are structures that permit single—rather than double—taxation. Under the dual system of taxation, corporate earnings from the sale of appreciated property are taxed twice, first to the corporation when the sale occurs and then to the shareholders upon the distribution of the net proceeds. This makes it important to use pass-through entities so that earnings are recognized and taxed only once. There are three types of pass-through entities: ■ ■ ■

Partnerships, both general and limited S corporations C corporations that file a consolidated income tax return with their corporate “parent”

The earnings of all C corporations are subject to double taxation, but the consolidated return provisions generally permit the earnings of subsidiary members of the consolidated return group to be taxed to the ultimate parent only. The earnings of an S corporation, with certain exceptions,


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are subject to taxation only at the shareholder level. The earnings of a partnership are also subject to a single tax, but only to the extent that such earnings are allocated to noncorporate partners (unless the partner is an S corporation). Partnership earnings that are allocated to corporate partners are subject to double taxation, just as though the income were earned directly by the corporations. What is a C corporation?

A C corporation is defined in the Internal Revenue Code as any corporation that is not an S corporation. As used in this chapter, however, the term C corporation excludes corporations that have been granted special tax status under the tax code, such as life insurance corporations, regulated investment companies (mutual funds), and corporations qualifying as real estate investment trusts (REITs). What is an S corporation?

An S corporation is simply a regular corporation that meets certain requirements and elects to be taxed under Subchapter S of the Internal Revenue Code. Originally called a “small business corporation,” the S corporation was designed to permit small, closely held businesses to have a corporate form, while continuing to be taxed generally as if they were operating as a partnership or an aggregation of individuals. As it happens, the eligibility requirements under Subchapter S, which are keyed to the criterion of simplicity, impose no limitation on the actual size of the business enterprise.27 Briefly, an S corporation may not (1) have more than 75 shareholders, (2) have as a shareholder any person (other than an estate and a very limited class of trust) who is not an individual, (3) have a nonresident alien as a shareholder, (4) have more than one class of stock, (5) be a member of an affiliated group with other corporations, or (6) be a bank, thrift, insurance company, or certain other types of business entities. What is a partnership for tax purposes?

Except under rare circumstances, a partnership for tax purposes must be a bona fide general or limited partnership under applicable state law.

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How are LLC mergers treated?

Under most state laws, a limited liability company may merge with or into a stock corporation, limited partnership, business trust, or another LLC. All members of the LLC must approve the merger unless they agree otherwise. Filing of articles and the effective date operate the same as for corporate mergers.

What is the most tax-efficient structure for acquiring or operating an acquired corporation’s business?

If it is practicable, not even a single level of corporate tax should be paid on income generated by the acquired corporation’s business. For this reason, a pass-through entity owned by individuals (as discussed later in this chapter) should be the structure whenever possible. With respect to an acquisition of assets by individuals, this means that the acquisition vehicle should be either a partnership (presumably limited) or an S corporation. In the case of a stock acquisition by individuals, the acquired corporation generally should be operated as an S corporation. When the buyer is a C corporation, the acquired corporation’s business, whether it is acquired through an asset or a stock purchase, should be operated as a division of the buyer or through a separate company included in the buyer’s consolidated return. In either case, the income of the acquired corporation will be subject to only one level of corporate tax prior to dividend distributions from the buyer to its shareholders.

Under what circumstances may a consolidated return be filed?

In order for two or more corporations to file a consolidated return, they must constitute an “affiliated group” for tax purposes. Although subject to numerous qualifications and complications, an affiliated group is essentially a chain of corporations in which a common parent owns at least 80 percent of the voting power and at least 80 percent of the value of the stock of the other members of the group.


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When should an S corporation be considered?

Typically, an S corporation should be considered when the acquired corporation is, or can become, a freestanding domestic operating corporation owned by 75 or fewer U.S. individual shareholders. Because the S corporation requirements are designed to ensure that such entities will have relatively simple structures, they are not inherently user-friendly vehicles for larger, complex operations. Nevertheless, because there is no limit on the size of the business that may be conducted in an S corporation, it is often possible to plan around obstacles to qualification under Subchapter S and to use this favorable tax entity.

When should a partnership be considered?

The partnership is an alternative to the S corporation that has several notable advantages. First, it is always available, without restrictions on the structure or composition of the acquired corporation’s ownership; therefore, it can be used when the S corporation is unavailable for technical reasons. In addition, the partnership is unique in enabling the partners to receive distributions of loan proceeds free of tax. Finally, if the acquired corporation is expected to generate tax losses, a partnership is better suited than an S corporation to pass these losses through to the owners. The last two advantages result from the fact that partners, unlike S corporation shareholders, may generally include liabilities of the partnership in their basis in the partnership.

In addition to the choice of entity, what major structural issues should be considered?

From a tax standpoint, probably the most important issue is whether the buyer should seek to obtain a cost basis or a carryover basis in the assets of the acquired corporation. Because of the potential for obtaining either of these results regardless of whether assets or stock is actually acquired, the determinations of the tax goal and the actual structure may initially be made on a separate basis.

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What are the mechanics of achieving a cost or carryover basis?

In a taxable acquisition, a carryover basis can be achieved only through a stock acquisition. For federal tax purposes, however, stock may be acquired in two ways: first, through a direct purchase of the seller’s stock, and second, through a reverse cash merger. As indicated earlier, a cost basis can be achieved by purchasing either assets or stock from the seller. As in the case of a stock purchase, the tax law permits an asset purchase to be effected in two ways: first, through a direct purchase of the seller’s assets, and second, through a forward cash merger. In the context of a stock acquisition, a cost basis can be achieved by making an election under Section 338 of the tax code. How are purchase price allocations made for tax purposes?

Although businesses are usually bought and sold on a lump-sum basis, for tax purposes, each such transaction is broken down into a purchase and sale of the individual assets, both tangible and intangible. There is no specific requirement under the tax laws that a buyer and seller allocate the lump-sum purchase price in the same manner. Because each party tends to take the position that is most favorable to it, allocation issues have been litigated by the IRS fairly often over the years. At the same time, the courts and, to a lesser extent, the IRS have tended to defer to allocations of purchase price that are agreed upon in writing between a buyer and seller in an arm’s-length transaction. Are there any rules governing the allocation of purchase price?

Yes. If the seller transfers assets constituting a business and determines its basis as the consideration (e.g., purchase price) paid for the assets, then this transfer is considered a Section 1060(c) “applicable asset” acquisition. In such a transaction, both the buyer and the seller must use the “residual method” to allocate the purchase price received in determining the buyer’s basis or the seller’s gain or loss. This method, which is the same as the one


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used for a stock purchase, requires that the price of the assets acquired be reduced by cash and cashlike items; the balance must be allocated to tangible assets, followed by intangibles, and finally by goodwill and goingconcern value. IRS regulations state that both buyer and seller are bound by the allocations set forth in the acquisition agreement. In 2009, the IRS approved a regulation pertaining to insurance companies.28 What about amortization of intangibles following an acquisition?

Acquirers must generally amortize the capitalized costs of “section 197 intangibles” over 15 years if they hold the section 197 intangibles in connection with their trade or business or in an activity engaged in for the production of income.29 1. 2. 3. 4.

5. 6. 7. 8. 9. 10. 11. 12.

Goodwill Going-concern value Workforce in place Business books and records, operating systems, or any other information base, including lists or other information concerning current or prospective customers A patent, copyright, formula, process, design, pattern, know-how, format, or similar item A customer-based intangible A supplier-based intangible Any item similar to items 3 through 7 A license, permit, or other right granted by a governmental unit or agency (including issuances and renewals) A covenant not to compete entered into in connection with the acquisition of an interest in a trade or business Any franchise, trademark, or trade name A contract for the use of, or a term interest in, any item in this list30

Acquirers cannot amortize any of the intangibles listed in items (1) through (8) that they created rather than acquired unless they created them

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in acquiring assets that make up a trade or business or a substantial part of a trade or business. What is the main difference between a partnership and an S corporation as far as their pass-through status goes?

The partnership is a more complete pass-through entity. With respect to the issuance of stock or debt, the S corporation is treated in exactly the same way as a C corporation: such events are not taxable transactions to it. Likewise, no taxable event is recognized to an S corporation when its warrants are issued or exercised. In contrast, most transactions undertaken by a partnership are viewed for tax purposes as if they were undertaken by the partners themselves. If the partnership is treated solely as an entity apart from its partners, the business arrangement will be undermined. Thus, the issuance and exercise of a warrant to buy a stated percentage of the outstanding stock of a corporation becomes a far more complex transaction to structure when it involves an interest in a partnership. TAX IMPLICATIONS OF FINANCING ARRANGEMENTS What tax issues should be analyzed in structuring straight debt financing?

Generally, straight debt is an unconditional obligation to repay principal and interest, has a fixed maturity date that is not too far removed, is not convertible, and has no attached warrants, options, or stock. A straight debt instrument ordinarily does not include interest that is contingent on profits or other factors, but it may provide for a reasonable variable interest rate. Its principal will not be subject to contingencies. In short, straight debt is an instrument without significant equity features. Straight debt instruments are generally classified as debt for tax purposes. Accrued interest on a straight debt instrument is deductible by the borrower and taxable to the lender. As a practical matter, the only tax issue in straight debt financing is the computation of the accrued interest. The Internal Revenue Code and proposed regulations contain an extremely com-


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plex set of comprehensive rules regarding interest accruals. These rules generally require that interest must accrue whether or not a payment of interest is made. Thus, interest may be taxed, or deducted, before or after it is actually paid. How is debt distinguished from equity for tax purposes?

U.S. federal tax law offers no specific, objective criteria to determine whether a given instrument should be treated as debt or equity, despite attempts to legislate such standards.31 State tax law offers more exemptions than rules. The debt-equity characterization issue has produced an abundance of tax litigation, with a resulting body of case law in which there are very few common principles. The judicial response to defining debt and equity has much in common with the response to defining obscenity under the First Amendment—that is, judges have been unable to enunciate a complete definition, but they know it when they see it. A few useful generalizations can be made. Virtually all the litigation and activity by the IRS has involved the recharacterization of purported debt as equity, not the other way around. Therefore, it is quite safe to say that recharacterization is not a problem in dealing with a purported equity instrument. In examining a purported debt instrument, the courts look for objective evidence that the parties intended a true debtor-creditor relationship. In particular, they have placed great weight on whether the instrument represents an unconditional promise to pay a certain sum at a definite time. Other significant factors that are considered include whether the loan was made by shareholders of the borrower, the borrower’s debt-to-equity ratio, whether the loan is subordinated to third-party creditors, and whether it has a market rate of interest. When debt is recharacterized as equity, the tax consequences may be severe. Can an acquirer deduct interest paid on loans made for acquisitions?

Only within limits. Section 279 of the tax code disallows interest deductions in excess of $5 million a year on debt that is used to finance an acqui-

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sition, to the extent that the company’s interest deductions are attributable to “corporate acquisition indebtedness.” Because its effects are direct and harsh, Section 279 must be considered in evaluating any debt instrument used in connection with a corporate acquisition, or a refunding of such a debt instrument. OTHER TAX ISSUES What role do state and local taxes play in structuring mergers and acquisitions?

State and local taxes generally play a secondary role in planning acquisitions and divestitures. First, most state income tax systems are based largely on the federal system, particularly in terms of what is taxable, to whom, when, and in what amount. Second, when an acquired corporation operates in a number of states, it can be inordinately difficult to assess the interaction of the various state tax systems. On the other hand, serious and embarrassing mistakes have been made by tax planners who ignored a transaction’s state tax consequences. Although a detailed discussion of state income tax consequences deserves a book of its own, several extremely important state tax issues merit attention here. First and foremost, there are income taxes. These vary from state to state and may affect companies that are located outside the state.32 In addition to income taxes, numerous other taxes imposed by states and localities may affect an acquisition. Although these rarely amount to structural prohibitions or incentives, they often increase cost. For example, when real estate is being transferred, there will often be unavoidable real property gain, transfer, or deed recordation taxes. Perhaps the most notorious of the real property gain and transfer taxes are those imposed by New York State and New York City, respectively, upon certain sales of real estate and of controlling interests in entities holding real estate. Purchases of assets may not be exempt from a state’s sales tax. Many states offer exemptions, but this should not be taken for granted. Check it out. Certain types of state and local taxes that are not directly associated with an acquisition can be significantly affected by an acquisition or by the particular structure of the acquisition. For example, a state’s real property


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and personal property taxes are based on an assessment of the value of the property owned by a taxpayer. Often, a transfer of ownership of the property will trigger a reassessment of the value of the property. RELATED ACCOUNTING CONSIDERATIONS What are the principal authoritative accounting pronouncements covering the accounting for mergers and acquisitions?

The issue of accounting for mergers and acquisitions has been a hot topic in accounting ever since the old days of purchase vs. pooling, an American anomaly that was abolished in 2001. In late 2007 and early 2008, the FASB and the IASB reconsidered the existing guidance for applying the purchase method of accounting for business combinations (now called the acquisition method). The stated objectives of the project were to “improve and simplify the accounting for business combinations and to develop a single high-quality standard of accounting for business combinations that could be used for both domestic and cross-border financial reporting.”33 Since then, there have been a number of key developments. For U.S. standards, the current standard is FASB ASC 805, “Business Combinations” [previously called SFAS No. 141(R)]. Topic 805, “Business Combinations,” is based entirely on FASB Statement No. 141(R), “Business Combinations (revised),” and related content. It excludes content from FASB Statement No. 141, “Business Combinations,” and related standards.34 Here are highlights: ■ ■

One entity must be identified as the acquirer. The acquirer gains control as of the acquisition date.

The following are measured at fair value as of the acquisition date: ■ ■ ■

Assets Liabilities Noncontrolling interest

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Goodwill and any gain from a bargain purchase are more complex. The formula for goodwill is Goodwill = consideration transferred + future value of noncontrolling interest − future value of net assets

The formula for gain from a “bargain purchase” is Gain from bargain purchase = fair value of net assets − considerations transferred − minus fair value of noncontrolling interest

(“Considerations transferred” do not include all compensation.)35 Acquisition-related costs are recognized as expenses, except for the issuance costs of debt or equity securities. CONCLUDING COMMENTS

Comprehensive due diligence requires the expertise of tax and accounting professionals. They alone can lead the analysis of the tax laws and accounting standards that will govern a particular transaction. Nonetheless, every person who is involved in conducting due diligence can benefit from a general understanding of this area. This chapter has attempted to present a framework for such understanding. The next section of this book breaks away from the details of transactional structuring to look at legal compliance in a number of broad business areas, beginning with antitrust—the natural enemy of mergers and a fundamental hurdle for any change of control involving significant revenues, assets, or market share.

PA R T

3

A Closer Look at Compliance

One of the most difficult areas of due diligence is ensuring legal compliance—the focus of this final section of our book. In Part 1 (Chapters 1 through 4), we provided an overview of financial, operational, and legal due diligence. In Part 2 (Chapters 5 through 7), we addressed the highly technical but necessary area of transactional due diligence. In this section, we return to the subject of legal due diligence, explaining the law on antitrust, intellectual property, consumer protection, the environment, and employment (Chapters 8 through 12). As mentioned in earlier chapters, the number of statutes and regulatory agencies has grown exponentially over time. As a result, many basic principles of financial and operational management have now been incorporated into the law. Thus, a focus on laws, however excessive they and their enforcers may be, will do managers little harm and much good. Indeed, in the current era, where it has been said that the center of economic power has shifted from Wall Street to Washington, attention to compliance is more critical than ever. We recognize that a legalistic focus is not natural for most corporate leaders and managers. If you, our reader, are an operating manager, you excel at what you do because you care about economic results, not red tape. So when it comes to legal risk, you probably let your advisors do the learn-

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PART 3: A Closer Look at Compliance

ing, while reserving decisions to yourself. This bifurcation of expertise and decision making can be deadly. A better model is to bring specialized experts into your decisions while gaining some expertise yourself. At times, we may sound like apologists for all the laws we describe here, and for the many regulations that they have engendered. This is certainly not the case. In fact, both authors agree with Thomas Jefferson that “the government governs best that governs least.” On the other hand, we do strongly believe in the value of self-regulation through knowledge. To avoid liability in general, and postmerger liability in particular, managers need to understand legal principles and know the gist of major laws. Such knowledge can be the cornerstone of thorough due diligence in any transaction.

CHAPTER

8

Detecting Exposure under Antitrust Law and International Economic Law As freak legislation, the antitrust laws stand alone. Nobody knows what it is they forbid. —Isabel Paterson, The God of the Machine (1943)

INTRODUCTION

Antitrust—the body of law that seeks to discourage concentration of corporate power— ranks high among the legal areas that acquirers must investigate when conducting M&A due diligence. The reasons are compelling. ■

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First, for any acquisition transaction that depends on approval or resources from third parties, such as lenders, it may be impossible to proceed with the transaction without obtaining the necessary approval from antitrust authorities. Second, simply by increasing the market strength of the acquirer, every acquisition transaction raises the potential, however distant, for an antitrust law violation. Finally, every acquisition candidate may bring with it the potential to be sued postclosing for some antitrust violation in the past. Antitrust law, after all, is not limited to M&A issues. It deals with restraint of competition in a number of areas—some of them classified as criminal.1

In the past two decades, the Department of Justice (DOJ) has filed more than one thousand cases in which individuals and companies were accused of antitrust violations, including hundreds involving merger or acquisition transactions.2

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Therefore, at the initial planning stages, potential buyers and sellers should be sure to provide adequate time and resources to explore potential antitrust issues—including the antitrust climate surrounding a given transaction. The following overview of antitrust law, focusing primarily on U.S. law, can make acquirers and sellers alike more sensitive to this important legal area.

ANTITRUST FUNDAMENTALS What are the basic concepts behind antitrust law?

Antitrust law in the United States derives from a late-nineteenth-century effort to break down “trusts”—the large, market-dominating companies that had evolved during that era. Classic antitrust policy looks at both the means and the potential results of large size. It reflects two fundamental beliefs (which we put in quotes to distinguish belief from known fact). ■

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“Any large company, in order to grow, may have restrained the trade of others in its industry.” “Once a company is large, by its sheer size it may harm the competitiveness of its smaller peers.”

Since one way for companies to grow is through acquisition, antitrust regulators often focus on acquisitions. As mentioned, these draw a substantial portion of regulatory attention. When antitrust regulators examine a merger, they ask, among other questions, whether the merger will lead to horizontal and/or vertical integration (a matter of structure) and whether it will enable collusion and/or exclusion (a matter of practice). Any given transaction could raise issues in any of these areas. With respect to structure, regulators have two basic categories: horizontal and vertical (or, more broadly, nonhorizontal). ■

Horizontal. A horizontal transaction (merger, acquisition, joint venture, partnership, or alliance) involves an acquisition of or alliance with a competitor. Such a transaction may create a monopoly or oligopoly in a market by eliminating or reducing competition.

CHAPTER 8: Detecting Exposure under Antitrust Law and International Economic Law

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Vertical. A vertical acquisition is one that does not involve a competitor. It involves similar connections with a supplier or customer. It is a kind of so-called nonhorizontal acquisition.3

These two basic categories involve the concept of structure. Crosscutting this is another concept: practice. ■

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Structure. A transaction may change the competitive balance in an industry or market. Practice. A company may engage in a predatory trade practice such as collusion or exclusion.

These four concepts—horizontal versus nonhorizontal transactions and structure versus practice, all of which are discussed further later in this chapter—form a kind of antitrust quadrant. See Exhibit 8-1. There are two main practices that should raise red flags in any due diligence investigation. ■

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Collusion. This occurs when a group of companies agree to take a course of action that harms the consumer, such as fixing prices at a high level, rather than competing among themselves to offer low prices. Exclusion. This occurs when a company takes action in order to prevent a competitor from entering or growing in a market— through such practices as tying, exclusive dealing, and selling at or below cost.

The Federal Trade Commission (FTC) and the DOJ keep an eye on both collusion and exclusion. They recently issued joint guidelines on collusion.4 Could you identify significant legal cases pertaining to horizontal and vertical mergers?

One recent case applying antitrust policy against horizontal mergers involved Ticketmaster and Live Nation, decided January 25, 2010.5 Under the terms of the proposed final judgment filed in U.S. District Court for the

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EXHIBIT

8-1

AN ANTITRUST QUADRANT FOR M&A DUE DILIGENCE Exclusionary Practice

Horizontal Structure

Vertical Structure

Collusionary Practice

When antitrust regulators examine mergers, they ask, among other things, if the merger causes horizontal and/or vertical integration (structure) and if it enables collusion and/or exclusion (practice). Any given transaction could raise issues in any of the four quadrants.

District of Columbia, the companies agreed to divest Ticketmaster’s selfticketing subsidiary, Paciolan, to Comcast-Spectacor, and to license the Ticketmaster Host technology to Anschutz Entertainment Group, Inc., along with other terms intended to protect competitive conditions in ticketing and promotions. Regarding vertical mergers, perhaps the most famous case was United States v. Standard Oil (1966), which was recently updated (2010).6 The DOJ


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alleged, and the court agreed, that the vertical aspects of this transaction violated Section 7 of the Clayton Act. So the court permanently enjoined Standard Oil “from taking any actions directly or indirectly, to purchase or acquire the stock, assets, properties or businesses of PCA, or from merging and consolidating such assets, properties, or businesses, or acquiring any financial or other interest in PCA.” The government claimed that by acquiring a major supplier of potash, the oil company would unduly lessen competition in the fertilizer industry. In January 2010, after 44 years, the DOJ lifted this injunction at the pleading of ExxonMobil, the successor to Standard Oil.7

Could you identify well-known merger cases involving the practice of collusion and/or exclusion?

The grandfather case in both collusion and exclusion is Standard Oil Co. v. United States (1911), which cites “evils which led to the public outcry against monopolies,” and summarizes them as the power to fix price and limit production.8 The case also cites the negative impact on product quality. A classic case on collusion is Matsushita v. Zenith (1986).9 In this case, an alleged conspiracy to impose price and market allocation restraints that did not have an injurious competitive effect on U.S. commerce was not actionable under U.S. antitrust laws. In general, where the factual context suggests the absence of a motive to engage in a predatory pricing conspiracy, plaintiffs have a more rigorous burden of proof than would otherwise be necessary.10 But the buying power of large wholesale buyers like WalMart has made price fixing much more difficult to do, let alone prove. As for exclusion, a well-known case was Jefferson Parish Hospital v. Hyde (1984), in which the U.S. Supreme Court found that an exclusive arrangement to use a single vendor did not violate antitrust laws (specifically, Section 1 of the Sherman Act, described later in this chapter). Using a market impact test, the court ruled that plaintiffs had failed to show competitive effects in the market. In recent times, legal scholars have questioned the market impact test used in the Jefferson Parish case, expressing the hope that it might be overruled in favor of true economic analysis.11 There has been some concern that franchisor-franchisee relations are a form of exclusion through tying, but sound legal arguments can be made against this notion.12

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What are some antitrust variables?

Analyzing exposure to antitrust issues is complex work. Each transaction has a unique combination of attributes, and regulatory guidelines don’t cover all aspects of all transactions. Indeed, regulators sometimes block transactions based on principles that don’t appear anywhere in their published guidelines.13 Another complicating factor is regulatory climate. Attitudes in different presidential administrations can vary greatly. Administrations that favor free markets will be far more lenient toward M&A than those that want to curb market behavior. As we go to press with this edition, government antitrust enforcement is relatively aggressive—to the point of revoking previous policies outright.14 Given all these variables, it is important that you retain expert attorneys and develop a general understanding of antitrust law so that you can make the most effective use of counsel. For an outline showing the regulatory framework of current antitrust law in the United States, see Appendix 8A. For antitrust guidelines from the FTC and the DOJ, see Appendixes 8B and 8C.

Could you give some background on how antitrust law has evolved in this and the previous century?

Antitrust policy has been through several phases during the past 100 years. In the early part of the twentieth century, policymakers broke up firms that dominated markets, whether individually as monopolies or in groups as oligopolies (more about these terms later). That policy said that big was bad, whether or not it involved mergers. Then, in mid-century, policymakers began to focus on merger transactions as a cause of market domination, challenging acquisitions involving vertical and horizontal integration through mergers. From the 1980s until the present time, policymakers have been using economics rather than size as the factor leading their analysis of transactions, fomenting a kind of “antitrust revolution.” Indeed, this is the title of a book edited by John E. Kwoka, Jr., and Lawrence J. White, now in its fifth edition.15


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In this new economically inclined view, transactions that make sense for consumers have had a good chance of being approved, even if they create horizontal or vertical integration. As of 2010, however, the pendulum is swinging back the other way— toward stricter interpretation and enforcement of antitrust laws and policies and away from a more laissez-faire approach based on economic theory.16 While this is partly due to a change in political party, it may also be linked to the general economy. According to one study, antitrust enforcement activity is countercyclical to boom and bust trends in the economy.17

MONOPOLIES AND OLIGOPOLIES What is a monopoly, and how does it relate to M&A activity?

Economists define a monopoly as a single firm selling a product for which there are no good substitutes and where entry into the market by other sellers is difficult or impossible.18 Such a company is capable, says classic economic theory, of charging more for less (and thus earning higher profits) than other sellers would, if those sellers could enter the market. (A single buyer in a market, called a monopsony, can do the converse, extracting a lower price from sellers than multiple competitive buyers could.) The concept of monopoly is important in M&A due diligence. In the words of the antitrust guidelines of the DOJ and FTC, “[Economic] efficiencies are most likely to make a difference in merger analysis when the likely adverse competitive effects, absent the efficiencies, are not great. Efficiencies almost never justify a merger to monopoly or near-monopoly.” Pure monopolies are rare, but they do exist for specific products and/or locations. Examples include, in some local markets, local residential telephone service; electricity, natural gas, water, and cable television distribution; and postal service for first-class and bulk mail.19 Another example is a single store that lacks nearby competitors. All of the forms just listed are permitted under current law because of special circumstances. Some dominant firms are quasi-monopolies—singularly large sellers with a fringe of smaller competitors. Recent examples include Microsoft

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in personal computer operating systems, Intel in microprocessors, and United Parcel Service for small package deliveries. Technological advances and competitive forces eventually overcome particular monopolies, but new ones always rise up. New monopolies arise in three ways, say experts: ■

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Through internal growth that achieves market-dominating economies of scale Through government action that takes over an industry, such as mail Through consolidation into massive organizations via mergers

In a speech entitled “Vigorous Antitrust Enforcement in This Challenging Era,” Christine Varney, the head of the Antitrust Division of the DOJ, announced an intention to focus on monopolistic behavior, an area that antitrust law largely ignored under her immediate predecessors.20

What is an oligopoly?

In an oligopoly, the number of sellers is small enough to enable collusion. Since mergers can reduce the number of sellers in the market, regulators have seen them as a cause of oligopoly conditions, and have challenged them on that basis.

What are the main federal antitrust regulators in the United States?

The two main agencies are the Department of Justice, which has an Antitrust Division, and the Federal Trade Commission.

THE SHERMAN ACT, THE CLAYTON ACT, AND THE HART-SCOTT-RODINO ACT What are the main U.S. antitrust laws?

The three main U.S. antitrust laws are the Sherman Act and the Clayton Act, which outlaw monopolies, and the Hart-Scott-Rodino Antitrust Improve-


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ments Act, which requires the parties to a proposed acquisition transaction to furnish certain information about themselves and the deal to the Antitrust Division of the DOJ and to the FTC.

What exactly does the Sherman Act outlaw?

The Sherman Act has 20 sections.21 For the purpose of due diligence for M&A, the most important ones to know are ■ ■ ■

Section 1, outlawing restraint of trade or commerce Second 2, outlawing monopoly Section 18, outlawing the purchase of stock with the intention to monopolize

A key question—and one that pertains to M&A—is whether regulators consider parents and subsidiaries to be separate companies or one company when it comes to accusing companies of restraining trade or commerce, or trying to monopolize. Fortunately, the general consensus is that parents and subsidiaries are considered to be one company, so they cannot be accused of colluding.22 However, when one company owns only a minority share in another company, the courts may find antitrust violations.23

What exactly does the Clayton Act say?

Section 7 of the Clayton Act prohibits a corporation from acquiring the stock or assets of another corporation if the acquisition might “substantially lessen competition or tend to create a monopoly” in any line of commerce in any section of the country. A violation of Section 7 may give rise to a court-ordered injunction against the acquisition, an order compelling divestiture of the property or other interests, or other remedies. Section 7 is enforced by the FTC and the DOJ. In November 1990, Congress passed the Interlocking Directorate Act of 1990, amending Section 8 of the Clayton Act to disallow any person from serving as a director or officer of two companies that are competing in the same industry or market. This provision does not apply to transactions in which the combined sales are small or where one of the participants is small. The definition of “small” is linked to the nation’s gross domestic product (GDP). For 2010,

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the threshold for a small-size exemption is a combined capital and surplus and undivided profits of under $25,841,000, or if either firm has less than $2,584,100 million. Mergers of companies with foreign operations or subsidiaries sometimes require review and approval by foreign governments. In addition, some foreign countries (most notably Canada) have their own premerger notification programs that require compliance. What does the Hart-Scott-Rodino Act say?

The Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act), as mentioned, requires the parties to a proposed acquisition transaction to furnish certain information about themselves and the deal to the FTC and the Antitrust Division of the DOJ before the merger is allowed to go forward. The information supplied is used by these government agencies to determine whether the proposed transaction would have any anticompetitive effects after completion. If so, in general, these effects must be cured prior to the transaction’s closing. A mandatory waiting period follows the agencies’ receipt of the HSR filings. Amendments passed in 2000 raised the threshold for reporting transactions.24 What mergers or acquisitions require premerger notification under the HSR Act?

Generally, all mergers and acquisitions that meet three size criteria must be reported under the HSR Act and the related premerger notification rules. Size criteria are adjusted annually. The following sizes will trigger review, effective February 20, 2010: ■

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As a result of the transaction, the acquiring firm will hold an aggregate total amount of voting securities, assets, and/or interests in noncorporate entities of the acquired firm valued in excess of $63.4 million. (Transactions larger than $253.7 million are reportable, regardless of this size of person test.) One of the firms has annual net sales or total assets of $126.9 million or more, and the other has annual net sales or total assets of $12.7 million or more.


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One of the persons involved is engaged in U.S. commerce or in an activity affecting U.S. commerce.25

The “persons” involved include not only the corporations that are directly involved but also any other corporation that is under common control. “Control,” for purposes of the HSR Act, is defined as ownership of 50 percent or more of a company’s voting securities or having the contractual power to designate a majority of a company’s board of directors. Special control rules apply to partnerships and other unincorporated entities. The HSR Act has additional thresholds for occasions when an acquirer who previously bought only part of a company buys additional shares.26 What information is required to be included in the HSR premerger notification form?

The form requires a description of the parties and the proposed merger or acquisition, certain current financial information about the parties, and a breakdown of the revenues of the parties according to industry codes (which are currently changing from the old Standard Industrial Classification codes). The FTC and DOJ use this breakdown of revenues to determine whether the proposed combination of the businesses would result in anticompetitive effects. The information filed is exempt from disclosure under the Freedom of Information Act, and no such information may be made public except pursuant to administrative or judicial proceedings. After the premerger notification form has been filed, how long must the parties wait before the merger or acquisition can be consummated?

When the acquisition is being made by a cash tender offer, the parties must wait 15 days before the purchaser may accept shares for payment. In all other cases, the parties must wait 30 days before the transaction can be completed. If the acquisition raises antitrust concerns, the government may extend the waiting period by requesting additional information from the parties. In that case, the waiting period is extended for 30 more days (10 more days in the case of a cash tender offer) past the time when the additional information is provided.27

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The parties may request early termination of the waiting period. If the acquisition raises no antitrust concerns, the government may grant the request at its discretion.

What is an example of a regulatory response to alleged Hart-Scott-Rodino violations?

On January 21, 2010, the DOJ announced a proposed settlement with Smithfield Foods Inc. and Premium Standard Farms LLC that would require the companies to pay a total of $900,000 in civil penalties for violating premerger waiting period requirements. That same day, the DOJ’s Antitrust Division filed a civil antitrust lawsuit in U.S. District Court for the District of Columbia, along with the proposed settlement that, if approved by the court, would resolve the lawsuit. According to the government’s complaint, after Smithfield and Premium Standard announced their proposed merger in September 2006, Smithfield exercised operational control over a significant segment of Premium Standard’s business without observing the premerger waiting period requirement—thus in effect “jumping the gun” in violation of HartScott-Rodino. After entering into the merger agreement, the DOJ’s Antitrust Division claimed, Premium Standard stopped exercising its “independent business judgment” with respect to hog procurement. Instead, Premium Standard allegedly sought Smithfield’s consent for all of the hog procurement contracts that arose during the waiting period, providing Smithfield with the contract terms, including price, quantity, and duration. This effectively transferred operational control prematurely, the department said.28

Are certain mergers and acquisitions exempt from the HSR Act?

Yes. Acquisitions made through newly formed corporate acquisition vehicles are frequently exempt from the reporting requirements of the HSR Act because the vehicle does not meet the “size-of-person” test. Special rules are also used to determine the “size” of a newly formed corporation, and care must be taken to avoid making contractual commitments for additional capital contributions or for guarantees of the new cor-


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poration’s obligations until after the formation has been completed. In general, the “assets” of a newly formed acquisition vehicle do not include funds contributed to the vehicle or borrowed by the vehicle at the closing to complete the acquisition. The HSR Act and FTC rules also provide numerous exemptions for special situations. Just because a transaction is exempt from HSR does not mean that it will be approved by regulators, however. Regulators are perpetually concerned about market concentration caused by horizontal mergers and have issued additional guidelines concerning such mergers.

APPLICATION OF ANTITRUST LAWS TO M&A How can we tell whether a particular horizontal merger is likely to be challenged by the federal government?

At present, the most authoritative document remains the revised Horizontal Merger Guidelines, which state that approval of mergers should take efficiencies into account.29 As this book goes to press in 2010, the DOJ’s Antitrust Division is conducting a review of the guidelines. The following discussion is based on the results of that review so far.30 According to these published guidelines, horizontal mergers are assessed according to a sliding scale of permissiveness. Thus, the less concentrated the industry, the larger is the permissible merger. The index used to measure concentration, the Herfindahl-Hirschman index (referred to as the HHI), is calculated by squaring the market share of each firm competing in the market and then summing the resulting numbers. The HHI takes into account the relative size and distribution of the firms in a market and approaches zero when a market consists of a large number of firms of relatively equal size. The HHI rises as the number of firms in the market decreases, and also as the disparity in size among those firms grows. Markets in which the HHI is between 1,000 and 1,800 points are considered to be moderately concentrated, and those in which the HHI is in excess of 1,800 points are considered to be concentrated. Transactions that increase the HHI by more than 100 points in concentrated markets can raise antitrust concerns under the Horizontal Merger Guidelines issued by the FTC and DOJ.31

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What might be an example of a merger that would create a “highly concentrated” industry?

For example, for a market consisting of four firms with shares of 30, 30, 20, and 20 percent, the HHI is 2,600 (302 + 302 + 202 + 202 = 2,600). A good example of a highly concentrated industry today would be the defense industry, discussed later in this chapter.

Is the HHI analysis conducted on the acquirer’s industry only?

No. An HHI analysis must be performed for each distinct “relevant market” in which both of the merging companies operate. From 2000 through 2009, there has been a steady increase in the fines levied by regulators for allegedly criminal antitrust activities, with the sharpest rise being in 2008. In that year alone, there were 10 fines of $10 million or more imposed, including one for $400 million. The heaviest fines pertained mostly to ongoing cases concerning price fixing in the thin film transistor liquid crystal display (TFT-LCD) technology, a key component for LCD monitors for televisions and computers.32 Also of note in this area are recent antitrust actions pertaining to cathoderay tubes and optical disk drives. Clearly, any acquirer that is involved directly or indirectly in an industry that produces these technologies needs to be alert to possible antitrust violations by the company itself or by key suppliers or customers. Other industries that are “red hot” for potential antitrust issues include agriculture (processed tomatoes), transportation (air cargo), energy (“marine” hoses used to transport oil between tankers and storage facilities), finance (municipal bonds), and a variety of industries that are dependent on government contracts (which can face bid-rigging allegations).33

What factors other than the HHI would the DOJ and FTC consider?

Regulators may find antitrust law violations in mergers that confer excessive market power on a single firm, even if that firm does not have a siz-


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able market share. If, for example, the two merging firms had previously sold products that were perceived by a substantial number of customers as being close substitutes for one another, the merged firms could raise prices on one product line and risk only some diversion of sales to the other product line. Whatever the level of concentration, regulators will challenge any merger that is likely to create or enhance one firm’s domination of a market. Thus a leading firm that accounts for 35 percent of the market and that is twice the size of its next largest competitor will normally not be allowed to acquire any firm accounting for even 1 percent of that market. In addition, analysis of horizontal mergers is no longer governed by the single-minded focus on market concentration that has, in theory, been the rule since the Supreme Court’s 1963 ruling in the Philadelphia National Bank case. In that ruling, the Court said that if a merger violates antitrust law, it should be barred, even if the merger delivers social benefits. The guidelines do indeed consider economic factors, including the following: ■

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Ease of entry into the market. (The easier it is for new firms to enter the market, the less the likelihood of challenge.) The availability of out-of-market substitutes. (The more readily available such substitutes are, the less prospect there is of market dominance.) The degree to which the merging firms confront one another within the relevant market. (If they occupy separate sectors of the market, the merger is less a cause of concern than if they are head-to-head in the same corner.) The level of product homogeneity. (The more homogeneous the products, the easier it is to collude.) The pace of technological change. (The slower the rate of change, the more likely is collusion.) The importance of nonprice terms. (The more important they are, the harder it is to collude.) The degree to which firms have access to information concerning their competitors’ transactions (the more information available, the greater is the likelihood of collusion).

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The size and frequency of orders. (The smaller and more frequent, the greater is the likelihood of collusion.) Whether the industry is characterized either by a history of collusion or by patterns of pricing conduct that make collusion more likely. (If it is, the likelihood of a challenge increases.) Historical evidence of noncompetitive performance. (Challenge is more likely.)

What about vertical or conglomerate mergers?

Regulators may find that the vertical integration resulting from vertical mergers can create unacceptable barriers to market entry. For such a finding, a transaction must satisfy at least three conditions: ■

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The degree of vertical integration between the two markets must be so extensive that entrants to one market would have to enter the second market at the same time. Entry at the secondary level must make entry at the primary level significantly more difficult and less likely to occur. The structure and other characteristics of the primary market must be so conducive to noncompetitive performance that the increased difficulty of entry will affect the performance (conduct) of the vertically integrated firm.

(For the full text of the federal guidelines on vertical acquisitions, see Appendix 8C.)

What about foreign competition?

Current federal guidelines state that “analysis of market definition and market measurement applies equally to foreign and domestic firms.” (See Appendix 8B.) These shares may have to be calculated over a longer period of time to account for exchange-rate fluctuations. They may also have to be adjusted to account for import quotas. Finally, market shares may have to be combined if foreign firms appear to be acting in a coordinated or collusive way.


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INDUSTRY FOCUS: DEVELOPMENTS AND CASES How much do antitrust concerns vary by industry?

Potential antitrust issues vary enormously by industry. Acquirers should remain informed of major regulatory and deregulatory developments in their industry and in industries that are of interest to them as a potential acquirer. Regulatory and deregulatory developments can change the business climate dramatically. Such events include new industrial policies arising from executive branch initiatives, new federal and state laws relating to industries, and new court decisions interpreting those laws. These all work together to create an antitrust climate for various industries. Sellers, too, should be aware of these issues. Since antitrust is an area of great caution for many acquirers, sellers need to be ready to answer an acquirer’s general antitrust questions. In conjunction with the federal laws, there are state laws that can restrict mergers. Under federal law (the McCarran-Ferguson Act, enacted as Title 15 of the U.S. Code, section 1011ff.), states are given broad authority to regulate mergers involving insurance companies. States have similar authority in certain other areas in which the states have special regulatory jurisdiction, such as the alcoholic beverages industry.

Could you give an example of regulatory and deregulatory events in a key industry— for example, defense?

Antitrust concerns are very relevant in the defense industry. There was dramatic consolidation in that industry throughout the 1990s. A key deregulatory event was the April 1994 agreement by a panel of officials from the DOJ, the FTC, and the Department of Defense to develop special standards to apply to defense acquisitions. The group declared that A broad range of efficiencies may be taken into account by the enforcement agencies in the exercise of prosecutorial discretion, and are sometimes taken into account by courts. Efficiencies will not carry much weight if they can be achieved through less anticompetitive means than mergers (for example, a temporary teaming arrangement), and must be demonstrated by clear evi-

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dence. In a situation where a merger between the only two firms in a market is proposed, a “winner take all” competition between the firms will almost always be preferable to a merger. A merger to monopoly could be preferable only in special circumstances and when the net benefit of efficiencies is greater than the anticompetitive effect.34

After development of the new standards, approval of defense mergers came more swiftly. A series of major defense mergers occurred during the 1990s, when antitrust regulation tended to be more liberal. The bestknown of these transactions were horizontal transactions between competitors, including Northrop and Grumman (1994), Lockheed and Martin Marietta (1995), Boeing and Rockwell (1996), Boeing and McDonnellDouglas (1997), and Hughes and Raytheon (1997). This caused a higher degree of concentration in the marketplace. As of 2010, there were only four large defense contractors: Lockheed Martin, Boeing, Northrop Grumman, and Raytheon.35

What has been happening in telecommunications with respect to antitrust?

In the telecommunications arena, for example, a key regulatory event was the 1982 consent decree (called the Modification of Final Judgment) that led to the breakup of AT&T and the creation of the system of Bell operating companies offering local telephone service. A key deregulatory event was the Telecommunications Act of 1996. Since the law was enacted, there have been several large telecommunications mergers, notably WorldCom and MFS Communications (1996) and then MCI (1998), Bell Atlantic and NYNEX (1997) and then GTE (2000), Sprint Nextel and Clearwire (2008), and Verizon Wireless and Alltel (2008). The DOJ approved Verizon Wireless’s purchase of Alltel as long as Verizon agreed to divest 100 markets in 22 different states. The divestitures covered North Dakota and South Dakota in their entirety; significant parts of Colorado, Georgia, Kansas, Montana, South Carolina, Utah, and Wyoming; and smaller portions of Alabama, Arizona, California, Idaho, Illinois, Iowa, Minnesota, Nebraska, Nevada, New Mexico, North Carolina, Ohio, and Virginia. The FCC later approved the acquisition with additional conditions.36 Verizon Wireless then sought DOJ and FTC permission to


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divest these same assets to AT&T—a process that is still pending as we go to press.37 The rate of approval has been high, but so too has the wait for it—in some cases lasting more than a year.

Could you give an example of a very large transaction that triggered antitrust scrutiny, and describe the results?

One of the largest and best-known examples is the $82 billion ExxonMobil merger, which was conditionally approved by the Federal Trade Commission on November 30, 1999. The new firm, called Exxon Mobil Corp. (XOM), came into being after predecessor firms complied with a government request to sell a combined total of $2 billion in assets. This was an all-time record—twice the size of the largest previous FTC-ordered divestiture. To satisfy FTC antitrust concerns, the new company was required to divest itself of 2,431 gasoline stations, pipeline interests in Alaska and the Southeast, an oil refinery in California, and other assets. The FTC also required that ■ ■

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Exxon sell its 128,000-barrel-per-day Benicia refinery.38 Exxon divest 85 Exxon stations in the San Francisco Bay area and 275 supply agreements for other California locations. Exxon be prohibited from using the Exxon name to sell diesel and gasoline in California for up to 12 years. Exxon and Mobil sell control of some of the production of paraffinic base oil, the foundation for most of the world’s finished lubricants. The firms sell their interests in one of two pipelines that ship gasoline to the Mid-Atlantic. Mobil sell its unused space in the trans-Alaska pipeline.

FTC Chairman Robert Pitofsky said in an interview with Associated Press reporters that this large, FTC-ordered asset sale would prevent unfair competition among gasoline retailers, as well as unfair pricing to consumers.

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The agreement gave the firm nine months to complete its divestitures, except for the sale of Exxon’s Benicia refinery and its gasoline stations in California, which Exxon was allowed to sell to a single buyer within 12 months. The FTC also ordered 1,740 gasoline stations sold on the East Coast, where Exxon and Mobil sell more gasoline than others. Exxon was required to sell stations that it owned, operated, or leased in New York, Connecticut, Rhode Island, Massachusetts, Vermont, New Hampshire, and Maine. Mobil was similarly ordered to make divestitures in New Jersey, Pennsylvania, Delaware, Maryland, Virginia, and the District of Columbia. The FTC also considered how Exxon and Mobil would be treating their service station owners and their employees, who stood to suffer in the wake of the merger and the related antitrust action. Exxon and Mobil station dealers in the Northeast, represented by the National Coalition of Petroleum Retailers, had threatened to sue if their rights were not protected in the merger and the resulting sell-offs. To resolve this issue, the FTC said that one or at most two other oil firms could take over the operations of Exxon and Mobil on the East Coast. The new owners could use the names “Exxon” and “Mobil,” and accept their credit cards for up to 10 years. The FTC took public comment for 30 days (during December 1999) before giving final approval to bidders for the assets at the end of that month. Since that time, ExxonMobil, already the world’s largest public company, with $12 billion in revenues, has continued to acquire. On January 20, 2010, the House Subcommittee on Energy and Environment held a hearing titled “The ExxonMobil-XTO Merger: Impacts on U.S. Energy Markets,” with testimony from the CEOs of the respective corporations.39 INTERNATIONAL ANTITRUST AND OTHER ECONOMIC LAW

Every country has its own antitrust laws. For a guide to antitrust law outside the United States, deal makers can consult professional service firms. Many of these have produced guides to global antitrust.40 How does international economic law come into the picture?

International law, including international antitrust law, is an intricate network of regulations and guidelines including international agreements,


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multinational treaties, and policies imposed by international bodies. Here is a list of such areas, adapted from a list by Joel P. Trachtman, Professor of International Law and Academic Dean at the Fletcher School of Law and Diplomacy, Tufts University. ■ ■

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Domestic laws involving international transactions International trade law, including both the international law created by members of the World Trade Organization and the United Nations and domestic trade laws Law pertaining to economic regions created by unification, association, or agreement, including the law of the European Union, the North American Free Trade Association, and the Latin American regional agreement Private international law, including international choice of law, choice of forum, enforcement of judgments, and the law of international commerce International regulation involving business (for example, to list the topics covered in this book, antitrust, intellectual property, product safety, labor, environment, labor, securities, and taxes) International financial law, including private transactional law, regulatory law, the law of foreign direct investment, and international monetary law, including the law of the International Monetary Fund and the World Bank

Clearly, few acquirers can or should master all these areas. But acquirers would be wise to run this checklist by the management or advisors of a candidate company to see if any red flags arise. Then the acquirer can focus on those.

What are the primary U.S. laws and international agreements affecting U.S. companies?

In the United States, there are laws pertaining to customs, tariffs, and quotas. These are administered by the Department of Commerce. In addition, there are several international agreements that are of general relevance. The two broadest of these are the United Nations Conven-

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tion on Contracts for the International Sale of Goods and the General Agreement on Tariffs and Trade (GATT). The UN Convention on Contracts for the International Sale of Goods covers a broad variety of issues pertaining to the sale of goods, including ■ ■ ■

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Formation of contracts Sale of goods Obligations of the seller (delivery of the goods and handing over of documents, conformity of the goods, third-party claims, and remedies for breach of contract by the seller) Obligations of the buyer (payment of the price, taking delivery, remedies for breach of contract by the buyer, and passing of risk) Obligations of both the seller and the buyer (provisions common to the obligations both of the seller and of the buyer) Installment contracts Damages Interest Exemptions41 Effects of avoidance Preservation of goods

Any acquirer of a company that sells goods abroad should check for compliance with these standards. The General Agreement on Tariffs and Trade (GATT), a better-known treaty, is the trade agreement that founded the aforementioned World Trade Organization (WTO), representing 117 nations. This group, which monitors more than 10,000 goods and services, met most recently in the fall of 2009 in Geneva, Switzerland, where it faced organized protests from labor and environmental groups.42 Despite its unpopularity with some, GATT is enforceable, and checking for compliance with it can be an important part of the due diligence work for a candidate company that is involved in international trade. GATT is still influential, and is often cited in trade negotiations.43 What about export controls? What should an acquirer know about them?

The prudent acquirer will ensure that the company it is buying conforms to U.S. export controls. If a company exports goods, it will need an export


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license prior to shipment. Here is a checklist of areas monitored when awarding such licenses, according to the most recent report of the U.S. Department of Commerce: ■ ■ ■ ■ ■ ■

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Crime control Human rights Regional stability Anti-terrorism controls Embargoes and other special controls Toxic chemicals, chemical precursors, and associated equipment, technology, and software Biological agents and associated equipment and technology Missile technology controls Encryption Significant items: “hot section” technology Nuclear nonproliferation Surreptitious listening Entity list

For more details, see the 2010 Report on Foreign Policy-Based Export Controls, U.S. Department of Commerce, Bureau of Industry and Security (http://www.bis.doc.gov/news/2010/2010_fpreport.pdf).

CONCLUDING COMMENTS

Antitrust issues are paramount in many mergers, particularly those involving candidate companies of significant size. Interested parties should determine early on how likely it is that they will be required to obtain the necessary consents, how long this will take, and how difficult and expensive it will be. Furthermore, thorough diligence in the area of business conduct requires some general knowledge of international economic law. As in any other legal area, consulting with qualified legal counsel is imperative. When the procedures and the criteria for obtaining consents are well defined, this regulatory “audit” can be performed relatively quickly and reliably, enabling the acquirer to focus on other issues of importance, as outlined in the following chapters.

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APPENDIX

8A

The Framework of Antitrust Law and Regulation in the United States

I. Statutes Enforced by the Antitrust Division A. Sherman Antitrust Act, 15 U.S.C. §§ 1–7 B. Wilson Tariff Act, 15 U.S.C. §§ 8–11 C. Clayton Act, 15 U.S.C. §§ 12–27 D. Antitrust Civil Process Act, 15 U.S.C. §§ 1311–14 E. International Antitrust Enforcement Assistance Act of 1994, 15 U.S.C. §§ 6201–12 II. Statutes Used in Criminal Antitrust Investigations and Prosecutions A. Offenses That Arise from Conduct Accompanying a Sherman Act Violation 1. Conspiracy; Aiding and Abetting 2. Fraud 3. Money Laundering 4. Tax Offenses B. Offenses Involving the Integrity of the Investigative Process 1. Obstruction 2. Perjury and False Statements 3. Criminal Contempt __________ Note: Numbering system edited for clarity. Source: http://www.justice.gov/atr/public/divisionmanual/chapter2.pdf.


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C. Procedural Statutes D. Statutes of Limitation E. Victim and Witness Rights 1. Attorney General Guidelines 2. Statutes Governing Victims’ Rights and Services for Victims F. Sentencing 1. General Provisions 2. Probation 3. Fines 4. Imprisonment 5. Restitution 6. Miscellaneous III. Statutes Affecting the Competition Advocacy of the Antitrust Division A. Statutory Antitrust Immunities 1. Agricultural Immunities 2. Export Trade Immunities 3. Insurance Immunities 4. Labor Immunities 5. Fishing Immunities 6. Defense Preparedness 7. Newspaper Joint Operating Arrangements 8. Professional Sports 9. Small Business Joint Ventures 10. Local Governments B. Statutes Relating to the Regulated Industries Activities of the Antitrust Division 1. Banking a. Bank Merger Act, 12 U.S.C. § 1828(c) b. Bank Holding Company Act of 1956, 12 U.S.C. §§ 1841-50, 1971-78 2. Communications a. Communications Act of 1934, as amended by the Telecommunications Act of 1996, 47 U.S.C. §§ 151-161, et alia

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b. Cable Communications Policy Act of 1984, as amended by the 1996 Telecommunications Act, 47 U.S.C. §§ 521-573 3. Foreign Trade a. Tariff Act of 1930 §337. Under this statute, the International Trade Commission (ITC) evaluates claims of unfair trade practices involving the importation of articles into the United States (primarily with regard to intellectual property rights). The ITC is required to seek the Department’s advice before making a final determination. The Department may also participate in the interagency group that advises whether to disapprove the ITC’s findings and proposed relief. b. Trade Act of 1974, 19 U.S.C. (various sections), allows American businesses claiming serious injury substantially caused by increased imports to petition the ITC for tariff and quota relief under the socalled “escape clause.” The Act also empowers the President to take action to support trade agreements, or to address “market disruption” from communist countries. c. The Trade Expansion Act of 1962 § 232, 19 U.S.C. §1862, requires the President to take action to control imports that could threaten national security. 4. Energy a. Department of Energy Organization Act, 42 U.S.C. §§ 7101-7352 and various laws affecting atomic energy, federal coal leasing, outer continental shelf, naval petroleum reserves, national petroleum reserves in Alaska, and deep water ports. 5. Transportation a. Shipping Act of 1984, 46 U.S.C. app. §§ 1701-19, grants carriers antitrust immunity under certain conditions. C. Statutes Relating to Joint Research and Development, Production, and Standards Development


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IV. Antitrust Division Guidelines A. Merger Guidelines B. Antitrust Guidelines for the Licensing of Intellectual Property C. Antitrust Enforcement Guidelines for International Operations D. Statements of Antitrust Enforcement Policy and Analytical Principles Relating to Health Care and Antitrust

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APPENDIX

8B

Revision to the Horizontal Merger Guidelines Issued by the U.S. Department of Justice and the Federal Trade Commission

0. PURPOSE, UNDERLYING POLICY ASSUMPTIONS AND OVERVIEW

These Guidelines outline the present enforcement policy of the Department of Justice and the Federal Trade Commission (the “Agency”) concerning horizontal acquisitions and mergers (“mergers”) subject to section 7 of the Clayton Act, to section 1 of the Sherman Act, or to section 5 of the FTC Act. They describe the analytical framework and specific standards normally used by the Agency in analyzing mergers. By stating its policy as simply and clearly as possible, the Agency hopes to reduce the uncertainty associated with enforcement of the antitrust laws in this area. Although the Guidelines should improve the predictability of the Agency’s merger enforcement policy, it is not possible to remove the exercise of judgment from the evaluation of mergers under the antitrust laws. Because the specific standards set forth in the Guidelines must be applied to a broad range of possible factual circumstances, mechanical application of those standards may provide misleading answers to the economic questions raised under the antitrust laws. Moreover, information is often incomplete and the picture of competitive conditions that develops from historical __________ Source: Guidelines originally issued April 8, 1997, including all current revisions. Reprinted without endnotes, except for Section 4, Efficiencies, from http://www.justice.gov/atr/public/guidelines/ horiz_book/22.html.


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evidence may provide an incomplete answer to the forward-looking inquiry of the Guidelines. Therefore, the Agency will apply the standards of the Guidelines reasonably and flexibly to the particular facts and circumstances of each proposed merger.

0.1 Purpose and Underlying Policy Assumptions of the Guidelines

The Guidelines are designed primarily to articulate the analytical framework the Agency applies in determining whether a merger is likely substantially to lessen competition, not to describe how the Agency will conduct the litigation of cases that it decides to bring. Although relevant in the latter context, the factors contemplated in the Guidelines neither dictate nor exhaust the range of evidence that the Agency must or may introduce in litigation. Consistent with their objective, the Guidelines do not attempt to assign the burden of proof, or the burden of coming forward with evidence, on any particular issue. Nor do the Guidelines attempt to adjust or reapportion burdens of proof or burdens of coming forward as those standards have been established by the courts. Instead, the Guidelines set forth a methodology for analyzing issues once the necessary facts are available. The necessary facts may be derived from the documents and statements of both the merging firms and other sources. Throughout the Guidelines, the analysis is focused on whether consumers or producers “likely would” take certain actions, that is, whether the action is in the actor’s economic interest. References to the profitability of certain actions focus on economic profits rather than accounting profits. Economic profits may be defined as the excess of revenues over costs where costs include the opportunity cost of invested capital. Mergers are motivated by the prospect of financial gains. The possible sources of the financial gains from mergers are many, and the Guidelines do not attempt to identify all possible sources of gain in every merger. Instead, the Guidelines focus on the one potential source of gain that is of concern under the antitrust laws: market power. The unifying theme of the Guidelines is that mergers should not be permitted to create or enhance market power or to facilitate its exercise. Market power to a seller is the ability profitably to maintain prices above competitive levels for a significant period of time. In some circumstances,

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a sole seller (a “monopolist”) of a product with no good substitutes can maintain a selling price that is above the level that would prevail if the market were competitive. Similarly, in some circumstances, where only a few firms account for most of the sales of a product, those firms can exercise market power, perhaps even approximating the performance of a monopolist, by either explicitly or implicitly coordinating their actions. Circumstances also may permit a single firm, not a monopolist, to exercise market power through unilateral or non-coordinated conduct—conduct the success of which does not rely on the concurrence of other firms in the market or on coordinated responses by those firms. In any case, the result of the exercise of market power is a transfer of wealth from buyers to sellers or a misallocation of resources.44 Market power also encompasses the ability of a single buyer (a “monopsonist”), a coordinating group of buyers, or a single buyer, not a monopsonist, to depress the price paid for a product to a level that is below the competitive price and thereby depress output. The exercise of market power by buyers (“monopsony power”) has adverse effects comparable to those associated with the exercise of market power by sellers. In order to assess potential monopsony concerns, the Agency will apply an analytical framework analogous to the framework of these Guidelines. While challenging competitively harmful mergers, the Agency seeks to avoid unnecessary interference with the larger universe of mergers that are either competitively beneficial or neutral. In implementing this objective, however, the Guidelines reflect the congressional intent that merger enforcement should interdict competitive problems in their incipiency. . . .

1. MARKET DEFINITION, MEASUREMENT AND CONCENTRATION 1.0 Overview

A merger is unlikely to create or enhance market power or to facilitate its exercise unless it significantly increases concentration and results in a concentrated market, properly defined and measured. Mergers that either do not significantly increase concentration or do not result in a concentrated market ordinarily require no further analysis.


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The analytic process described in this section ensures that the Agency evaluates the likely competitive impact of a merger within the context of economically meaningful markets—i.e., markets that could be subject to the exercise of market power. Accordingly, for each product or service (hereafter “product”) of each merging firm, the Agency seeks to define a market in which firms could effectively exercise market power if they were able to coordinate their actions. Market definition focuses solely on demand substitution factors— i.e., possible consumer responses. Supply substitution factors—i.e., possible production responses—are considered elsewhere in the Guidelines in the identification of firms that participate in the relevant market and the analysis of entry. A market is defined as a product or group of products and a geographic area in which it is produced or sold such that a hypothetical profit-maximizing firm, not subject to price regulation, that was the only present and future producer or seller of those products in that area likely would impose at least a “small but significant and nontransitory” increase in price, assuming the terms of sale of all other products are held constant. A relevant market is a group of products and a geographic area that is no bigger than necessary to satisfy this test. The “small but significant and nontransitory” increase in price is employed solely as a methodological tool for the analysis of mergers: it is not a tolerance level for price increases. Absent price discrimination, a relevant market is described by a product or group of products and a geographic area. In determining whether a hypothetical monopolist would be in a position to exercise market power, it is necessary to evaluate the likely demand responses of consumers to a price increase. A price increase could be made unprofitable by consumers either switching to other products or switching to the same product produced by firms at other locations. The nature and magnitude of these two types of demand responses respectively determine the scope of the product market and the geographic market. In contrast, where a hypothetical monopolist likely would discriminate in prices charged to different groups of buyers, distinguished, for example, by their uses or locations, the Agency may delineate different relevant markets corresponding to each such buyer group. Competition for sales to each such group may be affected differently by a particular merger and markets are delineated by evaluating the demand response of each such buyer

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group. A relevant market of this kind is described by a collection of products for sale to a given group of buyers. Once defined, a relevant market must be measured in terms of its participants and concentration. Participants include firms currently producing or selling the market’s products in the market’s geographic area. In addition, participants may include other firms depending on their likely supply responses to a “small but significant and nontransitory” price increase. A firm is viewed as a participant if, in response to a “small but significant and nontransitory” price increase, it likely would enter rapidly into production or sale of a market product in the market’s area, without incurring significant sunk costs of entry and exit. Firms likely to make any of these supply responses are considered to be “uncommitted” entrants because their supply response would create new production or sale in the relevant market and because that production or sale could be quickly terminated without significant loss. Uncommitted entrants are capable of making such quick and uncommitted supply responses that they likely influenced the market premerger, would influence it post-merger, and accordingly are considered as market participants at both times. This analysis of market definition and market measurement applies equally to foreign and domestic firms. If the process of market definition and market measurement identifies one or more relevant markets in which the merging firms are both participants, then the merger is considered to be horizontal. Sections 1.1 [et. seq.] describe in greater detail how product and geographic markets will be defined, how market shares will be calculated and how market concentration will be assessed. 1.1 Product Market Definition

The Agency will first define the relevant product market with respect to each of the products of each of the merging firms. 1.11 General Standards

Absent price discrimination, the Agency will delineate the product market to be a product or group of products such that a hypothetical profit-maximizing firm that was the only present and future seller of those products (“monopolist”) likely would impose at least a “small but significant and non-


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transitory” increase in price. That is, assuming that buyers likely would respond to an increase in price for a tentatively identified product group only by shifting to other products, what would happen? If the alternatives were, in the aggregate, sufficiently attractive at their existing terms of sale, an attempt to raise prices would result in a reduction of sales large enough that the price increase would not prove profitable, and the tentatively identified product group would prove to be too narrow. Specifically, the Agency will begin with each product (narrowly defined) produced or sold by each merging firm and ask what would happen if a hypothetical monopolist of that product imposed at least a “small but significant and nontransitory” increase in price, but the terms of sale of all other products remained constant. If, in response to the price increase, the reduction in sales of the product would be large enough that a hypothetical monopolist would not find it profitable to impose such an increase in price, then the Agency will add to the product group the product that is the next-best substitute for the merging firm’s product. In considering the likely reaction of buyers to a price increase, the Agency will take into account all relevant evidence, including, but not limited to, the following: 1. evidence that buyers have shifted or have considered shifting purchases between products in response to relative changes in price or other competitive variables; 2. evidence that sellers base business decisions on the prospect of buyer substitution between products in response to relative changes in price or other competitive variables; 3. the influence of downstream competition faced by buyers in their output markets; and 4. the timing and costs of switching products. The price increase question is then asked for a hypothetical monopolist controlling the expanded product group. In performing successive iterations of the price increase test, the hypothetical monopolist will be assumed to pursue maximum profits in deciding whether to raise the prices of any or all of the additional products under its control. This process will continue until a group of products is identified such that a hypothetical monopolist over that group of products would profitably

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impose at least a “small but significant and nontransitory” increase, including the price of a product of one of the merging firms. The Agency generally will consider the relevant product market to be the smallest group of products that satisfies this test. In the above analysis, the Agency will use prevailing prices of the products of the merging firms and possible substitutes for such products, unless premerger circumstances are strongly suggestive of coordinated interaction, in which case the Agency will use a price more reflective of the competitive price. However, the Agency may use likely future prices, absent the merger, when changes in the prevailing prices can be predicted with reasonable reliability. Changes in price may be predicted on the basis of, for example, changes in regulation which affect price either directly or indirectly by affecting costs or demand. In general, the price for which an increase will be postulated will be whatever is considered to be the price of the product at the stage of the industry being examined. In attempting to determine objectively the effect of a “small but significant and nontransitory” increase in price, the Agency, in most contexts, will use a price increase of five percent lasting for the foreseeable future. However, what constitutes a “small but significant and nontransitory” increase in price will depend on the nature of the industry, and the Agency at times may use a price increase that is larger or smaller than five percent.

1.12 Product Market Definition in the Presence of Price Discrimination

The analysis of product market definition to this point has assumed that price discrimination—charging different buyers different prices for the same product, for example—would not be profitable for a hypothetical monopolist. A different analysis applies where price discrimination would be profitable for a hypothetical monopolist. Existing buyers sometimes will differ significantly in their likelihood of switching to other products in response to a “small but significant and nontransitory” price increase. If a hypothetical monopolist can identify and price differently to those buyers (“targeted buyers”) who would not defeat the targeted price increase by substituting to other products in response to


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a “small but significant and nontransitory” price increase for the relevant product, and if other buyers likely would not purchase the relevant product and resell to targeted buyers, then a hypothetical monopolist would profitably impose a discriminatory price increase on sales to targeted buyers. This is true regardless of whether a general increase in price would cause such significant substitution that the price increase would not be profitable. The Agency will consider additional relevant product markets consisting of a particular use or uses by groups of buyers of the product for which a hypothetical monopolist would profitably and separately impose at least a “small but significant and nontransitory” increase in price. . . .

2. THE POTENTIAL ADVERSE COMPETITIVE EFFECTS OF MERGERS 2.0 Overview

Other things being equal, market concentration affects the likelihood that one firm, or a small group of firms, could successfully exercise market power. The smaller the percentage of total supply that a firm controls, the more severely it must restrict its own output in order to produce a given price increase, and the less likely it is that an output restriction will be profitable. If collective action is necessary for the exercise of market power, as the number of firms necessary to control a given percentage of total supply decreases, the difficulties and costs of reaching and enforcing an understanding with respect to the control of that supply might be reduced. However, market share and concentration data provide only the starting point for analyzing the competitive impact of a merger. Before determining whether to challenge a merger, the Agency also will assess the other market factors that pertain to competitive effects, as well as entry, efficiencies and failure. This section considers some of the potential adverse competitive effects of mergers and the factors in addition to market concentration relevant to each. Because an individual merger may threaten to harm competition through more than one of these effects, mergers will be analyzed in terms of as many potential adverse competitive effects as are appropriate. Entry, efficiencies, and failure are treated in Sections 3-5.

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2.1 Lessening of Competition through Coordinated Interaction

A merger may diminish competition by enabling the firms selling in the relevant market more likely, more successfully, or more completely to engage in coordinated interaction that harms consumers. Coordinated interaction is comprised of actions by a group of firms that are profitable for each of them only as a result of the accommodating reactions of the others. This behavior includes tacit or express collusion, and may or may not be lawful in and of itself. Successful coordinated interaction entails reaching terms of coordination that are profitable to the firms involved and an ability to detect and punish deviations that would undermine the coordinated interaction. Detection and punishment of deviations ensure that coordinating firms will find it more profitable to adhere to the terms of coordination than to pursue short-term profits from deviating, given the costs of reprisal. In this phase of the analysis, the Agency will examine the extent to which postmerger market conditions are conducive to reaching terms of coordination, detecting deviations from those terms, and punishing such deviations. Depending upon the circumstances, the following market factors, among others, may be relevant: the availability of key information concerning market conditions, transactions and individual competitors; the extent of firm and product heterogeneity; pricing or marketing practices typically employed by firms in the market; the characteristics of buyers and sellers; and the characteristics of typical transactions. Certain market conditions that are conducive to reaching terms of coordination also may be conducive to detecting or punishing deviations from those terms. For example, the extent of information available to firms in the market, or the extent of homogeneity, may be relevant to both the ability to reach terms of coordination and to detect or punish deviations from those terms. The extent to which any specific market condition will be relevant to one or more of the conditions necessary to coordinated interaction will depend on the circumstances of the particular case. It is likely that market conditions are conducive to coordinated interaction when the firms in the market previously have engaged in express collusion and when the salient characteristics of the market have not changed appreciably since the most recent such incident. Previous express collusion


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in another geographic market will have the same weight when the salient characteristics of that other market at the time of the collusion are comparable to those in the relevant market. In analyzing the effect of a particular merger on coordinated interaction, the Agency is mindful of the difficulties of predicting likely future behavior based on the types of incomplete and sometimes contradictory information typically generated in merger investigations. Whether a merger is likely to diminish competition by enabling firms more likely, more successfully or more completely to engage in coordinated interaction depends on whether market conditions, on the whole, are conducive to reaching terms of coordination and detecting and punishing deviations from those terms.

2.11 Conditions Conducive to Reaching Terms of Coordination

Firms coordinating their interactions need not reach complex terms concerning the allocation of the market output across firms or the level of the market prices but may, instead, follow simple terms such as a common price, fixed price differentials, stable market shares, or customer or territorial restrictions. Terms of coordination need not perfectly achieve the monopoly outcome in order to be harmful to consumers. Instead, the terms of coordination may be imperfect and incomplete—inasmuch as they omit some market participants, omit some dimensions of competition, omit some customers, yield elevated prices short of monopoly levels, or lapse into episodic price wars—and still result in significant competitive harm. At some point, however, imperfections cause the profitability of abiding by the terms of coordination to decrease and, depending on their extent, may make coordinated interaction unlikely in the first instance. Market conditions may be conducive to or hinder reaching terms of coordination. For example, reaching terms of coordination may be facilitated by product or firm homogeneity and by existing practices among firms, practices not necessarily themselves antitrust violations, such as standardization of pricing or product variables on which firms could compete. Key information about rival firms and the market may also facilitate reaching terms of coordination. Conversely, reaching terms of coordination may

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be limited or impeded by product heterogeneity or by firms having substantially incomplete information about the conditions and prospects of their rivals’ businesses, perhaps because of important differences among their current business operations. In addition, reaching terms of coordination may be limited or impeded by firm heterogeneity, for example, differences in vertical integration or the production of another product that tends to be used together with the relevant product.

2.12 Conditions Conducive to Detecting and Punishing Deviations

Where market conditions are conducive to timely detection and punishment of significant deviations, a firm will find it more profitable to abide by the terms of coordination than to deviate from them. Deviation from the terms of coordination will be deterred where the threat of punishment is credible. Credible punishment, however, may not need to be any more complex than temporary abandonment of the terms of coordination by other firms in the market. Where detection and punishment likely would be rapid, incentives to deviate are diminished and coordination is likely to be successful. The detection and punishment of deviations may be facilitated by existing practices among firms, themselves not necessarily antitrust violations, and by the characteristics of typical transactions. For example, if key information about specific transactions or individual price or output levels is available routinely to competitors, it may be difficult for a firm to deviate secretly. If orders for the relevant product are frequent, regular and small relative to the total output of a firm in a market, it may be difficult for the firm to deviate in a substantial way without the knowledge of rivals and without the opportunity for rivals to react. If demand or cost fluctuations are relatively infrequent and small, deviations may be relatively easy to deter. By contrast, where detection or punishment is likely to be slow, incentives to deviate are enhanced and coordinated interaction is unlikely to be successful. If demand or cost fluctuations are relatively frequent and large, deviations may be relatively difficult to distinguish from these other sources of market price fluctuations, and, in consequence, deviations may be relatively difficult to deter.


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In certain circumstances, buyer characteristics and the nature of the procurement process may affect the incentives to deviate from terms of coordination. Buyer size alone is not the determining characteristic. Where large buyers likely would engage in long-term contracting, so that the sales covered by such contracts can be large relative to the total output of a firm in the market, firms may have the incentive to deviate. However, this only can be accomplished where the duration, volume and profitability of the business covered by such contracts are sufficiently large as to make deviation more profitable in the long term than honoring the terms of coordination, and buyers likely would switch suppliers. In some circumstances, coordinated interaction can be effectively prevented or limited by maverick firms—firms that have a greater economic incentive to deviate from the terms of coordination than do most of their rivals (e.g., firms that are unusually disruptive and competitive influences in the market). Consequently, acquisition of a maverick firm is one way in which a merger may make coordinated interaction more likely, more successful, or more complete. For example, in a market where capacity constraints are significant for many competitors, a firm is more likely to be a maverick the greater is its excess or divertable capacity in relation to its sales or its total capacity, and the lower are its direct and opportunity costs of expanding sales in the relevant market. This is so because a firm’s incentive to deviate from price-elevating and output-limiting terms of coordination is greater the more the firm is able profitably to expand its output as a proportion of the sales it would obtain if it adhered to the terms of coordination and the smaller is the base of sales on which it enjoys elevated profits prior to the price cutting deviation. A firm also may be a maverick if it has an unusual ability secretly to expand its sales in relation to the sales it would obtain if it adhered to the terms of coordination. This ability might arise from opportunities to expand captive production for a downstream affiliate. 2.2 Lessening of Competition through Unilateral Effects

A merger may diminish competition even if it does not lead to increased likelihood of successful coordinated interaction, because merging firms

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may find it profitable to alter their behavior unilaterally following the acquisition by elevating price and suppressing output. Unilateral competitive effects can arise in a variety of different settings. In each setting, particular other factors describing the relevant market affect the likelihood of unilateral competitive effects. The settings differ by the primary characteristics that distinguish firms and shape the nature of their competition.

2.21 Firms Distinguished Primarily by Differentiated Products

In some markets the products are differentiated, so that products sold by different participants in the market are not perfect substitutes for one another. Moreover, different products in the market may vary in the degree of their substitutability for one another. In this setting, competition may be non-uniform (i.e., localized), so that individual sellers compete more directly with those rivals selling closer substitutes. A merger between firms in a market for differentiated products may diminish competition by enabling the merged firm to profit by unilaterally raising the price of one or both products above the premerger level. Some of the sales loss due to the price rise merely will be diverted to the product of the merger partner and, depending on relative margins, capturing such sales loss through merger may make the price increase profitable even though it would not have been profitable premerger. Substantial unilateral price elevation in a market for differentiated products requires that there be a significant share of sales in the market accounted for by consumers who regard the products of the merging firms as their first and second choices, and that repositioning of the non-parties’ product lines to replace the localized competition lost through the merger be unlikely. The price rise will be greater the closer substitutes are the products of the merging firms, i.e., the more the buyers of one product consider the other product to be their next choice. 2.211 Closeness of the Products of the Merging Firms

The market concentration measures articulated in Section 1 may help assess the extent of the likely competitive effect from a unilateral price elevation by the merged firm notwithstanding the fact that the affected products are


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differentiated. The market concentration measures provide a measure of this effect if each product’s market share is reflective of not only its relative appeal as a first choice to consumers of the merging firms’ products but also its relative appeal as a second choice, and hence as a competitive constraint to the first choice. Where this circumstance holds, market concentration data fall outside . . . safeharbor regions . . . and the merging firms have a combined market share of at least thirty-five percent, the Agency will presume that a significant share of sales in the market are accounted for by consumers who regard the products of the merging firms as their first and second choices. Purchasers of one of the merging firms’ products may be more or less likely to make the other their second choice than market shares alone would indicate. The market shares of the merging firms’ products may understate the competitive effect of concern, when, for example, the products of the merging firms are relatively more similar in their various attributes to one another than to other products in the relevant market. On the other hand, the market shares alone may overstate the competitive effects of concern when, for example, the relevant products are less similar in their attributes to one another than to other products in the relevant market. Where market concentration data fall outside . . . safeharbor regions . . . the merging firms have a combined market share of at least thirty-five percent, and where data on product attributes and relative product appeal show that a significant share of purchasers of one merging firm’s product regard the other as their second choice, then market share data may be relied upon to demonstrate that there is a significant share of sales in the market accounted for by consumers who would be adversely affected by the merger. 2.212 Ability of Rival Sellers to Replace Lost Competition

A merger is not likely to lead to unilateral elevation of prices of differentiated products if, in response to such an effect, rival sellers likely would replace any localized competition lost through the merger by repositioning their product lines. In markets where it is costly for buyers to evaluate product quality, buyers who consider purchasing from both merging parties may limit the

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total number of sellers they consider. If either of the merging firms would be replaced in such buyers’ consideration by an equally competitive seller not formerly considered, then the merger is not likely to lead to a unilateral elevation of prices.

2.22 Firms Distinguished Primarily by Their Capacities

Where products are relatively undifferentiated and capacity primarily distinguishes firms and shapes the nature of their competition, the merged firm may find it profitable unilaterally to raise price and suppress output. The merger provides the merged firm a larger base of sales on which to enjoy the resulting price rise and also eliminates a competitor to which customers otherwise would have diverted their sales. Where the merging firms have a combined market share of at least thirty-five percent, merged firms may find it profitable to raise price and reduce joint output below the sum of their premerger outputs because the lost markups on the foregone sales may be outweighed by the resulting price increase on the merged base of sales. This unilateral effect is unlikely unless a sufficiently large number of the merged firm’s customers would not be able to find economical alternative sources of supply, i.e., competitors of the merged firm likely would not respond to the price increase and output reduction by the merged firm with increases in their own outputs sufficient in the aggregate to make the unilateral action of the merged firm unprofitable. Such non-party expansion is unlikely if those firms face binding capacity constraints that could not be economically relaxed within two years or if existing excess capacity is significantly more costly to operate than capacity currently in use.

3. ENTRY ANALYSIS 3.0 Overview

A merger is not likely to create or enhance market power or to facilitate its exercise, if entry into the market is so easy that market participants, after the merger, either collectively or unilaterally could not profitably maintain a price increase above premerger levels. Such entry likely will


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deter an anticompetitive merger in its incipiency, or deter or counteract the competitive effects of concern. Entry is that easy if entry would be timely, likely, and sufficient in its magnitude, character and scope to deter or counteract the competitive effects of concern. In markets where entry is that easy (i.e., where entry passes these tests of timeliness, likelihood, and sufficiency), the merger raises no antitrust concern and ordinarily requires no further analysis. The committed entry treated in this Section is defined as new competition that requires expenditure of significant sunk costs of entry and exit. The Agency employs a three-step methodology to assess whether committed entry would deter or counteract a competitive effect of concern. The first step assesses whether entry can achieve significant market impact within a timely period. If significant market impact would require a longer period, entry will not deter or counteract the competitive effect of concern. The second step assesses whether committed entry would be a profitable and, hence, a likely response to a merger having competitive effects of concern. Firms considering entry that requires significant sunk costs must evaluate the profitability of the entry on the basis of long term participation in the market, because the underlying assets will be committed to the market until they are economically depreciated. Entry that is sufficient to counteract the competitive effects of concern will cause prices to fall to their premerger levels or lower. Thus, the profitability of such committed entry must be determined on the basis of premerger market prices over the long-term. A merger having anticompetitive effects can attract committed entry, profitable at premerger prices, that would not have occurred premerger at these same prices. But following the merger, the reduction in industry output and increase in prices associated with the competitive effect of concern may allow the same entry to occur without driving market prices below premerger levels. After a merger that results in decreased output and increased prices, the likely sales opportunities available to entrants at premerger prices will be larger than they were premerger, larger by the output reduction caused by the merger. If entry could be profitable at premerger prices without exceeding the likely sales opportunities—opportunities that include preexisting pertinent factors as well as the merger-induced output reduction— then such entry is likely in response to the merger

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The third step assesses whether timely and likely entry would be sufficient to return market prices to their premerger levels. This end may be accomplished either through multiple entry or individual entry at a sufficient scale. Entry may not be sufficient, even though timely and likely, where the constraints on availability of essential assets, due to incumbent control, make it impossible for entry profitably to achieve the necessary level of sales. Also, the character and scope of entrants’ products might not be fully responsive to the localized sales opportunities created by the removal of direct competition among sellers of differentiated products. In assessing whether entry will be timely, likely, and sufficient, the Agency recognizes that precise and detailed information may be difficult or impossible to obtain. In such instances, the Agency will rely on all available evidence bearing on whether entry will satisfy the conditions of timeliness, likelihood, and sufficiency.

3.1 Entry Alternatives

The Agency will examine the timeliness, likelihood, and sufficiency of the means of entry (entry alternatives) a potential entrant might practically employ, without attempting to identify who might be potential entrants. An entry alternative is defined by the actions the firm must take in order to produce and sell in the market. All phases of the entry effort will be considered, including, where relevant, planning, design, and management; permitting, licensing, and other approvals; construction, debugging, and operation of production facilities; and promotion (including necessary introductory discounts), marketing, distribution, and satisfaction of customer testing and qualification requirements. Recent examples of entry, whether successful or unsuccessful, may provide a useful starting point for identifying the necessary actions, time requirements, and characteristics of possible entry alternatives.

3.2 Timeliness of Entry

In order to deter or counteract the competitive effects of concern, entrants quickly must achieve a significant impact on price in the relevant market. The Agency generally will consider timely only those committed entry alternatives that can be achieved within two years from initial planning to


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significant market impact. Where the relevant product is a durable good, consumers, in response to a significant commitment to entry, may defer purchases by making additional investments to extend the useful life of previously purchased goods and in this way deter or counteract for a time the competitive effects of concern. In these circumstances, if entry only can occur outside of the two year period, the Agency will consider entry to be timely so long as it would deter or counteract the competitive effects of concern within the two-year period and subsequently.

3.3 Likelihood of Entry

An entry alternative is likely if it would be profitable at premerger prices, and if such prices could be secured by the entrant. The committed entrant will be unable to secure prices at premerger levels if its output is too large for the market to absorb without depressing prices further. Thus, entry is unlikely if the minimum viable scale is larger than the likely sales opportunity available to entrants. Minimum viable scale is the smallest average annual level of sales that the committed entrant must persistently achieve for profitability at premerger prices. Minimum viable scale is a function of expected revenues, based upon premerger prices, and all categories of costs associated with the entry alternative, including an appropriate rate of return on invested capital given that entry could fail and sunk costs, if any, will be lost. Sources of sales opportunities available to entrants include: (a) the output reduction associated with the competitive effect of concern, (b) entrants’ ability to capture a share of reasonably expected growth in market demand, (c) entrants’ ability securely to divert sales from incumbents, for example, through vertical integration or through forward contracting, and (d) any additional anticipated contraction in incumbents’ output in response to entry. Factors that reduce the sales opportunities available to entrants include: (a) the prospect that an entrant will share in a reasonably expected decline in market demand, (b) the exclusion of an entrant from a portion of the market over the long term because of vertical integration or forward contracting by incumbents, and (c) any anticipated sales expansion by incumbents in reaction to entry, either generalized or targeted at customers approached by the entrant, that utilizes prior irreversible investments in excess production capacity. Demand growth or decline will be viewed as

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relevant only if total market demand is projected to experience long-lasting change during at least the two year period following the competitive effect of concern. . . . 4. EFFICIENCIES

Competition usually spurs firms to achieve efficiencies internally. Nevertheless, mergers have the potential to generate significant efficiencies by permitting a better utilization of existing assets, enabling the combined firm to achieve lower costs in producing a given quantity and quality than either firm could have achieved without the proposed transaction. Indeed, the primary benefit of mergers to the economy is their potential to generate such efficiencies. Efficiencies generated through merger can enhance the merged firm’s ability and incentive to compete, which may result in lower prices, improved quality, enhanced service, or new products. For example, merger-generated efficiencies may enhance competition by permitting two ineffective (e.g., high cost) competitors to become one effective (e.g., lower cost) competitor. In a coordinated interaction context (see Section 2.1), marginal cost reductions may make coordination less likely or effective by enhancing the incentive of a maverick to lower price or by creating a new maverick firm. In a unilateral effects context (see Section 2.2), marginal cost reductions may reduce the merged firm’s incentive to elevate price. Efficiencies also may result in benefits in the form of new or improved products, and efficiencies may result in benefits even when price is not immediately and directly affected. Even when efficiencies generated through merger enhance a firm’s ability to compete, however, a merger may have other effects that may lessen competition and ultimately may make the merger anticompetitive. The Agency will consider only those efficiencies likely to be accomplished with the proposed merger and unlikely to be accomplished in the absence of either the proposed merger or another means having comparable anticompetitive effects. These are termed merger-specific efficiencies.* Only alternatives that are practical in the business situation faced by the __________ *The Agency will not deem efficiencies to be merger-specific if they could be preserved by practical alternatives that mitigate competitive concerns, such as divestiture or licensing. If a merger affects not whether but only when an efficiency would be achieved, only the timing advantage is a mergerspecific efficiency.


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merging firms will be considered in making this determination; the Agency will not insist upon a less restrictive alternative that is merely theoretical. Efficiencies are difficult to verify and quantify, in part because much of the information relating to efficiencies is uniquely in the possession of the merging firms. Moreover, efficiencies projected reasonably and in good faith by the merging firms may not be realized. Therefore, the merging firms must substantiate efficiency claims so that the Agency can verify by reasonable means the likelihood and magnitude of each asserted efficiency, how and when each would be achieved (and any costs of doing so), how each would enhance the merged firm’s ability and incentive to compete, and why each would be merger-specific. Efficiency claims will not be considered if they are vague or speculative or otherwise cannot be verified by reasonable means. Cognizable efficiencies are merger-specific efficiencies that have been verified and do not arise from anticompetitive reductions in output or service. Cognizable efficiencies are assessed net of costs produced by the merger or incurred in achieving those efficiencies. The Agency will not challenge a merger if cognizable efficiencies are of a character and magnitude such that the merger is not likely to be anticompetitive in any relevant market.† To make the requisite determination, the Agency considers whether cognizable efficiencies likely would be sufficient to reverse the merger’s potential to harm consumers in the relevant market, e.g., by preventing price increases in that market. In conducting this analysis,‡ the Agency will not simply compare the magnitude of the cognizable __________ †Section 7 of the Clayton Act prohibits mergers that may substantially lessen competition “in any line of commerce . . . in any section of the country.” Accordingly, the Agency normally assesses competition in each relevant market affected by a merger independently and normally will challenge the merger if it is likely to be anticompetitive in any relevant market. In some cases, however, the Agency in its prosecutorial discretion will consider efficiencies not strictly in the relevant market, but so inextricably linked with it that a partial divestiture or other remedy could not feasibly eliminate the anticompetitive effect in the relevant market without sacrificing the efficiencies in the other market(s). Inextricably linked efficiencies rarely are a significant factor in the Agency’s determination not to challenge a merger. They are most likely to make a difference when they are great and the likely anticompetitive effect in the relevant market(s) is small. ‡The result of this analysis over the short term will determine the Agency’s enforcement decision in most cases. The Agency also will consider the effects of cognizable efficiencies with no short-term, direct effect on prices in the relevant market. Delayed benefits from efficiencies (due to delay in the achievement of, or the realization of consumer benefits from, the efficiencies) will be given less weight because they are less proximate and more difficult to predict.

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efficiencies with the magnitude of the likely harm to competition absent the efficiencies. The greater the potential adverse competitive effect of a merger—as indicated by the increase in the HHI and post-merger HHI from Section 1, the analysis of potential adverse competitive effects from Section 2, and the timeliness, likelihood, and sufficiency of entry from Section 3— the greater must be cognizable efficiencies in order for the Agency to conclude that the merger will not have an anticompetitive effect in the relevant market. When the potential adverse competitive effect of a merger is likely to be particularly large, extraordinarily great cognizable efficiencies would be necessary to prevent the merger from being anticompetitive. In the Agency’s experience, efficiencies are most likely to make a difference in merger analysis when the likely adverse competitive effects, absent the efficiencies, are not great. Efficiencies almost never justify a merger to monopoly or near-monopoly. The Agency has found that certain types of efficiencies are more likely to be cognizable and substantial than others. For example, efficiencies resulting from shifting production among facilities formerly owned separately, which enable the merging firms to reduce the marginal cost of production, are more likely to be susceptible to verification, merger-specific, and substantial, and are less likely to result from anticompetitive reductions in output. Other efficiencies, such as those relating to research and development, are potentially substantial but are generally less susceptible to verification and may be the result of anticompetitive output reductions. Yet others, such as those relating to procurement, management, or capital cost are less likely to be merger-specific or substantial, or may not be cognizable for other reasons.


APPENDIX

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8C

Non-Horizontal Merger Guidelines Issued by the U.S. Department of Justice

4. HORIZONTAL EFFECT FROM NON-HORIZONTAL MERGERS

4.0 By definition, non-horizontal mergers involve firms that do not operate in the same market. It necessarily follows that such mergers produce no immediate change in the level of concentration in any relevant market as defined in . . . of these Guidelines. Although non-horizontal mergers are less likely than horizontal mergers to create competitive problems, they are not invariably innocuous. This section describes the principal theories under which the Department is likely to challenge non-horizontal mergers.

4.1 Elimination of Specific Potential Entrants 4.11 The Theory of Potential Competition

In some circumstances, the non-horizontal merger of a firm already in a market (the “acquired firm”) with a potential entrant to that market (the “acquiring firm”) may adversely affect competition in the market. If the merger effectively removes the acquiring firm from the edge of the market, it could have either of the following effects.

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4.111 Harm to “Perceived Potential Competition”

By eliminating a significant present competitive threat that constrains the behavior of the firms already in the market, the merger could result in an immediate deterioration in market performance. The economic theory of limit pricing suggests that monopolists and groups of colluding firms may find it profitable to restrain their pricing in order to deter new entry that is likely to push prices even lower by adding capacity to the market. If the acquiring firm had unique advantages in entering the market, the firms in the market might be able to set a new and higher price after the threat of entry by the acquiring firm was eliminated by the merger. 4.112 Harm to “Actual Potential Competition”

By eliminating the possibility of entry by the acquiring firm in a more procompetitive manner, the merger could result in a lost opportunity for improvement in market performance resulting [from] the addition of a significant competitor. The more procompetitive alternatives include both new entry and entry through a “toehold” acquisition of a present small competitor.

4.12 Relation between Perceived and Actual Potential Competition

If it were always profit-maximizing for incumbent firms to set price in such a way that all entry was deterred and if information and coordination were sufficient to implement this strategy, harm to perceived potential competition would be the only competitive problem to address. In practice, however, actual potential competition has independent importance. Firms already in the market may not find it optimal to set price low enough to deter all entry; moreover, those firms may misjudge the entry advantages of a particular firm and, therefore, the price necessary to deter its entry.

4.13 Enforcement Standards

Because of the close relationship between perceived potential competition and actual potential competition, the Department will evaluate mergers that raise either type of potential competition concern under a single structural


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analysis analogous to that applied to horizontal mergers. The Department first will consider a set of objective factors designed to identify cases in which harmful effects are plausible. In such cases, the Department then will conduct a more focused inquiry to determine whether the likelihood and magnitude of the possible harm justify a challenge to the merger. In this context, the Department will consider any specific evidence presented by the merging parties to show that the inferences of competitive harm drawn from the objective factors are unreliable. The factors that the Department will consider are as follows. 4.131 Market Concentration

Barriers to entry are unlikely to affect market performance if the structure of the market is otherwise not conducive to monopolization [or] collusion. Adverse competitive effects are likely only if overall concentration, or the largest firm’s market share, is high. The Department is unlikely to challenge a potential competition merger unless overall concentration of the acquired firm’s market is above 1800 HHI (a somewhat lower concentration will suffice if one or more of the factors . . . indicate that effective collusion in the market is particularly likely). Other things being equal, the Department is increasingly likely to challenge a merger as this threshold is exceeded.

4.132 Conditions of Entry Generally

If entry to the market is generally easy, the fact that entry is marginally easier for one or more firms is unlikely to affect the behavior of the firms in the market. The Department is unlikely to challenge a potential competition merger when new entry into the acquiring firm’s market can be accomplished by firms without any specific entry advantages under the conditions stated in Section 3.3. Other things being equal, the Department is increasingly likely to challenge a merger as the difficulty of entry increases above that threshold.

4.133 The Acquiring Firm’s Entry Advantage

If more than a few firms have the same or a comparable advantage in entering the acquired firm’s market, the elimination of one firm is unlikely to have

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any adverse competitive effect. The other similarly situated firm or firms would continue to exert a present restraining influence, or, if entry would be profitable, would recognize the opportunity and enter. The Department is unlikely to challenge a potential competition merger if the entry advantage ascribed to the acquiring firm (or another advantage of comparable importance) is also possessed by three or more other firms. Other things being equal, the Department is increasingly likely to challenge a merger as the number of other similarly situated firms decreases below three and as the extent of the entry advantage over nonadvantaged firms increases. If the evidence of likely actual entry by the acquiring firm is particularly strong, however, the Department may challenge a potential competition merger, notwithstanding the presence of three of more firms that are objectively similarly situated. In such cases, the Department will determine the likely scale of entry, using either the firm’s own documents or the minimum efficient scale in the industry. The Department will then evaluate the merger much as it would a horizontal merger between a firm the size of the likely scale of entry and the acquired firm. 4.134 The Market Share of the Acquired Firm

Entry through the acquisition of a relatively small firm in the market may have a competitive effect comparable to new entry. Small firms frequently play peripheral roles in collusive interactions, and the particular advantages of the acquiring firm may convert a fringe firm into a significant factor in the market. The Department is unlikely to challenge a potential competition merger when the acquired firm has a market share of five percent or less. Other things being equal, the Department is increasingly likely to challenge a merger as the market share of the acquired firm increases above the threshold. The Department is likely to challenge any merger satisfying the other conditions in which the acquired firm has a market share of 20 percent [or] more. 4.135 Efficiencies

As in the case of horizontal mergers, the Department will consider expected efficiencies in determining whether to challenge a potential competition merger. . . .


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4.2 Competitive Problems from Vertical Mergers 4.21 Barriers to Entry from Vertical Mergers

In certain circumstances, the vertical integration resulting from vertical mergers could create competitively objectionable barriers to entry. Stated generally, three conditions are necessary (but not sufficient) for this problem to exist. First, the degree of vertical integration between the two markets must be so extensive that entrants to one market (the “primary market”) also would have to enter the other market (the “secondary market”) simultaneously. Second, the requirement of entry at the secondary level must make entry at the primary level significantly more difficult and less likely to occur. Finally, the structure and other characteristics of the primary market must be otherwise so conducive to noncompetitive performance that the increased difficulty of entry is likely to affect its performance. The following standards state the criteria by which the Department will determine whether these conditions are satisfied. 4.211 Need for Two-Level Entry

If there is sufficient unintegrated capacity in the secondary market, new entrants to the primary market would not have to enter both markets simultaneously. The Department is unlikely to challenge a merger on this ground where post-merger sales (or purchases) by unintegrated firms in the secondary market would be sufficient to service two minimum-efficient-scale plants in the primary market. When the other conditions are satisfied, the Department is increasingly likely to challenge a merger as the unintegrated capacity declines below this level. 4.212 Increased Difficulty of Simultaneous Entry of Both Markets

The relevant question is whether the need for simultaneous entry to the secondary market gives rise to a substantial incremental difficulty as compared to entry into the primary market alone. If entry at the secondary level is easy in absolute terms, the requirement of simultaneous entry to that market is unlikely adversely to affect entry to the primary market. Whatever the difficulties of entry into the primary market may be, the Department is unlikely to challenge a merger on this ground if new entry into the secondary market can be accomplished under the conditions stated in Section 3.3. When entry

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is not possible under those conditions, the Department is increasingly concerned about vertical mergers as the difficulty of entering the secondary market increases. The Department, however, will invoke this theory only where the need for secondary market entry significantly increases the costs (which may take the form of risks) of primary market entry. More capital is necessary to enter two markets than to enter one. Standing alone, however, this additional capital requirement does not constitute a barrier to entry to the primary market. If the necessary [funds] were available at a cost commensurate with the level of risk in the secondary market, there would be no adverse effect. In some cases, however, lenders may doubt that would-be entrants to the primary market have the necessary skills and knowledge to succeed in the secondary market and, therefore, in the primary market. In order to compensate for this risk of failure, lenders might charge a higher rate for the necessary capital. This problem becomes increasingly significant as a higher percentage of the capital assets in the secondary market are long-lived and specialized to that market and, therefore, difficult to recover in the event of failure. In evaluating the likelihood of increased barriers to entry resulting from increased cost of capital, therefore, the Department will consider both the degree of similarity in the essential skills in the primary and secondary markets and the economic life and degree of specialization of the capital assets in the secondary market. Economies of [scale] in the secondary market may constitute an additional barrier to entry to the primary market in some situations requiring twolevel entry. The problem could arise if the capacities of minimum-efficientscale plants in the primary and secondary markets differ significantly. For example, if the capacity of a minimum-efficient-scale plant in the secondary market were significantly greater than the needs of a minimum-efficient-scale plant in the primary market, entrants would have to choose between inefficient operation at the secondary level (because of operating an efficient plant at an inefficient output or because of operating an inefficiently small plant) or a larger than necessary scale at the primary level. Either of these effects could cause a significant increase in the operating costs of the entering firm. 4.213 Structure and Performance of the Primary Market

Barriers to entry are unlikely to affect performance if the structure of the primary market is otherwise not conducive to monopolization or col-


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lusion. The Department is unlikely to challenge a merger on this ground unless overall concentration of the primary market is above 1800 HHI (a somewhat lower concentration will suffice if one or more of the factors discussed in Section 3.4 indicate that effective collusion is particularly likely). Above that threshold, the Department is increasingly likely to challenge a merger that meets the other criteria set forth above as the concentration increases.

4.22 Facilitating Collusion through Vertical Mergers 4.221 Vertical Integration to the Retail Level

A high level of vertical integration by upstream firms into the associated retail market may facilitate collusion in the upstream market by making it easier to monitor price. Retail prices are generally more visible than prices in upstream markets, and vertical mergers may increase the level of vertical integration to the point at which the monitoring effect becomes significant. Adverse competitive consequences are unlikely unless the upstream market is generally conducive to collusion and a large percentage of the products produced there are sold through vertically integrated retail outlets. The Department is unlikely to challenge a merger on this ground unless 1) overall concentration of the upstream market is above 1800 HHI (a somewhat lower concentration will suffice if one or more of the factors discussed in Section 3.4 indicate that effective collusion is particularly likely), and 2) a large percentage of the upstream product would be sold through verticallyintegrated retail outlets after the merger. Where the stated thresholds are met or exceeded, the Department’s decision whether to challenge a merger on this ground will depend upon an individual evaluation of its likely competitive effect. 4.222 Elimination of a Disruptive Buyer

The elimination by vertical merger of a particularly disruptive buyer in a downstream market may facilitate collusion in the upstream market. If upstream firms view sales to a particular buyer as sufficiently important, they may deviate from the terms of a collusive agreement in an effort to secure that business, thereby disrupting the operation of the agreement. The

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merger of such a buyer with an upstream firm may eliminate that rivalry, making it easier for the upstream firms to collude effectively. Adverse competitive consequences are unlikely unless the upstream market is generally conducive to collusion and the disruptive firm is significantly more attractive to sellers than the other firms in its market. The Department is unlikely to challenge a merger on this ground unless 1) overall concentration of the upstream market is 1800 HHI or above (a somewhat lower concentration will suffice if one or more of the factors discussed in Section 3.4 indicate that effective collusion is particularly likely), and 2) the allegedly disruptive firm differs substantially in volume of purchases or other relevant characteristics from the other firms in its market. Where the stated thresholds are met or exceeded, the Department’s decision whether to challenge a merger on this ground will depend upon an individual evaluation of its likely competitive effect.

4.23 Evasion of Rate Regulation

Non-horizontal mergers may be used by monopoly public utilities subject to rate regulation as a tool for circumventing that regulation. The clearest example is the acquisition by a regulated utility of a supplier of its fixed or variable inputs. After the merger, the utility would be selling to itself and might be able arbitrarily to inflate the prices of internal transactions. Regulators may have great difficulty in policing these practices, particularly if there is no independent market for the product (or service) purchased from the affiliate. As a result, inflated prices could be passed along to consumers as “legitimate” costs. In extreme cases, the regulated firm may effectively preempt the adjacent market, perhaps for the purpose of suppressing observable market transactions, and may distort resource allocation in that adjacent market as well as in the regulated market. In such cases, however, the Department recognizes that genuine economies of integration may be involved. The Department will consider challenging mergers that create substantial opportunities for such abuses.

4.24. Efficiencies

As in the case of horizontal mergers, the Department will consider expected efficiencies in determining whether to challenge a vertical


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merger. . . . An extensive pattern of vertical integration may constitute evidence that substantial economies are afforded by vertical integration. Therefore, the Department will give relatively more weight to expected efficiencies in determining whether to challenge a vertical merger than in determining whether to challenge a horizontal merger.

__________ Source: Current edition of U.S. Department of Justice Merger Guidelines, originally issued June 14, 1984. Subsequently revised.


CHAPTER

9

Detecting Exposure under Intellectual Property Law Nam et ipsa scientia potestas est. (Knowledge is power.) —Francis Bacon, Meditationes Sacrae (1597)

INTRODUCTION

When conducting legal due diligence on any company, acquirers should carefully review the status of that company’s intellectual property (IP)—an increasingly vital element in due diligence and corporate valuation. IP ranks high as a source of legal challenges; as mentioned in Chapter 4, copyright, patent, and trademark infringement is a common source of litigation against corporate officers and directors, particularly from suppliers to a corporation. But even setting lawsuits aside, IP matters a great deal to corporate value in this “age of intangibles.”1 This chapter summarizes the major laws governing the users of IP. Knowledge of these laws can help acquirers secure the rights to assets, protect themselves from litigation, and—beyond due diligence—build company value.

Checkpoints

When studying intellectual property for the purpose of buying the company that owns it, three steps are crucial. 1. Make sure the candidate company actually owns the property that it claims to own. That is, the acquirer can check to determine that all copyrights, patents, and trademarks that the 289

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candidate claims to own are registered with the proper authorities. This will increase the acquirer’s ability to prevail in IP litigation, whether as plaintiff or as defendant. 2. Check to ensure that all maintenance fees have been paid, so that all the patents owned by the candidate company are truly active. Sometimes companies believe that they own a patent that is listed on a property schedule, but they have failed to pay the maintenance fees, and so allowed the patent to lapse. In some cases, they are unable to reclaim the patent. 3. Make sure that the candidate company did not infringe the rights of the copyrights, patents, and trademarks held by others, and that it did not commit any other unfair trade practices.2

SCOPE OF INTELLECTUAL PROPERTY LAW What precisely is intellectual property?

Intellectual property comprises any and all intangible assets that are protectable as proprietary. There are three main types of intellectual property: copyrights, patents, and trademarks. Licenses to use such property are a derivative form of intellectual property, analogous to financial derivatives (and sometimes just as risky for unwary investors). All intellectual property is legally protectable. In fact, federal law specifically protects such property. The basis for this protection is found in Article I, Section 8, of the U.S. Constitution. This article states that, among other powers, “Congress shall have power to . . . promote the progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries.” The article also states that Congress has the right to regulate interstate and foreign commerce, making the potential reach of intellectual property law broad indeed. Copyright law grew out of the protection granted to “writings,” patent law developed out of the protection granted to “discoveries,” and trademark law grew out of Congress’s power to regulate commerce.

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COPYRIGHTS What exactly is a copyright, and what laws protect it?

A copyright is the right of ownership extended to an individual who has written or otherwise created a tangible or intangible work, or to an organization (e.g., an employer or publisher) that has paid the individual for the work while retaining right of ownership. Copyrights are protectable under the U.S. Copyright Act of 1976, which was enacted as part of Title 17 of the U.S. Code. State law in this area is inconsistent, and the federal law covering this area includes a provision that effectively gives federal law preeminence over state law when the latter is unclear.

What kinds of intellectual property are protected under copyright law?

In early copyright law, the term writings focused on the written word. The U.S. Copyright Act, amending Chapter 1 of the U.S. Code, broadened this term to include works in a variety of fields, including ■ ■ ■ ■ ■ ■ ■ ■

Literary works Musical works, including any accompanying words Dramatic works, including any accompanying music Pantomimes and choreographic works Pictorial, graphic, and sculptural works Motion pictures and other audiovisual works Sound recordings Architectural works3

Other chapters of the Code specify protections for additional types of property, including computer chips and original designs.4 All these kinds of work may be copyrighted, as long as they are “original” and in a “concrete medium of expression.” A copyright gives the owner exclusive rights to the work, including the right of

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■ ■ ■ ■

Display Distribution Performance (including digital audio transmission) Reproduction

A copyright may also grant to the owner the exclusive right to produce (or license the production of ) derivatives of the work. “Fair use” of the work is exempt from copyright law. There is no “bright line” test for fair use, despite rules of thumb such as “150 words.” Rather, the fairness of use is judged in relation to a number of factors, including ■ ■ ■

■

Nature of the copyrighted work Purpose of the use Size and substantiality of the portion of the copyrighted work used in relation to that work as a whole Potential market for or value of the copyrighted work

The primary global promoter of IP protection is the World Intellectual Property Organization. As of early 2010, this organization had 185 national signatories, including the United States, and was administering 24 international IP treaties.5

How long do copyrights last?

This depends on a number of factors. Copyright law has become very complex, with major changes every few decades and minor changes every few years.6 The main determinants of durations for most copyrights are found in two late-twentieth-century laws: ■ ■

The Copyright Act of 1976 The Copyright Term Extension Act of 1998

Under the 1976 law, the term of copyrights in most cases was the life of the author plus 50 years. This is still the minimum standard globally. Any country joining the World Trade Organization must agree to this standard. It is part of the agreement called Trade-Related Aspects of Intellectual Prop-


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erty Rights (nicknamed TRIPS), negotiated at the end of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT).7 Under the 1998 act (which is still in force as of 2010, despite legal challenges8), the term became longer and more complex: ■

■

■

Life of the author plus 70 years (for unpublished works and for works authored by individuals on or after January 1, 1978; for works by multiple authors, the life span counted is that of the last surviving author) Life of the author plus 95 years (for works published before January 1, 1978, and still protected by copyright at the time of the 1998 law) A period of 120 years from creation (for anonymous or pseudonymous works, or works for hire)

These three bullet points are simplified. There are actually more than 50 different categories of expiration date, based on the year and country of publication, type of authorship, and type of property.9 How does an organization or individual get a copyright?

It is customary to attach a copyright notice to a work. For example, in the beginning of this book, there is a notice: Copyright © 2011 The McGrawHill Companies, Inc. Simply affixing the copyright notice in this manner affords some protection. It is also traditional to register the copyright by filling out a copyright form and sending multiple copies of a work to the Copyright Office of the Library of Congress. However, even without taking such measures, the creator of an original work may assert a copyright claim. What documents pertaining to the candidate company’s copyrights should the due diligence investigator review?10

Key areas include ■

All registered copyrights and applications for copyright registration, including titles of works, authors, owners, publication

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■

■

■

■

■

■

■

dates, filing dates, issue dates, and countries of registration or application. All material unregistered copyrights, including those for software. Documentation concerning the chain of title, including assignments to the company of works created by contract programmers and chain of title opinion letters. Copyright clearance opinion letters evaluating possible infringement. Documentation concerning the recordation of copyright registrations with the U.S. Customs Service. Files concerning a review of software usage for unlicensed copies of copyrighted software. Files concerning copyright assignments, licenses, and security interests. (In some jurisdictions, security interests in copyrights must be perfected in the copyright office and must pertain to a registered copyright.) Files concerning any threatened or pending copyright infringement litigation.

PATENTS What exactly is a patent, and what laws protect it?

A patent is the right of ownership extended to an individual who has invented or otherwise discovered something of value, or to an organization that has paid that individual to do the work involved in the invention or discovery. A patent is typically defined as a grant extended to the owner of an invention (the individual inventor or the entity that owns the invention) that excludes others from making, using, or selling the invention and includes the right to license others to make, use, or sell the invention. Patents are protected under federal law. (All disputes over patents must be resolved in federal courts. Patent protection is not a matter for state law.) As with copyrights, the constitutional basis for patent protection comes from Article I, Section 8, of the U.S. Constitution. Patents are pro-


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tectable under the Patent Cooperation Treaty of 1970, which was incorporated into Title 35 of the U.S. Code. The 1970 Treaty made it possible to seek patent protection for an invention in multiple countries simultaneously by filing an “international” patent application. Currently 142 countries have signed the treaty, which is administered by the WIPO.11

What kinds of intellectual property are protected under patent law?

According the U.S. Patent and Trademark Office, there are three types of patents: ■

■

■

Utility patents may be granted to anyone who invents or discovers any new and useful process, machine, article of manufacture, or composition of matter, or any new and useful improvement thereof. Design patents may be granted to anyone who invents a new, original, and ornamental design for an article of manufacture. Plant patents may be granted to anyone who invents or discovers and asexually reproduces any distinct and new variety of plant.

Patent protection can be extended to inventions that are novel (new and original), useful, and not obvious. Patents may be issued for compositions of matter (chemicals), machines, man-made products, and processing methods. Inventors receive a patent labeled by group, class, and subclass. The four official groups are ■ ■

■

■

Chemical and related arts Communications, radiant energy, weapons, electrical, and computer arts Body treatment and care, heating and cooling, material handling and treatment, mechanical manufacturing, mechanical power, static, and related arts Industrial designs

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Within each of these four groups, there are about 450 classes and 150,000 subclasses.12 The last two items in the earlier list merit some commentary. The definition of “man-made products” is expanding to include inventions in the area of bioengineering. Traditionally, there has been a strict distinction between inventions by people and inventions by nature, but today, the patenting of human genes, drawing as it does on sequences occurring in nature, has complicated that distinction, creating litigation and controversy.13 Also, “processing methods” are now being interpreted more broadly, with authorities granting patents on processes that some consider to be generic, such as reverse auctions.14

How long do patents last?

The duration of patents is generally 20 years, Under TRIPS, mentioned earlier, patents are issued for a nonrenewable period of 20 years, measured from the date of application.15 Inventors who are granted patents in the United States must pay maintenance fees at 3.5, 7.5, and 11.5 years from the grant of the patent.16 Fees vary widely by country, however, and if an acquirer buys a company with patents in 70 countries, it will need to manage the varying patent fee schedules for these patents.

How can an individual or a company get a patent?

The inventor must send a model or a detailed description of the invention to the U.S. Patent and Trademark Office (USPTO), the federal agency charged with administering the patent laws. The USPTO employs examiners who review applications requesting patent protection for an alleged new invention. The average time between patent application and issuance is about 2.5 years, although the process may be much shorter or longer, depending on the situation. Acquirers of intellectual property with a patent pending will want to keep this time frame in mind. The USPTO looks to see whether the applicant for the patent has shown proper “diligence” in filing the application. (For excerpts from the Manual


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of Patent Examination Procedures on the subject of diligence, see Appendix 9B.) If an application is rejected, the inventor may appeal the decision.17

What aspects of the candidate company’s patents should the due diligence investigator review?18

Key areas include: ■

■

■

■

■ ■

■

■

■

All patents and pending patent applications, including filing date, issue date, status, country of issuance or application, and claims coverage. File wrappers (basic cover sheet information) for patent applications and patents with references, including assignments from inventors to the company. Files for any USPTO actions, interferences, continuations, terminal disclaimers, or other USPTO proceedings. Patent searches and opinion letters concerning noninfringement and patentability. Maintenance fee records for any issued patents. Engineers’ and scientists’ notebooks and invention disclosure schedules kept by the company. Files concerning any patent assignments, which should include the right to sue for past infringements. Files concerning any patent licenses (cross licenses), which should not exceed the term of the patent. (As mentioned, a patent lasts only 20 years from the date of application.) Files concerning any threatened or pending patent infringement litigation, whether brought by the company against another firm or brought by another firm against the company.

TRADEMARKS AND SERVICE MARKS What exactly is a trademark, and what laws protect it?

A trademark is the right to use a name associated with a company, product, or concept, and also the right to use a symbol, picture, sound, or even smell

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associated with these entities. The mark can already be in use or can be one that will be used in the future. (A trademark may be assigned to a trade name, which is the name that a company uses to operate its business.) The owner of a trademark has the exclusive right to use that trademark on the product it was intended to identify, and often on related products. Service marks receive the same legal protection as trademarks but are meant to distinguish services rather than products. Trademarks may be protected both by federal statute under the Lanham Act of 1946, which is now part of Section 15 of the U.S. Code, and by a state’s statutory and/or common law.

What kinds of intellectual property are protected under trademark law?

Trademark status may be granted to unique names, symbols, and pictures, and also to unique building designs, color combinations, packaging, presentation and product styles, and even Internet domain names. It is also possible to receive trademark status for identification that does not appear to be distinct or unique, but that over time has developed a secondary meaning identifying it with the product or the seller.

How long do trademarks last?

A trademark is indefinite in duration, so long as the mark continues to be used on or in connection with the goods or services for which it is registered, subject to certain defenses. Rights in trademarks arise through use. Federal registration is recommended. Federally registered trademarks must be renewed every 10 years. A statement of continuing use must be filed between the fifth and sixth years after registration, or the registration is canceled.19

How does a company receive a trademark?

As in the case of a patent, a company registers its trademark with the USPTO. If the trademark is initially approved by an examiner, it is published in the official gazette of the USPTO to notify other parties of the pending approval so that they may oppose the application if they wish.


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As with patents, rejected applicants may appeal. State trademark laws differ, but most states have adopted a version of the Model State Trademark Bill and/or the Uniform Deceptive Trade Practices Act of 1964, which cover trademarks. Under state law, trademarks are protected (even without federal registration) as part of the common law concept referred to as unfair competition.

What is the common law concept of unfair competition?

The law of unfair competition involves wrongs (torts) committed by a party that cause an economic injury to a business through a deceptive or wrongful business practice. (In this usage, unfair competition does not refer to the economic harm imposed by monopolies and oligopolies, which was covered in the previous chapter.)

Can you give an example of a deceptive or wrongful business practice?

There are many kinds of unfair trade practices, including ■

■

■ ■ ■

■

■

■ ■

Bait and switch—unauthorized substitution of one brand of goods for another. Breach of confidentiality—for example, the use of confidential information by a company’s former employee to solicit the company’s customers. Breach of a restrictive covenant. False advertising—using a false offer to lure customers. False representation—making false claims about products or services. Misappropriation—unauthorized use of an intangible asset that is not protected by trademark or copyright laws. Theft of trade secrets—stealing proprietary information from a business (see the discussion later in this chapter). Trade libel—negative untrue statements about a business. Trademark infringement—using another company’s trademark.

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The law regarding unfair competition is part of the common law of each state. In the areas of copyrights, trademarks, and false advertising, federal law may apply (and may preempt state law). In fact, one reason that Congress established the Federal Trade Commission (FTC), described in Chapter 4, was to protect consumers and other businesses from deceptive trade practices. A few states have enacted legislation modeled on the previously mentioned Uniform Deceptive Trade Practices Act of 1964 to ban certain kinds of unfair competition.

What are some review areas for trademarks?

The investigator should review ■

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■ ■

■

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All trademark and service mark registrations and applications, including dates of first use, filing dates, issue dates, classes of goods and services, status, countries of issuance or application, and assignments. All trade names, company names, brand names, and unregistered trademarks and service marks.20 File wrappers for trademark applications and registrations. Files for any office actions, oppositions, cancellations, or other USPTO proceedings. Searches and opinion letters concerning clearance and registrability. Files relating to any Internet domain names registered by the company, including any threatened or pending disputes under domain name dispute policies. Documentation concerning the recording of trademarks with the U.S. Customs Service. Files concerning any trademark assignments, which should include an assignment of goodwill and, if the mark is the subject of an intent-to-use application, an assignment of the business to which the mark pertains. Files concerning any trademark licenses, which should include quality control language. Files concerning any threatened or pending opposition or cancellation proceeding in the USPTO, or any federal or state


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trademark infringement, dilution, false advertising, or unfair competition proceedings involving either the company’s trademarks or the trademarks of another.

TRADE SECRETS What exactly is a trade secret?

A trade secret is “information, including a formula, pattern, compilation, program, device, method, technique, or process” that is kept secret and that derives value from being kept secret.21 Many states have adopted the Uniform Trade Secrets Act to govern this area. Acquirers need to pay special attention to trade secrets given the case of Electro Optical Industries v. White (1999). As described in the Landmark Cases section at the end of this book, the court found that certain types of trade secret disclosures are “inevitable” and therefore are not legally actionable.22

What documents pertaining to trade secrets should be reviewed in a due diligence investigation?

Key areas of review include ■

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All inventions that are not the subject of issued patents, but may be the subject of patent applications. All software developed by or for the company for which confidentiality has been maintained. All other material business that has been kept secret and from which the company derives economic benefit by keeping it secret. Documents reflecting procedures to protect the company’s trade secrets, such as the company’s written confidentiality policies and nondisclosure agreements. Documents reflecting the company’s implementation of such policies, such as by marking materials as “confidential,” restricting access to materials (such as barring entry into sensitive parts of its manufacturing plants), and similar actions.

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■

■ ■

■

■

Documents relating to hiring and exit interviews of technology and other sensitive personnel. Nondisclosure agreements (often called NDAs). Documents reflecting any company policies addressing protection of the trade secrets of others that may be received by the company through authorized disclosure, inadvertent receipt, or competitive intelligence. Documents relating to policies and procedures for receiving unsolicited submissions. Files concerning any trade secret misappropriation litigation, which may involve departed employees, relations with suppliers and customers, or competitive intelligence.

LICENSES AND LICENSE AGREEMENTS What exactly are licenses and license agreements?

The word license means “permission.” A license is the direct granting of permission by a governing entity to a governed entity, as when a local government permits a business to operate within its jurisdiction. A license agreement is an agreement between two peers to use, adapt, sell, or otherwise benefit from an invention or other item of value. An acquirer should try to become a successor to all the candidate company’s licenses and license agreements. As stated in the sample Due Diligence Checklist in the back of this book, licenses may be absolutely essential to the ability of a corporation to continue to conduct its business legally. The buyer should ensure that all such necessary licenses are current and in good order and that these licenses will be readily transferable, or remain valid, in the context of the acquisition transaction. It is generally useful to obtain the advice of special counsel or experts in the particular field (e.g., Federal Communications Commission counsel in the case of broadcasting licenses).

What documents pertaining to licenses should be reviewed in a due diligence investigation?

Key documents include


■

■

■

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All intellectual property licenses in which the company is a licensee, including the names of the parties, dates of expiration, rights granted, and any pertinent restrictions, such as territory or transferability. All intellectual property licenses in which the company is licensor, including the names of the parties, dates of expiration, rights granted, and any pertinent restrictions. Evidence of any registered user filings in countries where such filings are required.

OTHER INTELLECTUAL PROPERTY In addition to copyrights, patents, trademarks, trade secrets, and licenses, what other intellectual property should an acquirer examine?

This list covers most types of intellectual property, but acquirers should also look at the following: ■

■

Goodwill is one important asset. We are not referring to the concept of goodwill used in purchase accounting. (In that concept, goodwill is the difference between the purchase price and book value.) As intellectual property, goodwill is defined as the “expectancy of continued patronage.” Know-how is another distinct asset. It is knowledge within a company of how to perform actions that build company value.

ASSIGNMENTS AND TRANSFERS OF INTELLECTUAL PROPERTY In addition to documents pertaining to copyrights, patents, trademarks, and licenses, what other documents might help establish a company’s claim of intellectual property ownership?

The due diligence investigator should take a close look at any agreements with individual employees or subcontractors, or with other compan-

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ies, to identify any assignments or transfers of intellectual property of any kind. These documents include ■

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■ ■ ■

■

Documents showing assignments of intellectual property to or from the company, including grants of security interests. Documents showing recordation (a written record) of assignments of applications for intellectual property rights, including grants of security interests. Documents showing releases of security interests in intellectual property, and showing the recordation of such releases. Agreements with persons or entities that may create, work with, or have access to the company’s intellectual property (including employees and independent contractors), showing assignment to the company of rights in intellectual property and confidentiality of trade secrets. Agreements relating to databases, processing services, and/or software. Agreements pertaining to know-how, research and development, and technology. Joint venture, partnership, and strategic alliance agreements. Government grants and related agreements. Agreements pertaining to domain names, source codes, and the like. Noncompete and nonsolicitation agreements.

What other types of documents might be usefully examined in a due diligence investigation?

The acquirer should check any files pertaining to actual or potential litigation against the company for infringement of the intellectual property rights of others. As mentioned in Chapter 4, infringement is a common source of litigation from suppliers and competitors. Such litigation has increased in recent years, boosted by an increasing desire to protect technology that has become “standard” technology—that is, indispensable to other technolo-


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gies.23 The due diligence investigator should also look at relevant insurance policies covering such litigation matters.

Once the due diligence investigators have gathered all these files, what should they do?

First, they should maintain copies of the files for use in the event that the candidate company’s claims to intellectual property ownership are ever challenged. Investigators should also examine all these files to see if the company can document the ownership of all the property that it claims to have. If the company lacks such ownership, the acquirer can ask the company to obtain it, or to accept a reduced purchase price reflecting the lack of documentation. Having determined all the property owned by the candidate company, the acquirer is then in a good position to value it. Valuation can be based on current or potential future royalty revenues or other income generated by the property. Most professional service companies have teams specializing in intellectual property valuation, and there are a number of valuation services that specialize in it.

How can a candidate company make sure that the acquirer will not use some of the confidential knowledge that it gains during the intellectual property review?

This should be covered under the confidentiality agreement signed at the outset of the transaction. A sample confidentiality agreement can be found on the Web site for this book.

CONCLUDING COMMENTS

Intellectual property—including copyrights, patents, trademarks, licenses, and trade secrets—is an increasingly important part of the value of many companies today. It can add substantially to a company’s value if its ownership is well documented. At the same time, it can detract from value if

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ownership documentation is faulty, or if the company has violated the intellectual property rights of others. Therefore, the due diligence investigator needs to examine the ownership claims to such assets to ensure that they will be effectively transferred to the acquirer. At the same time, the investigator needs to make sure that the company is not vulnerable to major claims for intellectual property infringement. The investigator who does this work thoroughly will provide a major service to any corporate acquirer—especially in today’s information-based economy.


APPENDIX

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9A

The Intellectual Property “Pyramid”*

Intellectual property in a company forms a pyramid of activities.

Visionary Level Integration Level Profit Center Level Cost Control Level Defensive Level

At the defensive level, the company uses patents as a shield to protect itself from litigation. These companies hope that by creating a “pile of __________ *Julie L. Davis, Principal, Davis & Hosfield Consulting, LLC, Chicago, Illinois; dhllc.com.

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patents” and other intellectual property (IP) bigger than their competitors’ piles, they can shield themselves from litigation because they will be able to negotiate cross licenses rather than go to court. At the cost control level, the company focuses on how to reduce the costs of filing and maintaining its intellectual property rights. Well-executed strategies in this area can save large companies millions of dollars annually. At the profit center level, companies devise ways to continue reducing costs while at the same time generating more revenue from their existing IP through sales, licensing, and patent rights enforcement. At the integration level, the IP function stops focusing exclusively on self-centered activities and reaches out beyond its own department to serve a greater purpose within the organization as a whole. In essence, its activities have been integrated with the activities of other functions and embedded in the company’s day-to-day operations, procedures, and strategies. At the visionary level, the IP function takes on the challenge of identifying future trends in the industry. It identifies future industry and consumer trends, and anticipates technological revolutions. As such, it seeks to develop or acquire the IP that will be necessary to ensure the company’s long-term survival and success. Clearly, understanding such levels can help acquirers gain the most value from the intellectual property that they acquire.


APPENDIX

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9B

Diligence in Filing a Patent Application: Excerpts from the Manual of Patent Examination Procedures

The U.S. Patent and Trademarks Office (USPTO) has defined diligence in applications for patents and trademarks. The following text is composed of verbatim excerpts from the most recently posted Manual of Patent Examination Procedures (Washington, D.C.: Government Printing Office, July 2008). For ease of reading, we have omitted references to cases, and we have not used ellipses (. . .) to show breaks between paragraphs. Key terms include conception (meaning the initial idea for the invention) and reduction to practice (meaning application of the idea in a working invention). “REASONABLE DILIGENCE”—PATENTABILITY

[D]iligence . . . relates to reasonable “attorney-diligence” and “engineering-diligence,” which does not require that “an inventor or his attorney drop all other work and concentrate on the particular invention involved.” Critical Period for Establishing Diligence between One Who Was First to Conceive but Later to Reduce to Practice the Invention

The critical period for diligence for a first conceiver but second reducer begins not at the time of conception of the first conceiver but just prior to the entry in the field of the party who was first to reduce to practice and con-

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tinues until the first conceiver reduces to practice. What serves as the entry date into the field of a first reducer is dependent upon what is being relied on by the first reducer, e.g., conception plus reasonable diligence to reduction to practice; an actual reduction to practice or a constructive reduction to practice by the filing of either a U.S. application or reliance upon priority . . . of a foreign application.

The Entire Period during Which Diligence Is Required Must Be Accounted for by Either Affirmative Acts or Acceptable Excuses

An applicant must account for the entire period during which diligence is required. A 2-day period lacking activity has been held to be fatal. Efforts to exploit an invention commercially do not constitute diligence in reducing it to practice. An actual reduction to practice in the case of a design for a three-dimensional article requires that it should be embodied in some structure other than a mere drawing. (Diligence requires that applicants must be specific as to dates and facts.) The period during which diligence is required must be accounted for by either affirmative acts or acceptable excuses.

Work Relied upon to Show Reasonable Diligence Must Be Directly Related to the Reduction to Practice

The work relied upon to show reasonable diligence must be directly related to the reduction to practice of the invention in issue. [In one case] the court distinguished cases where diligence was not found because inventors either discontinued development or failed to complete the invention while pursuing financing or other commercial activity.

Diligence Required in Preparing and Filing Patent Application

The diligence of attorney in preparing and filing patent application inures to the benefit of the inventor. Conception was established at least as early as the date a draft of a patent application was finished by a patent attorney on behalf of the inventor. Conception is less a matter of signature than it is


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one of disclosure. Attorney does not prepare a patent application on behalf of particular named persons, but on behalf of the true inventive entity. Six days to execute and file application is acceptable.

End of Diligence Period Is Marked by Either Actual or Constructive Reduction to Practice

The end of that period [for diligence may be] fixed by a constructive, rather than an actual, reduction to practice.

__________ Source: http://www.uspto.gov/web/offices/pac/mpep/documents/2100_2138_06.htm#sect2138.06


CHAPTER

10

Detecting Exposure under Consumer Protection Laws Rather a tough customer in argyment. —Charles Dickens, Barnaby Rudge (1841)

INTRODUCTION

Consumers—paying customers—are a company’s main wellspring of revenues, a vital factor in the life of any business. Therefore, an important part of due diligence investigation is the analysis of the candidate company to ensure its compliance with consumer protection laws and respect for consumer interests. In this chapter, we will give an overview of consumer protection laws and regulations, as well as some general principles of consumer relations to consider when assessing a culture. By knowing consumer protection laws, the acquirer can do a more thorough job of litigation analysis—the examination of existing claims against a company to determine their validity and their potential dollar impact. Acquirers cannot be too careful here. As mentioned in Chapter 4, customer lawsuits are a major source of litigation against officers and directors. All the giant product liability cases, such as those involving asbestos or tobacco, began with a first case that changed life for one company, in some cases an acquirer. And as mentioned in an earlier chapter, courts are increasingly declaring successor (that is, acquirer) liability, particularly with respect to product liability claims.

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CONSUMER PROTECTION LAW: AN OVERVIEW What are the main kinds of consumer protection laws?

Consumer protection laws can be found in a variety of sources—notably the following: ■

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Product liability law (including contract law and tort law, discussed later in the chapter) Food and drug law Consumer credit law

PRODUCT LIABILITY LAWS What is product liability?

Product liability refers to the liability of any or all parties involved in the making or selling of a product for harm caused by that product.1 The parties that might be named in a product liability suit include ■

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The manufacturer of the parts that make up the product (component parts) The assembler of the product The wholesaler of the product The retailer of the product The “wholetailer” of the product (a company, often Internet based, that acts as both wholesaler and retailer)

The harm may be done to someone who bought, borrowed, or otherwise came into contact with the product, even if the harm occurs after an alteration of the product by a reseller. (See, for example, Saratoga Fishing Co. v. J. M. Martin & Co., 1997.) Court decisions have established certain ground rules for proving causation—the link between the alleged defect and the alleged harm—and for determining harm. The common point in all such suits is the argument that the product is defective.

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For the purpose of product liability lawsuits, what is the technical definition of “product”?

The term product generally includes some form of manufactured product, such as a lawn mower, but successful court cases have expanded the definition to include nonmanufactured products such as gas, personal residences, pets from pet stores, and even navigational charts.

What exactly is a product “defect”?

The law generally defines three types of defects: ■

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Design defects. These occur when the foreseeable risks of harm posed by the product could have been reduced or avoided by the adoption of a reasonable alternative design, and failure to use the alternative design renders the product not reasonably safe. Manufacturing defects. These occur when the product departs from its intended design, even if all possible care was exercised. Inadequate instructions or warnings defects. These occur when the foreseeable risks of harm posed by the product could have been reduced or avoided by reasonable instructions or warnings, and their omission renders the product not reasonably safe. This covers harms caused by misrepresentations, postsale failure to warn, and postsale failure to recall products.

What is the legal basis for product liability claims?

Product liability claims can be based on either contract law or tort law. ■

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Contract law applies if the defective product breaches a warranty and/or causes economic loss. Tort law applies if there is damage beyond the economic loss as a result of intention, negligence, or strict liability.

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What is the “economic loss” concept in contract law?

This judicially based rule says that when the purchaser of a product sustains economic loss without personal injury or damage to property (other than the product itself), the purchaser must seek a remedy in contract law, not tort law.2

What are the intention, negligence, and strict liability concepts in tort law? ■

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Intentional torts are wrongs that the defendant knew or should have known would occur as a result of his or her action or inaction. Negligent torts occur when the defendant’s actions were unreasonably unsafe. Generally, negligence is the failure to meet some expected standard of care. Strict liability wrongs do not depend on the defendant’s degree of care; if there is a defect in the product, the manufacturer will be liable for it.

Product liability is generally considered a “strict liability” offense. Clearly, this makes the inspection of manufacturing processes an important part of due diligence, as explained at the end of this chapter.

What are the main sources of product liability law?

There is no single federal product liability law. Instead, there is a patchwork of federal and state laws. Federal laws address specific aspects of product safety. These laws, which are periodically updated, include ■ ■ ■ ■

The Consumer Product Safety Improvement Act3 The Flammable Fabrics Act4 The Poison Prevention Packaging Act5 The Federal Hazardous Substances Act6 (see also Chapter 11)

If there is a conflict between state and federal law, federal law takes precedence.


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What regulators have jurisdiction over consumer product safety?

There is a federal agency devoted to this, called the Consumer Product Safety Commission (CPSC). This agency has jurisdiction to enforce the product safety laws just listed. It protects consumers and families from products that pose a fire, electrical, chemical, or mechanical hazard, or that can injure children. It has jurisdiction over about 15,000 types of consumer products, from fireworks to toys to lawn mowers. The commission has also extended its reach into nontraditional areas, such as the health hazards of nanotechnology.7 Some products are covered by other federal agencies. For example, alcohol, tobacco, and firearms are within the jurisdiction of the Department of the Treasury. Cars, trucks, and motorcycles are covered by the Department of Transportation, and foods, drugs, and cosmetics are covered by the Food and Drug Administration. The CPSC is responsible for working to reduce the risk of injuries and deaths from consumer products by ■ ■

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Developing voluntary standards with industry Issuing and enforcing mandatory standards, and banning consumer products if no feasible standard would adequately protect the public Obtaining the recall of products or arranging for their repair Conducting research on potential product hazards Informing and educating consumers through the media, state and local governments, and private organizations and by responding to consumer inquiries8

What about state laws regulating consumer product safety and related liability?

Since state laws can vary greatly, the U.S. Department of Commerce has promulgated a Model Uniform Products Liability Act (MUPLA) for voluntary use by the states.9 Many states have enacted comprehensive product liability statutes. The general law of product liability derives from two sources: tort law and the Uniform Commercial Code.

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Could you review the basics of tort law as they apply to product liability?

Torts, as mentioned in Chapter 4, are wrongs that are recognized by law as grounds for a lawsuit. Tort law is state law, generally created by judges (common law) and by legislatures (statutory law). Tort law, whether created by judges or by legislatures, includes consideration of injury or harm caused by products. While some torts may also be crimes punishable by imprisonment, the aim of tort law is to provide monetary relief to victims for the damages incurred by another person’s actions and to deter others from committing the same harms. The injured person may sue for monetary damages and/or an injunction to prevent the continuation of the wrongful conduct. Monetary damages collectible by the injured party may include compensation for loss of earning capacity, pain and suffering, and/or reasonable medical expenses. Damages may include both present and future expected losses and even a punitive component. The payment of punitive damages is a U.S. phenomenon that has met with criticism in other countries as being out of proportion to the damage caused.10 There has been movement to cap the award of punitive damages, but so far without universal application. (See Honda Motor Company Co., Ltd., et al. v. Oberg, 1994.)

What does the Uniform Commercial Code say about product liability?

The Uniform Commercial Code sets some standards for the sale of goods that have an impact on the manufacture and sale of products. Of special importance is Article 2, which deals primarily with the sale of goods. A major part of Article 2, which has been adopted by a majority of states, describes the implied and express warranties of merchantability in the sale of goods as follows. I. Unless excluded or modified, a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to goods of that kind. . . . II. Goods to be merchantable must [at least]: A. pass without objection in the trade under the contract description; and


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B. in the case of fungible goods, [be] of fair average quality within the description; and C. [be] fit for the ordinary purposes for which such goods are used; and D. run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and E. [be] adequately contained, packaged, and labeled as the agreement may require; and F. conform to the promise or affirmations of fact made on the container or label if any. III. Unless excluded or modified . . . other implied warranties may arise from course of dealing or usage of trade.11

What is the authoritative text on product liability under tort law, and what basic points does it cover?

In 2010, the American Law Institute published the first of two volumes intended to be a comprehensive statement on tort law in the product liability area, entitled Restatement Third, Torts: Liability for Physical and Emotional Harm. The first volume covers the most basic topics of the law of torts: liability for intentional physical harm and for negligence causing physical harm, duty, strict liability, factual cause, and scope of liability (traditionally called proximate cause). A second volume, dealing with affirmative duties, emotional harm, landowner liability, and liability of those who retain independent contractors, is planned for 2011.12 As in preceding editions, this Restatement identifies three types of defects, as outlined earlier in this chapter: defects in design, manufacturing, and instructions or labeling. Importantly, the Restatement covers the liability of a successor to the business of a product seller. In particular, it covers liability for harm caused by defective products that were sold commercially by a predecessor, for a successor’s own postsale failure to warn, and for selling or distributing as one’s own a product manufactured by another. It also covers the related topic of affirmative defenses, dealing with the apportionment of responsibility between or among plaintiffs, sellers and distributors of defective products, and others, as well as with disclaimers,

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limitations, waivers, and other contractual outs as defenses to products liability claims for harm to persons. Finally, the Restatement covers product liability in consumer-sensitive industries such as food and drugs—the focus of our next section.

FOOD AND DRUG LAW What is the basis for consumer protection via food and drug laws?

Food production has been regulated in the United States ever since the dawn of the Industrial Revolution in the mid-1800s. The federal government, however, did not pass major legislation until 1906, when the U.S. Congress enacted the Food and Drug Act and the Meat Inspection Act as Section 21 of the U.S. Code. The Food and Drug Act was later repealed but was replaced with a wide range of consumer protection statutes, including ■

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The Food Additives Amendment of 1957, requiring the evaluation of food additives to establish their safety The Delaney Clause of the Food Additives Act of 1958, forbidding the use in foods of substances that cause cancer in laboratory animals The Food, Drug, and Cosmetic Act of 1938, regulating cosmetics and therapeutic devices The Kefauver-Harris Drug Amendments of 1962, requiring drug manufacturers to show that their drugs are safe The Nutrition Labeling and Education Act of 1990, requiring all packaged foods to carry labels with nutrition information The Food and Drug Administration Amendments Act of 2007, authorizing fees to help fund the FDA’s drug review work

What federal agency regulates consumer protection in the area of food and drugs?

In the United States, food and drugs are regulated by the Food and Drug Administration (FDA). It began as an independent agency, but it has been part of the Department of Health and Human Services since 1979.


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The FDA is responsible for working to achieve better food and drug safety by ■

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Protecting the public health by assuring the safety, effectiveness, and security of human and veterinary drugs, vaccines and other biological products, medical devices, our nation’s food supply, cosmetics, dietary supplements, and products that give off radiation. Regulating tobacco products. Advancing the public health by helping to speed product innovations. Helping the public get the accurate, science-based information that people need to use medicines and foods to improve their health.

In addition to product liability law and food and drug law, there is consumer credit law.

CONSUMER CREDIT LAW What is consumer credit law?

Consumer credit law is an area of law that ensures equal access to credit by creditworthy individuals, and protects consumers from false advertising, exorbitant interest, and other ills associated with credit. Credit enables consumers to purchase goods or services without paying their full cost at the time of the purchase. Consumer credit may be in the form of a credit card, a line of credit, or a loan.

What are the main sources of consumer credit law?

Consumer credit law is embodied primarily in federal and state statutory laws that provide consumers with protection in their transactions. These laws protect consumers and provide guidelines for the credit industry. States have passed various statutes regulating consumer credit. The Uniform Consumer Credit Code has been adopted by 11 states and Guam.13 Its purpose is to protect consumers who are obtaining credit to finance their

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transactions, ensure that adequate credit is provided, and govern the credit industry in general. Congress passed the Consumer Protection Act (as part of U.S. Code Section 15, Chapter 41) in part to regulate the consumer credit industry. It requires creditors to disclose credit terms to consumers who are obtaining credit. The Consumer Protection Act also protects consumers from loan sharks, restricts the garnishing of wages, and established the National Commission on Consumer Finance to investigate the consumer finance industry. Credit card companies and credit reporting agencies are also regulated by the act. The act also prohibits discrimination based on sex or marital status in the extending of credit. It also regulates certain debt collectors. More recently, Congress passed the Wall Street Reform and Consumer Protection Act (Dodd-Frank); this bill was signed into law July 2010 as we went to press.14

CONCLUDING COMMENTS

Consumer issues are too often overlooked in acquisitions, yet they are an important part of any company’s life. Consumers drive the top line of business, bringing in revenues. They also create an important aspect of the company’s general reputation in the financial marketplace. Finally, they can become a formidable adversary in court, with the help of the plaintiffs bar and regulators. Knowledge of consumer protection laws and related global standards can help any acquirer conduct a comprehensive and consumerfriendly due diligence on any transaction. Looking beyond the letter of the law, an acquirer can achieve excellence in consumer relations by following the principles of the Caux Round Table Principles for Business, from Caux, Switzerland, a multinational group.15 The stakeholder principles, in part, read as follows: ■

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We believe in treating all customers with dignity, irrespective of whether they purchase our products and services directly from us or otherwise acquire them in the market. We therefore have a responsibility to: Provide our customers with the highest quality products and services, consistent with their requirements.


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Make every effort to ensure that the health and safety of our customers, as well as the quality of their environment, will be sustained or enhanced by our products and services. Assure respect for human dignity in products offered, in marketing, and in advertising. Respect the integrity of the culture of our customers.

Companies that abide by these five simple principles are well on their way to avoiding litigation from or on behalf of consumers. The following chapter will discuss environmental issues as they impact not only consumers and other stakeholders but also the general public.


CHAPTER

11

Detecting Exposure under Environmental Laws The Good Man pouring from his pitcher clear, But brims the poisoned well. —Herman Melville, Timoleon, 1891

INTRODUCTION

One major source of potential acquirer liability is compliance with applicable environmental laws. Unfortunately, as in many areas of due diligence, good intentions may be of no avail here. An innocent acquirer may well be tainted by environmental crimes committed long ago and far away by the employees of an acquired corporation—sometimes at a level beyond the easy scrutiny of officers and directors. Therefore, this chapter begins with an overview of this complex legal area, followed by some tips on environmental due diligence. A word of advice: environmental law is not just for “smokestack industries.” Most industries—in the manufacturing and service sectors alike—have some connection with the environment. The environment, after all, encompasses land, water, and air, all of which affect one another. A study of the law brings this point home—and shows the way toward due diligence in this area.

ENVIRONMENTAL LAW: AN OVERVIEW What are the main types of environmental laws?

The U.S. Code includes several relevant sections:

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Section 7: Insecticides and Environmental Pest Control Section 16: Conservation Section 22: Various Areas, including International Environmental and Natural Resources, Tropical Forests, and Endangered Species Section 26: Environmental Taxes Section 33: Protection of Navigable Waters, Clean Water Act, Ocean Dumping, Prevention of Pollution from Ships, and Oil Pollution Section 40: Public Property, establishing the Environmental Protection Agency to interpret and enforce environmental laws as found throughout the U.S. Code Section 42: National Drinking Water Regulations, Atomic Energy, National Environmental Policy, Noise Pollution, Development of Energy Sources, Solid Waste Disposal, Clean Air Act, and Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA, aka Superfund), the Energy Policy Act

Following the BP oil spill of April 2010, Section 33 gained attention, but the section with the broadest impact for most acquirers is 42, covering the protection of natural resources, which are defined broadly as “land, fish, wildlife, biota, air, water, ground water, drinking water supplies, and other such resources belonging to, managed by, held in trust by, appertaining to, or otherwise controlled by the United States, any State, or Indian tribe.”

What is the most important environmental law?

There is no dominant environmental law. Instead, there is a patchwork of federal and state laws. ■ ■

Clean Air Act (CAA) aims to curb air pollution.1 Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), also known as “Superfund,” outlaws certain types of pollution, generally defined as the contamination of air, water, or earth by harmful substances.

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Energy Policy Act gives tax breaks for alternative energy investments. Federal Clean Water Act (FCWA) aims to curb the pollution of water, both directly through dumping and indirectly through ground pollution that seeps into reservoirs.2 Nuclear Waste Policy Act aims to achieve safe disposal of nuclear wastes. Resource Conservation and Recovery Act (RCRA) is a comprehensive regulatory statute aimed at controlling solid waste disposal. Toxic Substances Control Act (TSCA) aims to screen new chemicals produced by companies before they enter the environment.

State laws supplement federal laws. Some states have adopted model statutes.3 Some states have their own Environmental Protection Agency.4 In addition, common law (particularly in decisions pertaining to nuisance) provides some remedies; plaintiffs can use nuisance law to seek a judicial remedy for environmental harms. In addition, some states have enacted environmental protection statutes that create a “superlien” on the property of individuals or companies liable for pollution. As mentioned in previous discussions, if there is a conflict between state and federal law, federal law takes precedence.

What agencies are involved in environmental protection?

The primary government agency involved in environmental protection is the Environmental Protection Agency (EPA), founded in 1970. The EPA enforces 30 laws, including the seven key laws listed earlier. In its original charter, the EPA set forth five straightforward tasks focused on coordination, ranging from “Enable coordinated and effective governmental action on behalf of the environment” to “Furnish written comments on environmental impact statements and publish its findings.” Today, the EPA has a broader sense of its mission. The EPA’s Web site states that its purpose is to ensure that

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all Americans are protected from significant risks to human health and the environment where they live, learn and work; national efforts to reduce environmental risk are based on the best available scientific information; federal laws protecting human health and the environment are enforced fairly and effectively; environmental protection is an integral consideration in U.S. policies concerning natural resources, human health, economic growth, energy, transportation, agriculture, industry, and international trade, and these factors are similarly considered in establishing environmental policy; all parts of society—communities, individuals, businesses, and state, local and tribal governments—have access to accurate information sufficient to effectively participate in managing human health and environmental risks; environmental protection contributes to making communities and ecosystems diverse, sustainable and economically productive; and the United States plays a leadership role in working with other nations to protect the global environment.

The EPA Web site states further that to accomplish these goals, the EPA sets national standards that states (and tribes) enforce through their own regulations. If they fail to meet the national standards, the EPA offers support to help them meet those standards. It also enforces regulations and helps companies understand the requirements.5 The broad sweep and messianic tone of this elaborated mission statement make it clear that this agency has zeal for its purpose; its enforcers may not always care much about the niceties of federal vs. state, public vs. private, or U.S. vs. foreign jurisdiction. Thus acquirers had best err on the side of caution when conducting environmental due diligence. So before assuming that any natural resource falls under company jurisdiction, check with a qualified attorney. In addition to the EPA, the Occupational Safety and Health Administration (OSHA) within the Department of Labor (DOL) has regulations affecting the storage and security of hazardous substances. (For more on OSHA, see Chapter 12.) Furthermore, the Department of Energy and the Department of the Interior have regulations that may affect businesses.


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Delineating all these restrictions is beyond the scope of this chapter, but we urge acquirers to request due consideration of such regulations from their advisors.

What kinds of reporting obligations do companies have with respect to any environmental problems that they discover?

Problems may have to be reported (either by the seller or, after closing, by the buyer) to one or more of the following parties: ■ ■ ■ ■

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EPA Insurers Lenders Outside directors (the audit committee or some other committee that is charged with risk and/or legal compliance oversight) Securities and Exchange Commission6 Stock exchanges Shareholders Tenants Unions

CHECKING FOR ENVIRONMENTAL COMPLIANCE How long should an acquirer spend on environmental due diligence?

The amount of time required for environmental due diligence can vary greatly depending on the level needed. Here are some timelines according to one expert: ■

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Screening or assessment for a purchase involving real estate: highly variable, based on the standard used7 Internet search for record of violations: one to two weeks Preliminary assessment under state law: three to five weeks Full site investigation, including soil or groundwater sampling: one to two months

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Remedial investigation/feasibility study, including review of internal and external compliance records and interviews with employees and regulators: six months or more8

Who should be involved in conducting the due diligence investigation?

Ideally, this should be done by an expert professional (such as an attorney or consultant) who is familiar with environmental issues. First and foremost, the investigator should talk to the manager with line responsibility for environmental compliance in the company that is being sold.

In assessing a company’s potential exposure to environmental liability, where should an acquirer start?

Before getting into details, an acquirer should conduct a broad environmental exposure analysis. As mentioned in previous chapters in this section, acquirers need to be particularly sensitive to potential environmental problems that will have an impact on value—by increasing liabilities, decreasing earnings, and/or driving down the stock price. Generally speaking, there are two kinds of problems that can force a reduction in value: the need to pay for legal violations committed by the acquired company in the past (cost of successor liability), and the need to pay to prevent something from happening in the future (cost of ongoing compliance).

What kind of costs might be incurred under successor liability for past problems?

The most significant cost may be the cost of cleaning up environmental damage caused by the seller or one of the seller’s predecessors. This can include charges for removing contaminated soil or purifying tainted groundwater, and can cover not only the site purchased by the buyer, but also adjoining properties or remote locations where hazardous substances generated by the business were used and/or dumped, potentially contaminating the air, ground, or water.


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Any acquirer of an entity that includes real estate should automatically check for environmental compliance at the site and should comply with requirements for worker and community right-to-know filings and dissemination. Moreover, under the Superfund, officers, directors, and even stockholders can be personally liable for cleanup costs, and the companies that contributed to the pollution of a common dump site are jointly and severally liable for such cleanup costs. Finally, even secured lenders that wind up operating or controlling the contaminated property can be liable for cleanup costs. As a result, the buyer must not just approach these problems from his or her own point of view, but must also consider how the lender will react. In addition to cleanup costs, a company can be liable to third parties who have become ill or died as a result of drinking contaminated groundwater, or whose property has been contaminated by pollution emanating from the company’s facilities.

Is an acquirer automatically on the hook for cleaning up past problems?

Not necessarily. First, if the acquirer has purchased assets rather than stock, and has negotiated representations and warranties that place responsibility on the seller, the acquirer may not be liable for the cleanup costs. Furthermore, an acquirer can seek innocent purchaser status. Under SARA, anyone who is in the chain of title becomes responsible for such cleanup, even those with no responsibility for the pollution. One exception is a purchaser who knew nothing about the contamination and conducted appropriate inquiries (due diligence) prior to the purchase.

How can an acquirer conduct appropriate inquiries?

ASTM (originally, the American Society for Testing and Materials) has a number of applicable standards, including ■

“Standard Practice for Limited Environmental Due Diligence: Transaction Screen Process”9

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“Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process”10 “Standard Guide for Environmental Site Assessments: Phase II Environmental Site Assessment Process”11

The first standard is good for a general target screening, but it is not suitable for in-depth due diligence once a target is selected. The other two standards (for actual site assessment) can help an acquirer satisfy one of the requirements to qualify for the innocent landowner, contiguous property owner, or bona fide prospective purchaser limitations on CERCLA liability. That is, an assessment that meets these standards will constitute “all appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice,” as defined under CERCLA.12 What about assessing a target company for ongoing compliance issues? How does an acquirer do that?

Sometimes due diligence may reveal that the acquired company has a history of noncompliance with applicable air or water emissions standards. When the due diligence process discloses such a history of operating problems, the prospective purchaser needs to calculate the cost of bringing the company into compliance and keeping it in compliance. This may involve significant unbudgeted capital costs (to procure needed emissions control equipment, for example) or higher than anticipated operating costs (to ensure that the offending equipment is operated in conformity with applicable environmental standards), or both. In extreme cases, the buyer’s due diligence may disclose that the company (or a particular plant) cannot be economically operated in compliance with environmental law. For example, if the target company has a great deal of real estate, but no ongoing process to ensure compliance with environmental laws, this can be a problem. When it comes to assessing real estate for toxicity, how bad can it get? How can an acquirer analyze what it is purchasing?

An acquirer can get an environmental assessment that follows along the lines of a government investigation known as the Hazard Ranking System


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(HRS), the main mechanism that the EPA uses to place uncontrolled waste sites on its National Priorities List (NPL). The HRS scores sites by assigning numerical values to various pathways based on factors that relate to risk based on conditions at the site. Four pathways can be scored under the HRS: ■ ■

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Groundwater migration (drinking water) Surface water migration (drinking water, human food chain, sensitive environments) Soil exposure (resident population, nearby population, sensitive environments) Air migration (population, sensitive environments)

Each pathway can be scored on three dimensions: ■

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The likelihood that a site has released or has the potential to release hazardous substances into the environment Characteristics of the waste (for example, toxicity and waste quantity) People or sensitive environments (targets) affected by the release

When conducting due diligence for past and ongoing environmental problems, what are the first questions that the acquirer should ask?

Any diligent buyer should work from a comprehensive environmental checklist, or retain a qualified environmental attorney or consultant to do so. An initial list of questions might be as follows: ■

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Were any toxic or hazardous substances used or generated by the candidate company? Are there lagoons or settling ponds that may contain toxic wastes? Are there underground tanks that may have leaked and discharged their contents into the groundwater? What about unregistered, abandoned tanks or “brownfields”? Were any hazardous wastes shipped off site for disposal?

The last two categories are particularly treacherous.

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Why are brownfields so problematic for acquirers?

Brownfields are industrial and commercial properties that have been abandoned or that are idle or underused because of real or perceived environmental contamination. Brownfields create relationship problems with communities. They take up space without affording the opportunity for development, without generating tax revenues, and without using and thus paying for the sewers and utilities that service their area. Furthermore, they contribute to the ugliness and dangers of urban blight. Anecdotal and visual evidence suggests that there are a significant number of these sites nationally. Many of these sites are in the Northeast and Midwest, where, after a period of intense industrial activity (for example, the textile industry in the Northeast and automotive production in the Midwest), plants were shut down or relocated.

Why is off-site shipping of waste problematic?

If the target company shipped wastes to a dump that has been or may be declared a federal Superfund site, the buyer might inherit a substantial liability irrespective of the structure of the transaction (assets versus stock). Moreover, the purchaser may be liable even though it expressly does not assume the liability, if in fact the purchaser does not intend to continue the same business as the predecessor.

What kinds of industries are most likely to have environmental exposure?

The classic asset-based leveraged buyout involving a company in a smokestack industry is the one that is most likely to present environmental concerns, such as the use of landfills for the disposal of waste or the use of heavy metals (such as lead, arsenic, and cadmium) in various industrial processes and paints. Another environmentally sensitive industry is health care. There are regulatory requirements affecting the storage and disposal of medical wastes, and licensing and inspection requirements for X-ray machines.


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Aside from such obvious examples, what other types of acquisitions can pose environmental risks?

Environmental problems are by no means limited to the manufacturing and health care sectors. Warehouses, retail businesses, and service companies may own structures that contain the following problems: ■ ■

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Asbestos in wall insulation or pipe wrapping. Electrical transformers filled with polychlorinated biphenyls (PCBs). As well as electrical transformers, these compounds are used in commercial solvents such as those found in paint thinner and degreasing agents. They are potent carcinogens and migrate readily into groundwater if they are spilled. Fuel storage tanks located underground. If a business operates or has operated a fleet of trucks or cars, these tanks may contain or have contained gasoline. And any business, or even a residence, may have tanks containing heating oil. All such structures may eventually leak. Insulation made from urea-formaldehyde foam. Lead-based paint. Radon gas. Septic systems and wells that have been abandoned.

What special problems are posed by Superfund liability?

First, Superfund can pierce the corporate veil. Officers, directors, and even shareholders can be held personally liable. Second, cleanup costs can be enormous—well beyond the value of the assets purchased. Third, the liabilities of companies that generated wastes that were dumped in a common site are joint as well as several; every contributor of hazardous waste to that site is theoretically liable for the whole cleanup. And fourth, it can take years before liability is finally determined.

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What can a buyer do to protect itself against exposure to past or ongoing environmental liabilities? ■

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Hire an environmental consulting firm to do an environmental liability audit of the candidate company. Many lenders require delivery of such an audit report, showing an essentially clean bill of health, as a condition to lending. Although the EPA has relaxed lenders’ liability under Superfund, lenders still remain cautious.13 Make sure that the seller’s warranties are broad enough to cover (1) environmental liabilities arising as a result of on-site or offsite pollution and (2) all actions causing pollution, whether or not such actions were in violation of any law or standard at the time they were taken. The latter point is critical because Superfund liability can reach back to actions that were taken before the adoption of modern environmental protection laws, when the shipment of wastes by unlicensed carriers to unlicensed sites was not illegal. Make sure that environmental warranties and any escrows or offset rights survive as long as possible. It may take years before pollution is discovered and traced back to the company.

LENDER LIABILITY What can a lender do to protect itself? If a lender loans money for a transaction that is secured by an interest in contaminated property, and EPA brings a CERCLA enforcement action, will the lender be held liable for any cleanup costs?

Not necessarily. The CERCLA law contains a secured creditor exemption that eliminates owner/operator liability for lenders who hold ownership in a CERCLA facility primarily to protect their security interest in that facility, provided that they do not “participate in the management of the facility.”14


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How can a lender show that it did not participate in the management of a facility?

The term participate in management does not include ■

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Merely having the capacity to influence or the unexercised right to control facility operations Performing an act or failing to act prior to the time at which a security interest in a facility is created Holding a security interest or abandoning or releasing a security interest Including in the terms of an extension of credit, or in a contract or security agreement relating to the extension, a covenant, warranty, or other term or condition that relates to environmental compliance Monitoring or enforcing the terms and conditions of the extension of credit or security interest Monitoring or inspecting the facility Requiring a response action in connection with a release or threatened release of a hazardous substance Providing financial or other advice to the borrower in an effort to mitigate, prevent, or cure default or diminution in the value of the facility Restructuring the terms and conditions of the extension of credit or security interest, or exercising forbearance Exercising other remedies for the breach of the extension of credit or security agreement Conducting a response action under CERCLA or under the National Contingency Plan (unless these actions rise to the level of “participation in management” within the meaning of the statute)15

What types of activities do constitute “participation in the management of a facility,” according to CERCLA?

Lenders or other parties “participate in management” if, while the borrower is still in possession of the facility encumbered by the security interest, they

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Actually participate in the management or operational affairs of a facility. Merely having the capacity to influence or the unexercised right to control the facility does not constitute participating in management. Exercise decision-making control regarding environmental compliance related to the facility and, in doing so, undertake responsibility for hazardous substance handling or disposal practices. Exercise control at a level similar to that of a manager of the facility and, in doing so, assume or manifest responsibility with respect to day-to-day decision making on environmental compliance or all, or substantially all, of the operational (as opposed to financial or administrative) functions of the facility other than environmental compliance.16

If a lender is forced to foreclose on or take title to contaminated property, what steps can it take after foreclosure and still remain exempt from “owner or operator” liability under CERCLA?

After foreclosure, a lender who did not “participate in management” prior to foreclosure may generally ■ ■ ■

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Maintain business activities. Wind up operations. Undertake a response action under CERCLA Section 107(d)(1) or under the direction of an on-scene coordinator. Sell, re-lease, or liquidate the facility. Take actions to preserve or protect the property or prepare the property for sale.

A lender may conduct these activities provided that the lender attempts to sell or re-lease the property held pursuant to a sale or lease financing transaction, or otherwise divest itself of the property, at the ear-


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liest practicable, commercially reasonable time using commercially reasonable means.17

If an acquirer is buying a property from a lender who has taken title to a contaminated property as a secured creditor, what should the acquirer want to learn about its potential CERCLA cleanup obligations before buying the property?

In 2002, Congress passed the Small Business Liability Relief and Brownfields Revitalization Act (“Brownfields Amendments”), creating a new landowner liability protection from CERCLA for bona fide prospective purchasers.18 Prior to the Brownfields Amendments, a person who purchased property after January 11, 2002, with knowledge of the contamination was subject to “owner or operator” liability under CERCLA. Prospective landowners with knowledge of contamination may now purchase property and obtain protection from liability, provided that they meet certain pre- and postpurchase requirements. CERCLA does not require lenders to notify future owners of landowner rights or potential cleanup obligations. To meet the prepurchase requirements to qualify as a bona fide prospective purchaser, a person must ■ ■

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Not be potentially liable. Establish that all disposal occurred before the person acquired the facility. Make all appropriate inquiries into previous ownership and uses prior to acquiring the property.19 Not be affiliated with a potentially responsible party.20

Also, bona fide prospective purchasers must demonstrate that they are not potentially liable for the costs of cleanup at the property or affiliated with any other entity that is potentially liable, including a predecessor entity. That is, structural reorganizations do not eliminate liability.21

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Once a landowner qualifies as nonliable through the bona fide prospective purchaser liability exemption, are there any other requirements it must satisfy to maintain this status?

To maintain their bona fide prospective purchaser status (i.e., meet all postpurchase requirements), landowners must meet continuing obligations during their property ownership. To meet these continuing obligations, bona fide prospective purchasers must ■

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Provide all legally required notices with respect to the discovery or release of a hazardous substance. Exercise appropriate care with respect to the hazardous substances by taking reasonable steps to stop or prevent continuing or threatened future releases and exposures, and to prevent or limit human and environmental exposure to previous releases. Provide full cooperation, assistance, and access to persons authorized to conduct response actions or natural resource restoration. Comply with land use restrictions and not impede the effectiveness of institutional controls. Comply with information requests and subpoenas.22

CERCLA also imposes liability on persons who arrange for the transportation of hazardous substances for disposal or treatment. Other federal environmental laws have different liability standards and may be relevant to secured creditors.23

Suppose a seller has already obtained environmental clearances. Are these automatically transferable?

Not necessarily. Federal, state, and local permits and consent decrees relating to water quality, air emissions, and hazardous wastes should be checked carefully to make sure that they remain effective after closing. In addition, in at least one state (New Jersey), the seller of an industrial or commercial facility, with certain exceptions, cannot pass an effective title to the buyer without state approval or waiver of a cleanup plan.


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If an acquirer discovers an environmental liability during a due diligence investigation by an attorney or a consultant retained by outside counsel, will it be covered by attorney-client privilege?

If there is active litigation, such privilege may be extended. However, in the absence of active litigation, this doctrine may not be applicable. Professional ethics require an advisor who finds evidence of a legal violation to alert management to the problem. Then, if the problem is not resolved or reported by management, an attorney may have an ethical duty to report the matter to the board of directors, which may, in turn, decide to disclose the matter to regulators in order to receive more lenient treatment, as described in the next section and in Appendix 11B.

VOLUNTARY DISCOVERY AND DISCLOSURE OF ENVIRONMENTAL VIOLATIONS Do states or the federal government provide incentives for companies that voluntarily discover and disclose environmental violations?

Some states do offer such incentives, but these protections are limited to state law concerns. Where state and federal laws overlap (which is to say, in most cases), acquirers should turn to federal law.24 The EPA has an “Audit Policy” that extends lesser penalties to acquirers that discover and report violations on their own. The policy is reprinted as Appendix 11B.

According to this policy, at what point does an entity have to disclose to EPA that a violation “may have occurred?”25

The regulated entity must disclose violations when there is an objectively reasonable factual basis for concluding that violations may have occurred. Where the facts underlying the violation are clear but the existence of a violation is in doubt due to the possibility of differing interpretations of the law, the regulated entity should disclose the potential violations.

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If an owner or operator discovers at its facility a violation that began when the facility was owned and/ or operated by a previous entity, can the subsequent owner/operator receive penalty mitigation under the final Audit Policy? Can the previous owner/operator also obtain such mitigation?

In both cases, the regulated entity must meet all conditions in the final Audit Policy, including the requirement for prompt disclosure. . . . Separate entities are considered independently. The Audit Policy does not spell out all applications of this concept, but its meaning is easy to apply. Suppose, for example, that one company buys a unit from another company, and the buyer and seller of the unit remain separate entities. There may be situations where a subsequent owner/operator can receive penalty mitigation while the previous owner/operator cannot. This would happen where the new owner discloses violations promptly to the EPA, whereas the previous owner had not disclosed such violations. The old owner may still be obliged to pay a fine for its past failure to report violations, even though it sold the unit involved. Clearly, it is in the interests of sellers to help buyers conduct environmental due diligence, to avoid such a situation down the road.

CONCLUDING COMMENTS

Environmental liability exposure deserves its reputation as an area of extreme caution for all M&A participants. The vast reach of federal and state law touches buyers and sellers, lenders, and advisors. All can benefit from a general knowledge of environmental law, and from a commitment to respecting it. In the words of the Caux Round Table’s Principles for Business (introduced in the previous chapter), one of the callings of any corporation is to “promote and stimulate sustainable economic development and play a leading role in preserving and enhancing the physical environment and conserving the earth’s resources.” For every acquirer, this goal can be furthered during the due diligence process by noting the candidate company’s environmental record and prac-


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tices, and protecting itself against inheritance of any future negative developments with regard to these practices. In brief, then, environmental due diligence is an important part of the M&A process. Although the number and complexity of the laws may seem daunting, competent professional advisors can do much to help an acquirer identify and mitigate the risk of legal exposure in this area. Such careful attention to environmental issues will ideally parallel concern for employment issues, the subject of our concluding chapter.

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APPENDIX

11A

The Ceres Principles

In the fall of 1989, Ceres announced the creation of the Ceres Principles, a ten-point code of corporate environmental conduct to be publicly endorsed by companies as an environmental mission statement or ethic. Imbedded in that code of conduct was the mandate to report periodically on environmental management structures and results. In 1993, following lengthy negotiations, Sunoco became the first Fortune 500 company to endorse the Ceres Principles. Today [as of 2010], the tide has changed dramatically. Over 50 companies have endorsed the Ceres Principles, including 13 Fortune 500 firms that have adopted their own equivalent environmental principles. By endorsing the Ceres Principles or adopting their own comparable code, companies not only formalize their dedication to environmental awareness and accountability, but also actively commit to an ongoing process of continuous improvement, dialogue and comprehensive, systematic public reporting. Endorsing Ceres companies have access to the diverse array of experts in our [the Ceres] network, from investors to policy analysts, energy experts, scientists, and others. The Ceres Principles are:

Protection of the Biosphere

We will reduce and make continual progress toward eliminating the release of any substance that may cause environmental damage to the air, water,


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or the earth or its inhabitants. We will safeguard all habitats affected by our operations and will protect open spaces and wilderness, while preserving biodiversity.

Sustainable Use of Natural Resources

We will make sustainable use of renewable natural resources, such as water, soils and forests. We will conserve non-renewable natural resources through efficient use and careful planning.

Reduction and Disposal of Wastes

We will reduce and where possible eliminate waste through source reduction and recycling. All waste will be handled and disposed of through safe and responsible methods.

Energy Conservation

We will conserve energy and improve the energy efficiency of our internal operations and of the goods and services we sell. We will make every effort to use environmentally safe and sustainable energy sources.

Risk Reduction

We will strive to minimize the environmental, health and safety risks to our employees and the communities in which we operate through safe technologies, facilities and operating procedures, and by being prepared for emergencies.

Safe Products and Services

We will reduce and where possible eliminate the use, manufacture or sale of products and services that cause environmental damage or health or safety hazards. We will inform our customers of the environmental impacts of our products or services and try to correct unsafe use.

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Environmental Restoration

We will promptly and responsibly correct conditions we have caused that endanger health, safety or the environment. To the extent feasible, we will redress injuries we have caused to persons or damage we have caused to the environment and will restore the environment.

Informing the Public

We will inform in a timely manner everyone who may be affected by conditions caused by our company that might endanger health, safety or the environment. We will regularly seek advice and counsel through dialogue with persons in communities near our facilities. We will not take any action against employees for reporting dangerous incidents or conditions to management or to appropriate authorities.

Management Commitment

We will implement these Principles and sustain a process that ensures that the Board of Directors and Chief Executive Officer are fully informed about pertinent environmental issues and are fully responsible for environmental policy. In selecting our Board of Directors, we will consider demonstrated environmental commitment as a factor.

Audits and Reports

We will conduct an annual self-evaluation of our progress in implementing these Principles. We will support the timely creation of generally accepted environmental audit procedures. We will annually complete the CERES Report, which will be made available to the public.


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CERES DISCLAIMER

These Principles establish an environmental ethic with criteria by which investors and others can assess the environmental performance of companies. Companies that endorse these Principles pledge to go voluntarily beyond the requirements of the law. The terms “may” and “might” in Principles one and eight are not meant to encompass every imaginable consequence, no matter how remote. Rather, these Principles obligate endorsers to behave as prudent persons who are not governed by conflicting interests and who possess a strong commitment to environmental excellence and to human health and safety. These Principles are not intended to create new legal liabilities, expand existing rights or obligations, waive legal defenses, or otherwise affect the legal position of any endorsing company, and are not intended to be used against an endorser in any legal proceeding for any purpose.

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APPENDIX

11B

EPA’s Audit Policy

EPA’s Audit Policy, formally titled “Incentives for Self-Policing: Discovery, Disclosure, Correction and Prevention of Violations,” safeguards human health and the environment by providing several major incentives for regulated entities to voluntarily come into compliance with federal environmental laws and regulations. To take advantage of these incentives, regulated entities must voluntarily discover, promptly disclose to EPA, expeditiously correct, and prevent recurrence of future environmental violations. Disclosures are often preceded by consultation between EPA and the regulated entity, so that they can discuss mutually acceptable disclosure details, compliance, and audit schedules.

Summary of Incentives: Significant Penalty Reductions

Civil penalties under the environmental laws generally have two components, an amount assessed based upon the severity or “gravity” of the violation, and the amount of economic benefit a violator received from failing to comply with the law. ■

No gravity-based penalties if all nine of the Policy’s conditions are met. EPA retains its discretion to collect any eco-


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nomic benefit that may have been realized as a result of noncompliance. Reduction of gravity-based penalties by 75 percent where the disclosing entity meets all of the Policy’s conditions except detection of the violation through a systematic discovery process. No recommendation for criminal prosecution for entities that disclose criminal violations if all of the applicable conditions under the Policy are met. “Systematic discovery” is not a requirement for eligibility for this incentive, although the entity must be acting in good faith and adopt a systematic approach to preventing recurring violations. No routine requests for audit reports would be made.

Conditions for Penalty Mitigation

Entities that satisfy the following conditions are eligible for Audit Policy benefits. Even if your entity fails to meet the first condition—systematic discovery—you can still be eligible for 75 percent penalty mitigation, and a recommendation for no criminal prosecution of the violations against your entity. ■

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Systematic discovery of the violation through an environmental audit or the implementation of a compliance management system. Voluntary discovery of the violation was not detected as a result of a legally required monitoring, sampling or auditing procedure. Prompt disclosure in writing to EPA within 21 days of discovery or such shorter time as may be required by law. Discovery occurs when any officer, director, employee or agent of the facility has an objectively reasonable basis for believing that a violation has or may have occurred. Independent discovery and disclosure before EPA or another regulator would likely have identified the violation through its own investigation or based on information provided by a third-party.

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Correction and remediation within 60 calendar days, in most cases, from the date of discovery. Prevent recurrence of the violation. Repeat violations are ineligible, that is, the specific (or closely related) violations have occurred at the same facility within the past 3 years or those that have occurred as part of a pattern at multiple facilities owned or operated by the same entity within the past 5 years; if the facility has been newly acquired, the existence of a violation prior to acquisition does not trigger the repeat violations exclusion. Certain types of violations are ineligible such as those that result in serious actual harm, those that may have presented an imminent and substantial endangerment, and those that violate the specific terms of an administrative or judicial order or consent agreement. Cooperation by the disclosing entity is required.

CHAPTER

12

Detecting Exposure under Employment Law “A fair day’s wages for a fair day’s work”: . . . It is the everlasting right of man. —Thomas Carlyle, Past and Present (1843)

INTRODUCTION

In this chapter, we aim to summarize the major employment law issues that an acquirer will encounter when conducting due diligence. Our goal is ambitious: entire books (not to mention multiple volumes of regulations) have been written about single, narrow aspects of this topic—for example, health and safety law. Nonetheless, we believe that a brief overview of a variety of employment law areas can be helpful to acquirers. Human capital, after all, is arguably the single most valuable asset of any company. Employees—including current, past, or prospective employees and unions—are a common source of litigation against corporate directors and officers. As noted in Chapter 4, they sue over a variety of issues, including these: ■ ■ ■ ■ ■ ■ ■ ■

Breach of employment contract Defamation Discrimination Employment conditions/safety Failure to hire or promote Harassment or humiliation Pension, welfare, or other employee benefits Retaliation/whistle-blowing 351

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Salary, wage, or compensation disputes Wrongful termination

Lawsuits on these issues typically refer to federal or state law setting standards for equal opportunity, health and safety, wages and hours (including issues of benefits and leave), or workforce reduction. In this chapter, we summarize the relevant federal law in these four key areas, as well as two more specialized areas: collective bargaining and immigration.

AN OVERVIEW OF EMPLOYMENT LAW What areas are covered by employment law?

Employment law, like the other areas of law discussed previously in this book, consists of thousands of federal and state laws, administrative regulations, and judicial decisions. These laws, regulations, and decisions set boundaries on corporate behavior with respect to a variety of issues. State law concerns include contractual rights created by agreements between employers and employees—a very important area in disputes involving departing employees. The focus of this chapter, however, is on the vast scope of federal law. As mentioned immediately above, these issues may be usefully classified as issues of equal opportunity, health and safety, wages and hours, and workforce reduction. In addition, federal law has protected the rights of workers to influence these issues by affirming their right to collective bargaining. (This last category is not a cause of private lawsuits because the federal government is typically the plaintiff in such cases.) Finally, federal law covers the important human resource issue of immigration.

EQUAL OPPORTUNITY LAWS What do you mean by equal opportunity laws?

Equal opportunity laws assert the rights of individuals to obtain and retain employment in jobs for which they are qualified and capable, irrespective of their age, disabilities, gender, national origin, race, religion, or sexual orientation. These laws oppose discrimination against individuals because

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of their status in these regards. Discrimination means prejudice that has an economic effect on an employee, such as bias in hiring, promotion, job assignment, termination, and compensation, or that results in harassment of an employee.

What is the major equal opportunity law?

Title 7 of the Civil Rights Act of 19641 prohibits discrimination based on any of the following: ■ ■ ■ ■

National origin Race or skin color Religion Sex

It makes it illegal for employers to discriminate in the following areas: ■ ■ ■ ■ ■ ■

Hiring Discharging (firing) Pay Terms of employment Conditions of employment Privileges of employment (perquisites)

In addition, there is the Civil Rights Act of 1991, which, among other changes, amended Title 7 of the Civil Rights Act of 1964 to make it clear that discrimination need not be the only factor; as long as it is one of the factors, a case may be made. This is called a “mixed motives” case. The Civil Rights Act applies to most employers with more than 15 employees that are engaged in interstate commerce, as well as labor organizations and employment agencies. It is enforced by the Equal Employment Opportunity Commission, which also enforces the other discrimination laws described later in this chapter.2 Court cases have provided a number of significant interpretations of these points. State statutes also provide extensive protection from employment discrimination. The laws of some states extend federal-type protections to employees who are not covered by federal law—for example, employees

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who may experience discrimination based on sexual orientation. Other statutes expand the federal requirements by covering more employers and by providing employees with greater rights.

What specific law protects employees against discrimination based on age?

As seen earlier, the Civil Rights Act of 1964 and the amendments to it do not cover discrimination based on age. This is where the Age Discrimination in Employment Act (ADEA) comes in. It bans discrimination based on age. An employee is protected from discrimination based on age if he or she is over 40. The ADEA also contains guidelines for benefit, pension, and retirement plans. It was amended by the Older Workers Benefit Protection Act of 1990 and the Pension Protection Act of 2006, which protect the pensions of older workers. (See the discussion later in this chapter for its application to reductions in force.) The prohibited practices are nearly identical to those outlined in Title 7, except that the ADEA does not specifically allow for mixed motives cases, where age is only one of the factors. On June 18, 2009, in Gross v. FBL Financial Services,3 the U.S. Supreme Court handed down a decision in favor of an employer who was accused of age discrimination. The Court noted that the ADEA puts the burden of proof on a plaintiff to show that the employee was dismissed because of age; if there were other reasons, the employee has no standing. A bill now pending in Congress, the Protecting Older Workers against Discrimination Act,4 would amend the Age Discrimination Act and other federal antidiscrimination and retaliation laws to allow for mixed motives cases. Acquirers should keep an eye on this legislation, as it could make age discrimination an even more potent source of risk.

What specific federal law protects employees against discrimination based on disabilities?

Discrimination based on disabilities is covered at the federal level primarily by the Americans with Disabilities Act of 1990, which became effective in 1992. This law prohibits discrimination against a qualified individual with


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a disability who can perform the essential functions of a position with or without accommodation. The purposes of the act, among other goals, are to prevent employers from discriminating against disabled individuals and to require them to provide certain accommodations to qualified individuals. The law extends beyond employment issues to issues involving other constituencies, such as customers. The law bans discrimination against certain disabled individuals with respect to the following: ■ ■ ■ ■ ■

Education Employment Housing Access to public buildings Access to transportation

The ADA applies to all employers that are engaged in interstate commerce and have 15 employees or more. In addition, the disability laws of some states may expand on the rights of employees and the obligations of employers. The ADA defines a disability as “a physical or mental impairment that substantially limits one or more of the major life activities of the individual.” It requires the protection of such individuals, and also of individuals who have “a record of such impairment” or who are “regarded as having such an impairment.” The law specifically withholds ADA protection from those who engage in illegal and/or socially undesirable behavior, such as active addiction to illegal drugs, kleptomania, pyromania, or sexual behavior disorders. However, if an individual is a rehabilitated drug user, is participating in a supervised drug rehabilitation program, or is erroneously regarded as a drug user, then the individual may receive ADA protection. The law does not specifically exclude alcoholism, but in at least two cases—Burch v. Coca-Cola Co. (1997) and Zenor v. El Paso Healthcare Systems, Ltd. (1999)5—the court said that the evidence presented did not show limitation in a major life activity, and hence failed to qualify as a disability. There is also the Rehabilitation Act of 1973, which was enacted to “promote and expand employment opportunities in the public and private sectors for handicapped individuals” by banning discrimination. This law also sets up affirmative action programs, which are programs designed to

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actively encourage the hiring of individuals who in the past have been subject to discrimination. Companies covered by the act include employers receiving federal contracts for over $2,500 or federal financial assistance.6 Since many companies and organizations in the private sector receive federal contracts or assistance, the reach of this law is long. For military contractors, there is the Vietnam Era Veterans’ Readjustment Assistance Act (VEVRAA) of 1972. Under this law, employers with federal contracts or subcontracts of $10,000 or more are required to provide equal employment opportunity, take affirmative action, and comply with mandatory job listing requirements to employ and advance protected veterans.7 This law is enforced by the Office of Federal Contract Compliance Programs (OFCCP) of the U.S. Department of Labor.

What specific laws ban discrimination based on gender?

As mentioned, Title 7 of the Civil Rights Act of 1964 prohibits discrimination based on gender. This can be discrimination against either men or women. In addition, to ensure lack of discrimination against women, Congress passed the Pregnancy Discrimination Act in 1978, which includes under Title 7 sex discrimination any bias against employees because of pregnancy, childbirth, or related medical conditions. The Equal Pay Act of 1963, amending an older law called the Fair Labor Standards Act, applies to companies involved in interstate commerce, regardless of size. The Equal Pay Act prohibits sex-based bias in the award of pay. The law states that equal pay must be paid for equal work if jobs require “equal skill, effort, and responsibility, and are performed under similar working conditions.” The work need not involve the same title and job description. It can be applied to work that is superficially dissimilar in title and job description, while being similar in fact. For example, if a woman in an organization is paid a certain amount to be a “coordinator” and a man is paid twice as much to be a “director,” and if their work requires the same skill, effort, and responsibility under similar working conditions, then the woman could have grounds for a suit—especially if there were a pattern of


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such discrimination. The same would be true for a male “coordinator” visà-vis a female “director.” Furthermore, over the past two decades, a series of court decisions has increased liability exposure in the area of sexual harassment as a form of discrimination. For example, in Oncale v. Sundowner Offshore Services, Inc. (1998), the court clarified that Title 7 covers same-sex harassment. The 1964 act also has a whistle-blower provision that can create liability for an employer. Lawsuits alleging retaliation by employers following discrimination complaints have doubled in the past two decades.8 In Crawford v. Metropolitan Government of Nashville and Davidson County, Tenn. (2009), the court was asked whether a plaintiff could sue under a provision of Title 7 of the Civil Rights Act of 1964 barring retaliation against people who opposed unlawful employment practices, and found in the plaintiff’s favor.

What are the key issues and court decisions in the area of sexual harassment?

Two key issues are the hostile work environment and the quid pro quo arrangement. A hostile work environment was the issue in the U.S. Supreme Court case of Meritor Savings Bank v. Vinson (1986). In this case, the court stated that harassment is illegal when it “is sufficiently severe or pervasive to alter the conditions of the victim’s employment and create an abusive working environment.” The Court has been expansive in identifying such an environment. In Harris v. Forklift Systems, Inc. (1993), the Court held that plaintiffs need not prove that the harassment seriously affected their “psychological well-being” in order to have an actionable cause. Quid pro quo means “this for that,” and it refers to a situation in which the employee is expected to grant sexual favors in return for a benefit or lack of a disbenefit (as in, “Do this and you will get a promotion; refuse and you will be fired”). If an employee can prove that a quid pro quo condition exists, the employee has standing to sue for harassment. If a supervisor harasses an employee, but the employee experiences no tangible employment action as a consequence of the harassment (such as promotion or firing, depending on the situation), then the employer can

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raise an affirmative defense against liability or damages. This was the finding in both Burlington Industries Inc. v. Ellerth (1998), in which both plaintiff and defendant were given a second chance to prove their cases, and Faragher v. City of Boca Raton (1998)9, in which the plaintiff prevailed. ■

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The Burlington decision held that an employee who resists a supervisor’s advances need not have suffered a tangible job detriment, such as dismissal or loss of a promotion, to be able to pursue a lawsuit against the company. At the same time, Justice Anthony M. Kennedy also explained that such a suit cannot succeed if the company in question has an antiharassment policy that an employee fails to use. The Faragher decision found that employers are responsible for preventing and extinguishing harassment in the workplace. They are liable for even those harassing acts of supervisory employees that violate clear policies and of which top management has no knowledge.

When an employer points to its antidiscrimination system as its defense, this is called the Faragher defense (even though, ironically, in the Faragher case, the defense failed).10 Both cases gave some guidelines (summarized well by the late Kermit L. Hall): ■

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Employers are responsible for harassment engaged in by their supervisory employees. When a quid pro quo condition can be demonstrated (i.e., a discharge or demotion), the employer is absolutely liable. Where there is no tangible action, an employer can defend itself by showing that it took reasonable care to prevent and correct harassing behavior and that the complaining employee had failed to take advantage of preventive or corrective opportunities provided by the company.11

Since these landmark decisions, a series of appeals court decisions has shown that it is not easy for an employer to use the Faragher defense.12


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Rather, there is a “fact-intensive matrix” for proving that the employer has proactively deterred and/or responded to harassment. Prompt suspension and termination, if appropriate, provide the best proof that a system is working. The following practices are not sufficient to establish a defense: ■ ■

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Generalized references to an antiharassment policy Adopting a policy without promulgating and/or enforcing it Having a slow or inadequate investigation13

During due diligence, it is important to determine whether the company to be acquired has policies and training programs aimed at preventing sexual harassment from occurring in the workplace by detecting and preventing a hostile work environment, quid pro quo arrangements, and other forms of sexual harassment. The Faragher case states that the employer must establish that it exercised reasonable care to prevent and correct promptly any sexually harassing behavior, and that “the plaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer or to avoid harm otherwise.” What is the statute of limitations on discrimination cases? Can they be filed years after an event that showed discrimination?

There is no hard and fast statute of limitations for discrimination cases. Whether the period should be measured from the announcement of the discriminatory practice or from the use of the practice is still an open question—a question that the U.S. Supreme Court is discussing in Lewis v. City of Chicago (2010) as we go to press.14 One issue has been resolved. The Lilly Ledbetter Fair Pay Act of 2009 clarified that a “discriminatory compensation decision” or other practices that are illegal under these laws “occurs each time compensation is paid pursuant to the discriminatory compensation decision or other practice, and for other purposes.” This in effect extended the time period in which a plaintiff can sue for various kinds of discrimination.15

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Are there any other major discrimination laws that we have not mentioned?

One new law is the Genetic Information Nondiscrimination Act of 2008 (GINA), which prohibits employment discrimination based on genetic information about an applicant, employee, or former employee. This new law can make it more difficult for employers to administer employee wellness programs that may require medical information from employees.16

HEALTH AND SAFETY LAWS What are the main health and safety laws?

The primary law protecting the health and safety of workers in the workplace is the Occupational Safety and Health Act (OSHA), which fills five volumes of the Code of Federal Regulations. The law covers all nongovernment employers that engage in interstate commerce. In most of its provisions, there is no size limit; even small companies come under the regulations. There are, however, exemptions for small businesses with respect to record keeping. (In addition, some discrimination laws pertain to health, as some disabilities are related to health and thus are protectable. Also, the Black Lung Act prohibits discrimination by mine operators against miners who suffer from pneumoconiosis, known as “black lung,” and, as mentioned, the Civil Rights Act of 1964 prohibits discrimination involving pregnancy, childbirth, and related conditions.) The OSHA law established the Occupational Safety and Health Administration (also called OSHA), a unit of the Department of Labor (DOL) that sets forth regulations to promote health and safety in the workplace. States may enact their own health and safety laws, but they must either be in areas not covered by OSHA or receive federal approval.17 OSHA has asserted that although its authority extends to the homes of telecommuters, it has no plans to issue regulations or conduct inspections in this regard.18 The DOL, through OSHA, may authorize inspections of workplaces to determine what future regulations may be needed, supported by research from the National Institute for Occupational Safety and Health. Through these inspections, the DOL also aims to ensure compliance with current


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regulations and to examine conditions that have inspired past complaints. If the DOL finds that an employer is violating a safety or health regulation, it issues an injunction or a citation. DOL citations may be reviewed by the Occupational Safety and Health Review Commission (established at the same time as OSHA) or by federal judges. The DOL may also impose fines for noncompliance.

What is happening currently with OSHA?

As we go to press, the agency has issued a Draft Proposed Safety and Health Program Rule.19 The purpose of this rule is to reduce the number of jobrelated fatalities, illnesses, and injuries by requiring employers to establish a workplace safety and health program to ensure compliance with OSHA standards. Although this program is not legally required at this point, we will summarize it as a possible model to help due diligence efforts. As an acquirer looks at safety and health programs in a target company, it will be important to confirm that these elements are there, or to raise a yellow flag if they are not. Under the proposed rule (pending as of February 2010), each employer must set up a safety and health program appropriate to conditions in the workplace. The program must have the following core elements: ■ ■ ■ ■ ■

Management leadership and employee participation Hazard identification and assessment Hazard prevention and control Information and training Evaluation of program effectiveness

Employers who have implemented a safety and health program before the effective date of this rule may continue to implement that program if it satisfies the basic obligation for each core element, and if the employer can demonstrate the effectiveness of any provision of the program that differs from the other requirements included under the core elements of this rule. The DOL may regulate a number of areas. For example, it has recently been active in creating and enforcing laws in the area of “ergonomics,” a

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term for workplace designs intended to prevent “musculoskeletal disorders” that can arise from working conditions.

Could you describe the new rules for ergonomics?

In January 2010, OSHA announced its intent to reinstate the musculoskeletal disorder column on its Form 300 for the reporting of injury and illness. The agency is also developing a proposed rule that provides a definition of musculoskeletal disorders. The science of ergonomics seeks to reduce the chances of injury when workers do repetitious, strenuous, or awkward tasks. A well-known example of this is carpal tunnel syndrome, which occurs in work as diverse as word processing and poultry plucking. Federal ergonomics rules set forth guidelines for good ergonomics and require employers that report injuries to train their employees in the new guidelines. The rules also set standards for computer keyboards, desks, manufacturing equipment, and other machines and furnishings in the work environment, thus affecting makers and buyers of such equipment.20 OSHA laws do not extend overseas, but this creates the opposite problem: poor working conditions that decline to the level of “sweatshops.”

What exactly are “sweatshops,” and how much of a risk do they pose to acquirers in the manufacturing sector?

Sweatshops are manufacturing operations that pose undue hardships for workers. The term is generally reserved for small manufacturing operations in developing countries where workers receive substandard wages while working in crowded and unsafe conditions. Sweatshops do pose risks to acquirers. Aside from the obvious ethical issues that they raise, accusations of “sweatshop” conditions can damage the reputation of a company and expose it to lawsuits and federal fines. Companies and coalitions of companies have developed and attempt to enforce codes of ethics against maintaining or enabling sweatshops. Sometimes, however, these codes fail to prevent the unwanted practices. For ethical and reputational reasons, and in some cases legal reasons,


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acquirers must be especially vigilant in this domain. When buying a company that uses parts supplied from overseas, they need to be proactive to ensure that their suppliers are practicing what they preach in this regard.21 A good proactive example is Hewlett-Packard (HP), which ensures good working conditions in the factories that supply computer parts to HP and its competitors.22

WAGES AND HOURS LAWS What are the main areas covered by wages and hours laws?

Areas covered include minimum wage and family/medical leave, as well as laws affecting pensions and laws affecting insurance that employers must pay on behalf of their employees, such as workers’ compensation insurance and unemployment insurance. Also, employers need to know current regulations regarding health plans and health insurance.

Could you give an overview of minimum wage law?

The minimum wage is an hourly amount that certain employers must match or exceed when compensating employees. The federal minimum wage provisions are contained in the Fair Labor Standards Act of 1938 (FLSA). The law applies to employees of enterprises that do at least $500,000 in business a year. The law also applies to employees of smaller firms if the employees are engaged in interstate commerce or in the production of goods for commerce, such as employees who work in transportation or communications or who regularly use the mails or telephones for interstate communications. Where state law requires a higher minimum wage, that higher standard applies. As we go to press, the federal minimum wage, with certain exceptions for some workers such as youths, is $7.25 per hour.23

How does overtime pay fit in?

For the purposes of overtime pay, federal law defines two classes of employees: exempt and nonexempt.

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Exempt employees receive wages that are exempt from overtime rules because they are managerial or professional workers. Even if they work more than a certain number of hours per week (as defined by federal law), they do not have a right to receive overtime pay. Nonexempt employees receive wages that are covered by federal overtime law. If they work more than a certain number of hours per week (currently set at 40), then they must receive overtime pay (currently set at 1.5 times normal pay).24

To be classified as an exempt employee, a worker must have a job that entails a great deal of decision-making discretion, such as a managerial or professional job.

What laws affect leave?

The primary law here is the Family and Medical Leave Act of 1993. Under this law, an employee may take up to 12 weeks of unpaid, job-protected leave per year for a serious medical condition of the employee or his or her spouse, child, or parent; or for the birth or adoption of a child. The burden is on the employer to determine whether the employee is eligible under the law. Under the FMLA, an employee must have worked at least 1,250 hours over a period of 12 months, and must work at a site where 50 or more employees are employed within a 75-mile radius.

PENSIONS AND INSURANCE Why are there pension funding rules?

Company pension funds need funding rules because the company doesn’t really own the money—the employees do. The money is deferred employee compensation that has been set aside for a future award. There are two types of plans: defined-contribution plans (more common), in which the employee is given a set amount in each designated period, and defined-benefit plans (less common), in which the employee is promised


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a set amount upon retirement. Defined-contribution plans by definition are always fully funded. Defined-benefit plans can become underfunded, as the value of the plan’s assets (which are typically invested in a combination of stocks and bonds) may drop and/or the extent of its obligations may rise.

What laws govern pensions paid by companies?

Pensions paid by companies are regulated under the Employee Retirement and Income Security Act of 1974, as amended (ERISA), described in Title 29 of the U.S. Code. There are two types of pension plans: qualified (meaning that they meet certain federal standards and qualify for tax-favorable treatment) and nonqualified. There are two types of qualified pension plans: defined-benefit plans and defined-contribution plans. ■

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A defined-benefit plan (DBP) is a pension plan that uses a formula to determine the total value of benefits and requires the employer to meet certain actuarial standards in making contributions to the plan. Contributions must be sufficient to pay obligations when they fall due. A defined-contribution plan (DCP) is a pension plan that requires minimum contributions for each year in which the plan is in existence. These plans can take the form of profit-sharing plans with or without salary deferral [the well-known 401(k) plan] and usually have variable contribution levels.

Both defined-benefit and defined-contribution plans are subject to a compensation cap. More broadly, they are subject to rules set forth under the Internal Revenue Code and ERISA, administered by the Department of Labor. Nonqualified plans—generally plans for senior executives—are often funded by contributions, either as additional compensation or as salary deferrals to a rabbi trust (an irrevocable trust used to defer taxation).

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Who sets pension funding rules, and what are they?

Pension funding requirements are set by federal law. All laws enacted by Congress become a part of the U.S. Code.25 Three sections of the U.S. Code set forth funding standards for pension funds: ■

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U.S. Code Title 26 (tax code, in part pertaining to taxation of deferred income): ■ Section 430 for single-employer plans ■ Section 431 for multiemployer plans26 U.S. Code Title 29 (labor code, in part pertaining to employee pension plans) ■ Section 1082.27 These standards are consistent with those in Title 26.

Code sections are adapted directly from laws—for example, the Employee Retirement Income Security Act of 1974 (ERISA) or more recently the Pension Protection Act of 2006 (PPA).28 A Department of Labor (DOL) Bulletin dated February 2009 requires disclosure of conditions that fall short of these funding standards.29 What does the Pension Plan Act require concerning pension plan funding?

The PPA now requires that a plan stay fully funded. That means that its assets (the money that it has in the account) have to be equal to its liabilities (what it owes to participants). For a plan to stay fully funded, the contributions that a company makes to the plan (increasing its assets) have to be equal to the increased obligations of the plan (cost of benefits, or liabilities) incurred during the year. The pension rules set forth standards for measuring and making up a shortfall. What is the required minimum contribution to plans, according to the tax code (Title 26 of the U.S. Code)?

This is found at length in the tax code, which is consistent with the shorter statement in the labor code.


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The tax code sets detailed standards for single-employer and multiemployer plans. For single-employer plans, the minimum required contribution is generally calculated as follows: ■

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If the value of the plan assets is less than the funding target of the plan for the plan year, the minimum required contribution is the sum of the target normal cost of the plan for the plan year + the shortfall amortization charge (if any) for the plan for the plan year + the waiver amortization charge (if any) for the plan for the plan year. If the value of the plan assets equals or exceeds the funding target of the plan for the plan year, the minimum required contribution is the target normal cost of the plan for the plan year minus this excess amount (but not below zero).

For multiemployer plans the required minimum contribution is as follows: ■

According to the Pension Benefit Guaranty Corporation, in multiemployer plans the amount of the employer’s contribution is set by a collective bargaining agreement that specifies a contribution formula (such as $3 per hour worked by each employee covered by the agreement) and further provides that contributions must be paid to the plan on a monthly basis. If an employer is delinquent, ERISA § 502(g) permits the plan to sue and obtain the delinquency, plus interest, liquidated damages, and its attorney fees. This is a major difference between single and multiemployer plans.

Additional requirements are as follows: ■

The accumulated funding deficiency of a multiemployer plan for any plan year generally is the amount, determined as of the end of the plan year, equal to the excess (if any) of the total

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charges to the funding standard account of the plan for all plan years over the total credits to such account for such years. (Note: There is also an alternative minimum funding standard.) Full-funding limitation means the excess (if any) of the accrued liability under the plan over the lesser of the fair market value of the plan’s assets or the value of such assets determined under any reasonable actuarial method of valuation that takes into account fair market value and that is permitted under regulations prescribed by the Treasury Secretary.

What is a funding shortfall?

A funding shortfall is generally calculated as the excess (if any) of the funding target of the plan (for the plan year) over the value of plan assets (for the plan year) held by the plan on the valuation date. A key term here is funding target attainment percentage, which is calculated as the value of plan assets for the plan year (after subtracting the prefunding balance and funding standard carryover balance) divided by the funding target of the plan for the plan year.

What is an underfunded plan?

An underfunded plan is defined as a plan in which the value of plan assets for the preceding plan year is less than 80 percent of the funding target of the plan for the preceding plan year. (Notice is required if the value of plan assets is less than 100 percent.)

What is a plan at risk?

A plan is in at-risk status for a plan year if the funding target attainment percentage for the preceding plan year is less than 80 percent, and the funding target attainment percentage for the preceding plan year is less than 70 percent. A plan may not change its actuarial assumptions if


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Aggregate unfunded vested benefits as of the close of the preceding plan year exceed $50,000,000. The change in assumptions would lower a funding shortfall that exceeds $50,000,000, or that exceeds $5,000,000 and is 5 percent or more of the funding target of the plan before such change.

When a plan tries to catch up from a shortfall, how does it amortize the shortfall?

Shortfall amortization installments are the amounts necessary to amortize the shortfall amortization base of the plan for any plan year in level annual installments. There is a seven-year amortization period. The rules provide a table for these.

When is a plan in endangered and critical status?

The Pension Protection Act of 2006 deems a plan to be in endangered status if it is not in critical status for the plan year and either (1) its funded percentage for the plan year is less than 80 percent or (2) it has an accumulated funding deficiency for the plan year or is projected to have such a deficiency for any of the six succeeding plan years, taking into account any extension of certain amortization periods. Plans are deemed to be in critical status if their funded percentage is less than 65 percent and certain other conditions are present, and in specified alternative circumstances.

What is the funding standard according to the labor code (Title 29)?

The minimum funding standard under the labor code is met if the plan does not have an accumulated funding deficiency. For the purposes of this part, the term “accumulated funding deficiency” means for any plan the excess of the total charges to the funding standard account for all plan years (beginning with the first plan year to which this part applies) over the total credits to such account for such years.30

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What does an acquirer need to decide about a candidate’s pension plan?

Acquirers need to be aware of the fiduciary duties of the directors and officers of both the acquiring company and the target company. Each plan has ■

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A written plan that describes the benefit structure and guides the day-to-day operations A trust fund to hold plan assets A record-keeping system to track the flow of money going into and out of the plan Documents to provide plan information to participants and the government

There are two types of decisions for plans: management and fiduciary. Decisions to establish a plan, to determine the benefit package, to include certain features in a plan, to amend a plan, and to terminate a plan are business decisions that are not governed by labor laws such as ERISA and PPA. When making these decisions, an employer is acting on behalf of its business, not the plan, and therefore is not a fiduciary. However, when a person takes steps to implement these decisions, that person is acting on behalf of the plan and, in carrying out these actions, may be a fiduciary. This may include the board of directors of an acquiring or acquired firm.31

What are some concerns that acquirers might face with respect to pensions?

Concerns for acquirers include underfunded and overfunded pension plans, plan termination, plan mergers, severance agreements, and the treatment of pension beneficiaries in the sale of a business. It is beyond the scope of this chapter to go into any of these complex subjects in depth, but we will say a few words about each. Underfunded and overfunded pension plans are possible only with DBPs, not DCPs. As mentioned, in a DBP, unlike a DCP, the acquirer guarantees a certain pension amount. Underfunded plans occur when the company winds up having less in a plan than it needs in order to pay the


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promised benefits; overfunded plans occur when the company has more. Plan termination occurs when a plan is liquidated, and when it is merged with another plan (discussed later in this chapter). Treatment of pensioners when a business is sold is another area for litigation. Section 510 of ERISA bans companies from discharging or otherwise taking action against an employee for the purpose of “interfering” with the employee’s right to obtain benefits under a pension plan. Plant closings that entail mass layoffs have generated claims by plaintiffs that the plant closing was motivated by the employer’s desire to save benefit costs. In Millsap v. McDonnell Douglas (1998), the court refused to dismiss a class action against McDonnell Douglas Corp., finding that the plaintiffs established a prima facie case that the company closed its Tulsa, Oklahoma, plant in order to deprive employees of retirement benefits in violation of Section 510. On the other hand, Section 510 does not require every purchaser of a going concern to credit service with a predecessor employer, nor does it require that a successor’s plan be identical to the predecessor’s in every respect.

What else should acquirers know about pensions, besides their funding levels?

Over the years, acquirers have faced a narrowing range of options with respect to the management of pension plans. In 1987, the Omnibus Budget Reconciliation Act of 1987 (OBRA) imposed a standard range of interest assumptions for funding purposes. OBRA also precluded termination and reversion except under exceptional circumstances. This was to prevent employers from gutting plans —a tactic that was employed in the mid-1980s prior to the passage of OBRA. Fifteen years later, with the passage of Sarbanes-Oxley in 2002, new restrictions were imposed with respect to pension blackouts (times when no one may sell the company stock that is in a pension plan). The law bans selling securities “acquired in connection with service or employment as a director or executive officer” during a blackout period, with exemptions for merger situations.

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What exactly are the exemptions in Sarbanes-Oxley covering pension fund blackouts?

In the case of blackout periods with limited applicability, such as blackouts in connection with a merger, the notice requirement applies only to those who are affected by the blackout period. Rules cover the case of equity securities acquired in connection with a merger by an individual who was a director or executive officer of the target entity and is to become a director or executive officer of the acquiring entity. The rules say that at the time of and following the completion of the transaction, the securities will be considered “acquired in connection with service or employment as a director or executive officer” and are covered by the blackout restrictions only to the extent that they were acquired in connection with service or employment as a director or executive officer of the target entity. For example, when an executive officer of a target entity becomes an executive officer of the acquiring entity in a business combination and, in the transaction, receives equity securities of the acquiring entity in exchange for equity securities of the target entity that he or she owned, the equity securities received will be considered “acquired in connection with service or employment as a director or executive officer” only to the extent that they are received “in respect of ” (that is, in exchange for) securities that were previously acquired in connection with service or employment as a director or executive officer of the target entity. So new stock from the acquirer is not covered by the blackout.32

What did the big 2008 “bailout bill” say about golden parachutes?

The Emergency Economic Stabilization Act of 2008 included provisions covering severance agreements in a change of control, also known as golden parachutes.33 These are contracts between a company and one of its executives that provide the executive with certain payments or guarantees of future benefits in the event of a takeover. Such arrangements vary widely as to amounts


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and triggers. The first trigger is a change of control or a hostile takeover as defined in the particular contract; a common second trigger is the termination, demotion, or constructive termination of the executive. Payments in excess of certain calculated amounts can be nondeductible by the company and result in excise taxes on the recipient, as set forth in Section 280G of the Internal Revenue Code. Change of control agreements are complex and add further complications and costs to each compensation package. It is important that acquirers understand these elements. The committee should consider not only the current and financial cost of an element, but also any reputational cost the element may have. Acquirers must also consider their need for flexibility so that they can change and evolve to meet the needs of the combined company. Golden parachutes are often seen as an entrenchment tool or an antitakeover device. Boards should understand that many shareholders view antitakeover devices as unduly protective of the status quo. Careful consideration should be given to whether antitakeover devices are in the best long-term interests of the company. The American Recovery and Reinvestment Act (ARRA) of 2009, signed into law in February 2009, mandates government investments in certain sectors, but it also increases restrictions on executive compensation for entities participating in the Troubled Asset Relief Program (TARP), which was mandated under the Emergency Economic Stabilization Act (EESA) passed in October 2008.34 ARRA prohibits any “golden parachute payment” to a named executive officer or any of the next five most highly compensated employees in any organization that received TARP funds. It defines this as “any payment . . . for departure from a company for any reason, except for payments for services performed or benefits accrued.” (The EESA had defined a golden parachute more narrowly by referring to the rules under Section 280G of the Internal Revenue Code, which allow for severance benefits up to three times the executive’s base compensation less $1.) Under ARRA, there is no grandfathering restriction for severance arrangements that were previously permissible under EESA. For a good summary, see http://www.mwe.com/ info/news/wp0209c.pdf.

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If a buyer and a seller both have defined-contribution plans—for example, two 401(k)s—how can these be merged?

This is a complex area that is best understood on a plan-by-plan basis.35 Consider the example of the most common type of defined-contribution plan, the 401(k). The procedure depends on whether the acquirer bought the stock of the acquired company or its assets. In an asset acquisition, with certain exceptions,36 the plans must remain separate, and the acquired company’s plan must be managed by the seller. In stock acquisitions, three approaches are possible: maintaining separate plans, terminating the acquired plan, or merging the two plans. To maintain separate plans, the acquirer simply has to make sure that each plan files its own forms (Form 5500) and satisfies federal requirements for minimum coverage and nondiscrimination in the amount of contributions. The Internal Revenue Code provides a transition period of the remainder of the plan year through the last day of the first plan year, beginning on the day of the acquisition, to meet these requirements. The “successor plan rule” of the Internal Revenue service says that an acquired company’s plan will be disqualified if more than 2 percent of its employees participate in another defined-contribution plan (except for an employee stock ownership plan) within one year of the termination. This rule can be avoided by terminating the plan prior to the acquisition. Merging the two plans can save administrative expense, but it also has its complications. All “valuable benefits” in both plans must be preserved, complicating plan administration. Furthermore, if a company with a 401(k) plan is acquired by a nonprofit, the procedures become extremely complex.

What about severance agreements?

There are two distinct domains here. Some severance agreements, such as those awarded to rank-and-file employees, are seen as employee entitlements. Other severance agreements, such as those awarded to senior executives, are seen as excessive compensation. Some recent laws passed in the wake of the 2007–2009 financial crisis disallow golden parachutes for any


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firm receiving bailout funds. Under the relevant regulations, golden parachutes are defined broadly as any severance pay awarded to senior executives, not just pay following a merger. Overall, severance agreements also rank high among potential sources of litigation. Landmark cases in the field have held that severance plans are “employee welfare benefit plans” and that such plans are subject to the disclosure, reporting, and fiduciary requirements imposed by ERISA. For instance, in Adcock v. Firestone Tire & Rubber Co. (1987), a Tennessee district court held that employees have a contractual right under federal common law to severance benefits established by their employer. On the senior executive side of the spectrum, courts have held that as long as a board uses an independent and otherwise appropriate process to review compensation, the mere size of the compensation is not an issue, according to William B. Chandler, speaking for the Delaware Court of Chancery, in In re The Walt Disney Company Derivative Litigation (2005): “Nature does not sink a ship merely because of its size, and neither do courts overrule a board’s decision to approve and later honor a severance package, merely because of its size,” stated Chandler in the landmark decision, which was upheld by the Delaware Supreme Court.37 Still, shareholders, boards, and the general public as represented by legislators all favor pay that is linked to performance, so acquirers that are conducting due diligence should scrutinize the employment contracts that they will inherit or develop during the transaction to make sure that these do not cause reputational and financial problems.

Anything else?

On April 29, 2010, the International Accounting Standards Board released an exposure draft proposing amendments to IASB 19 Employee Benefits. The proposal would dramatically revise accounting for defined-benefit plans, moving plan sponsors away from the current approach, which involves considerable “smoothing” of period-to-period measurements. The proposal does not, however, impose a strict mark-to-market regime on income statement reporting. Instead it takes a “middle” approach of booking returns on the net plan asset (liability) as a finance charge calculated using the plan’s discount rate assumption.38

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Moving away from pensions and severance pay, and toward insurance, what laws cover the insurance aspects of compensation?

As mentioned, major employers may be required to pay insurance for unemployment and for disability. Although they are not currently required to provide group health insurance, if they do provide such insurance, they must follow certain regulations. Also, as we go to press, there is a major initiative to expand insurance coverage for employees and other citizens, and part of this payment would come from companies with 50 or more employees.39

What laws require unemployment compensation insurance?

Unemployment insurance laws require employers to pay taxes so that in the event that they discharge workers, the workers will be able to receive payments for a period of time or until they find a new job. Tax payments, both state and federal, are deposited in an Unemployment Trust Fund, which has a separate account for each state. The main federal unemployment insurance law is the Social Security Act of 1935, supplemented by the Federal Unemployment Tax Act. States also have unemployment insurance programs. The federal and state programs are coordinated to avoid overlap, with federal law taking precedence.

What about workers’ compensation laws—how do they differ from unemployment compensation?

Workers’ compensation insurance is similar to unemployment insurance, but its function is to provide pay to workers who still have their jobs, but who must miss work because of an injury or disablement on the job. Workers’ compensation laws also provide benefits for the dependents of workers who die from work-related accidents or illnesses. Some laws also protect employers and fellow workers by limiting the amount that an injured employee can recover from an employer and by eliminating the liability of coworkers in most accidents. Several states, for example, California, have


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comprehensive workers’ compensation statutes that require employers to provide workers’ compensation insurance. Federal statutes cover both federal employees and workers employed in some significant aspect of interstate commerce.

What do acquirers need to know about health plans or health insurance?

Medical plans fall into two basic types, funded and unfunded. Funded plans are funded through a trust. An acquirer that is buying a company with a trust may have to terminate or transfer the trust. Because of strict deductibility rules under the Internal Revenue Code, Section 419A, the buyer should ask the seller to provide assurance (through representations in the acquisition agreement) that contributions to the plan are deductible. Benefits under unfunded plans are provided through insurance, either as an insured plan or as a self-insured plan (also called an “administrativeservices-only” or ASO plan). The term insured can be misleading, since most insured plans today contain features (such as retrospective rating programs, minimum premium adjustments, or reserves) that essentially adjust the premium cost of the policy to the claim experience under the policy. These features may create unexpected benefits or costs for a buyer. With medical plans of any type, it is critical to determine exactly what benefits are provided, as of what time, and what will happen if the policy is terminated. Many of the laws applying to health plans are undergoing change as we go to press with this book.

WORKFORCE REDUCTION LAWS What laws govern workforce reduction?

There are two primary laws, one regarding layoffs (also known as reductions in force, or RIFs) and the other regarding notice of layoffs.

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What laws govern layoffs?

Actually, companies are free to reduce their workforce, as long as in doing so they comply with other laws—notably equal opportunity law prohibiting discrimination.40 To avoid lawsuits over discrimination in layoffs, companies can offer employees extra compensation in return for getting the employee to sign a waiver of any discrimination claims. The Age Discrimination in Employment Act (ADEA) includes guidelines for the use of such a procedure. In any event, it is advisable to provide a kind of “due process” to departing employees. An acquirer who wishes to set up a policy for RIFs might consider studying these government regulations (found in Title 5, Volume 1, of the Code of Federal Regulations), which can be customized to the needs of the company.41 To the reader who is unfamiliar with human resources (or “human capital”) issues, the Title 5 list may seem like a bureaucratic list that is more concerned with form than with function. But to the employee, it can represent a form of due process that can make the loss or reduction of income more acceptable—and prevent postacquisition litigation.

Could you give details on the law regarding discrimination waivers signed by older workers when they are being discharged?

In presenting a severance agreement to an employee who is to be discharged, an acquirer (or any company) should know that the ADEA requires that the company advise the employee in writing that the employee should consult with an attorney. Also, the company must provide the employee with at least 21 calendar days to consider the agreement before the agreement can be in force. The employee is also entitled to revoke the agreement at any time during the seven days following the employee’s signing of the agreement by giving the employer written notice of the revocation. The severance agreement and the release do not become effective until the day after the seven-day revocation period has expired. Also, for the release to be binding, the employee should receive some consideration (that is, additional compensation in some form) in return for signing the waiver. Additional requirements apply if the discharge is part of a reduction in force42 (that is, an “exit incentive or other employment termination pro-


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gram offered to a group or class of employees”). In this case, the employer must provide, at the beginning of the 45-day election period, a written description of the eligibility requirements and time limits applicable to the program, and the job titles and ages of all employees who are eligible or were selected for the program. An employee who has signed a waiver promising not to sue may still sue—and keep the money received for signing the waiver—if the release agreement is invalid. What laws govern notice of layoffs?

The primary law here is a provision within the Omnibus Trade and Competitiveness Act of 1988 called the Worker Adjustment and Retraining Notification (WARN) Act. WARN applies to companies with 100 or more employees who close a single site with 50 or more employees, or who institute a mass layoff that affects one-third or more of the employees at that site (provided that at least 50 are affected). Under WARN, such employers must give their employees and communities at least 60 days’ notice of a plant closing or mass layoff. The law defines all its key terms. Employees under this law means all full-time employees. Part-time employees do not count, unless all employees together work 4,000 hours per week, including overtime. Plant closing means a permanent or temporary shutdown of a single site that results in loss of employment for 50 or more full-time employees during any 30-day period. A mass layoff is one that affects one-third of the employees in an action that affects 50 or more employees, or that affects 500 or more employees (even if the percentage of all employees is under one-third). Notice to employees and communities means notice to the chosen representative of the employees (for example, a labor union) or the employees themselves, the state of the affected employees, and the chief elected official of the local government. The law includes exemptions for faltering companies and for unforeseen circumstances. An employer need not warn of a plant shutdown if it is actively seeking capital in order to avoid the shutdown, and if it believes that giving notice would harm its changes of obtaining that capital. An employer is also exempt if the business circumstances that forced the shutdown were not reasonably foreseeable at the time that the notice would have

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been required. An employer must still give as much notice as practical, and, when giving notice, must explain why it is shorter than the 60 days required.

COLLECTIVE BARGAINING LAWS What is collective bargaining?

As this term suggests, collective bargaining means negotiating on behalf of a group. In the labor law context, it means negotiating with employers on behalf of employees who are members of labor unions. The bargaining is done in the interests of obtaining an agreement, called a collective bargaining agreement. Negotiations are used to determine various conditions of employment. Such conditions may include any aspect of work, but collective bargaining tends to focus on areas that are not already fully covered by federal law, such as pay. Negotiators might seek to ensure payment for union members at a level well above minimum wage, for example, and it is in their discretionary power to do so.

What laws cover collective bargaining?

Collective bargaining is governed by federal and state statutory law, administrative agency regulations, and judicial decisions. In areas where federal and state law overlap, federal law rules. State laws are the main source of collective bargaining for agricultural workers, who are not covered under federal law. Federal employment law often has precedence over bankruptcy law.43 Collective bargaining laws entered federal law through the National Labor Relations Act (NLRA) of 1935, which outlaws certain unfair labor practices and grants employees the right to join trade unions and to bargain collectively. The law covers most industries. Exceptions include agriculture, which is covered under state law, and certain types of transportation, which are covered under the Railway Labor Act governing labor relations in the railway and airline industries. The NLRA has grown in importance over the years, having been amended by the Labor Management Relations (Taft-Hartley) Act in 1947 and the Labor Management Reporting and Disclosure (Landrum-Griffin) Act in 1959. The NLRA gave rise to a National Labor Relations Board


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(NLRB), which to this day works to clarify the law and to add to its reach through regulations. The NLRB also schedules, conducts, and supervises representation elections (in which workers are voting for or against being represented by a union). The board is also the primary adjudicatory body for processing and prosecuting unfair labor practice charges. It has virtually unlimited powers when it comes to interpreting and applying the NLRA. The NLRA requires the employer to bargain with the appointed representative of its employees (typically an organized labor union). The law also sets limits on the subject matter and tactics of collective bargaining,44 and gives procedural guidelines for good faith bargaining, leaving the results up to the negotiating parties.

What is the role of arbitration in collective bargaining?

In collective bargaining agreements, arbitration is commonly designated as the way to resolve disputes between employees and employers over rights (as opposed to disputes over interests arising during negotiations, which are usually resolved through a strike or a lockout). In disputes over rights, the parties select a neutral third party (an arbiter) to hold a formal or informal hearing on the disagreement. The third party then arbitrates the dispute by issuing a binding decision. Laws covering arbitration include the Federal Arbitration Act, which federal courts often apply in labor disputes (although the law does not expressly cover employment contracts), and the Uniform Arbitration Act, a model law adopted by 35 states.

Could you list some due diligence issues in an acquisition involving one or more unionized companies?

First of all, if the acquired company is unionized, the acquirer will want assurance that it is in compliance with the collective bargaining regulations described previously. As in checking any aspect of the acquired company’s legal compliance, the first focus should be on an overall process for legal compliance, and, if this is found wanting, then on the particulars. In addition, the acquirer will have to deal with issues of accretion and/or successor liability under the following scenarios:

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The acquirer and the acquired both have unions. Does the bargaining unit of the company fold into the acquirer’s bargaining unit, or does it remain freestanding? (This is called an accretion issue.) The acquirer has a union, and the acquired does not. Should the employees of the acquired company automatically join the acquired company’s unit? (This is also considered an accretion issue.) The acquirer does not have a union, and the acquired does. The acquirer may be deemed a successor employer. That is, it may not have to recognize the union right away, but it may be deemed a successor employer based on whether the acquirer hires a majority of the unionized workers. (This is called a successor liability issue.) Neither company has a union. There are no collective bargaining issues.

IMMIGRATION LAW What are some of the immigration law basics that an acquirer should know?

Under federal law, companies may not employ illegal aliens. U.S. federal law defines who is a citizen and who is an alien (noncitizen). It also sets forth the different types of aliens: resident versus nonresident, immigrant versus nonimmigrant, and documented versus undocumented (or illegal). The typical legal alien is a resident, immigrant, documented alien—that is, an alien who has an immigrant visa is permitted to work in the United States, and receives documents to that effect. Visas are issued for temporary periods and must be renewed periodically unless and until the holder becomes a citizen. Federal law, in U.S. Code Title 28, defines how an alien can become a citizen or can obtain the right to live and work in the country legally. States have some limited legislative authority regarding immigration, as described in Title 28, Section 1251 of the U.S. Code. The primary immigration law of the United States is the Immigration and Nationality Act of 1952 (INA), as amended. In addition, the Immigration Reform and Control Act (IRCA) of 1986 toughened criminal


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sanctions for employers who hire illegal aliens, among other provisions. The Immigration Act of 1990 increased the level of immigration and evened the allocation of visas.45

CONCLUDING COMMENTS

As in other legal areas, the acquirer should check for the candidate company’s compliance with employment laws—especially the laws covering equal opportunity, health and safety, pay and hours, workforce reduction, collective bargaining, and immigration discussed in this chapter. If the candidate company has a strong compliance program in place, the due diligence process in this legal area can be brief. However, if the candidate company has no such program, the acquirer will need to exercise extreme caution, given the high incidence of lawsuits in these areas. To protect its future, the acquirer may need to negotiate stronger representations and warranties in the employment area. The usual warning applies: reps and warranties are only as good as the money behind them. And so, once again: caveat emptor.


CONCLUSION

Risk has always been a companion of reward, inherent in assessing opportunities against a company’s strengths and weaknesses. —Dr. Reatha Clark King Adm. William J. Fallon “Letter from the Co-Chairs,” Report of the NACD Blue Ribbon Commission on Risk Governance (2009)

Due diligence can limit risk, but it can never—and should never—extinguish it. The mastery of risk, as Peter Bernstein noted in his classic work Against the Gods, has yielded great benefits to society. Without a command of probability theory and other instruments of risk management, engineers could never have designed the great bridges that span our wildest rivers, homes would still be heated by fireplaces or parlor stoves, electric power utilities would not exist, polio would still be maiming children, no airplanes would fly, and space travel would be just a dream.

These words can offer hope to any participant in the due diligence process. The sound conduct of this process can enable corporate progress— and, we would add, progress for all of us in a free society. If decision makers in all organizations exercise diligence in all their affairs, then they will or should be free from second-guessing by the courts, and free, too, from overregulation by governments. By its very nature, the topic of due diligence enables free enterprise and confirms the wisdom of “federalist” philosophy. Such a philosophy, based on the wisdom of the Constitution of the United States and similar constitutions in other countries, affirms the wisdom of limited government,

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CONCLUSION

based on the virtues that emanate from the prudent self-interest of the average informed citizen. You, our valued reader, are surely such a citizen—whatever nation you call home. As such, we believe that you will put this book to sensible use. You will let common sense and decency be your guide as you study acquisition candidates with the informed diligence that is due the situation—no more and no less.

DUE DILIGENCE CHECKLIST

DOCUMENTS Corporate Documents Certificate of Incorporation (CI), Including All Amendments, Name Changes, and Mergers

The CI is particularly helpful in determining what name to search for title to real estate. Special care should be taken not to overlook name variations, for example, “Rocket Airlines Inc.,” “Rocket Air Lines, Inc.,” and “Rocket Airlines Corp.” These are quite likely to be separate legal entities. The date and state of incorporation are also critical. There may be different companies with identical names incorporated in different states. Bylaws

Look for change of control provisions. Many bylaws contain “poison pill” provisions that are designed either to restrict changes in control or to make such changes very expensive for the potential acquirer. If the company is public, its bylaws may be available from an online research service. Minutes

Look for information on past acquisitions or mergers and other transactions affecting capital; this will help you trace the ownership of assets and equity. Make certain that the election and appointment of the current directors and 387

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officers is duly reflected and that the issuance of all outstanding stock has been properly authorized. Financial Statements

Develop breakdowns, by location, of the company’s assets (land, buildings, equipment, inventory, vehicles, and, if not billed out of a central office, receivables). Consider whether the financial statements that are provided are adequate for use in possible SEC filings or whether pro forma financials are needed. Examine footnotes as a source of information for more detailed inquiries into the existing debt, leases, pensions, related-party arrangements, and contingent liabilities. Especially in leveraged acquisitions, consider the target’s debt. Focus on areas of potential vulnerability, and check for compliance with the generally accepted accounting principles as determined by the Financial Accounting Standards Board (FASB), as well as any International Financial Reporting Standards (IFRS) jointly formed by the FASB and the International Accounting Standards Board (IASB). Note that FASB has codified its standards into clusters. One of the clusters (in the 800s) is for transactions and includes the following important items: 805 Business Combinations (includes old FAS 141R) 810 Consolidation (includes old FAS 160) 815 Derivatives and Hedging (includes old FAS 161) 820 Fair Value Measurements and Disclosures (includes old FAS 157) 825 Financial Instruments (includes old FAS 159) Be sure that your accountant’s review of the transaction is compliant with these standards. Engineering Reports

Try to find “as-built” drawings, especially if surveys are not available. Review these reports for environmental problems or other factors that might require major capital expenditures.


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Market Studies/Reports on Company’s Products

These may have been written in-house or by outside consultants. In the case of public companies, if the findings are material, they may be mentioned in the “management discussion and analysis” section of the company’s annual report. Check the 10-Ks and proxies, too. Note that marketing is a land mine of potential liability concerns, as described in Chapter 8.

Key Intangibles Patents, Trademarks, Trade Names, and Copyrights

These items generally involve “registered” or “filed” rights that can be searched for at the U.S. Patent and Trademark Office or, for copyrights, at the Library of Congress, Washington, D.C. However, such rights may not have been filed for. Also, corporations frequently have other key intangibles that have not been filed for anywhere, such as trade secrets. This is especially true of companies that deal in high technology, software, and the like. Due diligence calls for inquiry into the status of these items and the methods of protecting them. Review all related trade secrets, know-how, and license agreements. Licenses and Permits

Whether they are granted by the government or by a private third party, licenses and permits may be absolutely essential to the ability of a corporation to continue to conduct its business legally. The buyer should ensure that all such necessary licenses and permits are current and in good order and that these licenses and permits will be readily transferable, or remain valid, in the context of the acquisition transaction. It is generally useful to obtain the advice of special counsel or experts in the particular field (for example, FCC counsel in the case of broadcasting licenses). Licenses and permits should be studied in connection with state and federal law and regulations. In acquiring power plants or IPP industries, permits and licenses will be a key item for the due diligence checklist.


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Key Tangibles Mortgages

If these are significant, request a closing binder. Look for notes or other evidence of indebtedness. In the case of International Development Bank (IDB) or other quasi-public financing, request the closing binder and be sure to review the indenture and other such documents. Title Documents to Real Estate and Personal Property

Review title policies, documents creating any encumbrance upon title, and deeds or bills of sale by which the company acquired assets. If assets were acquired by stock purchase or merger, find evidence that the appropriate corporate documents were filed in the jurisdiction(s) where the assets are located as well as in the company’s state(s) of incorporation. Identification of Real Property and Assets

Ask the seller to give the complete address (including county) of every facility or piece of real estate owned or leased by the company, and describe each such facility using the following list of categories (indicate more than one category if appropriate): ■ ■ ■ ■ ■ ■ ■ ■ ■

Corporate offices Production, manufacturing, or processing facilities Warehouses, depots, or storage facilities Distribution facilities Sales offices Repair/warranty work facilities Apartments or other residential real property Undeveloped real property Any other facilities

If a property is owned, the seller should label it “O” and provide the full legal name in which the title is recorded. If it is leased, the seller should label it “L” and provide the full name of the lessor. The seller should indicate whether there is any inventory at any such facility by “I.” The seller should indicate any goods, products, or materials at any such facility that are there on consignment from a supplier by labeling the


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facility “Supp C.” Ask the seller to provide the complete address (including county) of every site not included in the previous list where any of the company’s assets are located, including every facility of any customer or processor at which the company has raw materials, goods, products, or inventory on consignment, and the name of the party that is in possession of such assets, including any such customer or processor. Compare the actual documents to the title insurance. Look for encumbrances, easements, rights of third parties, and personal property encumbrances appearing on UCC records that should be checked. When in doubt, send someone to the site. Contracts Supply and Sales Agreements

Do these meet the company’s future business requirements? Review them for assignability, term, and expenditures required. (Some long-time distribution contracts will survive a merger, but not an acquisition of assets.) Employment and Consulting Agreements

These relate to both the current key employees that the acquirer wishes to retain to ensure that the terms are good enough to hold them, and exposure to claims of past employees or those that the acquirer does not wish to retain. They should also be reviewed to discover if they restrict employees’ retaining of proprietary information, such as customer lists. Leases

Get legal descriptions. Pay particular attention to terms, expiration dates and renewal rights, rent, and special provisions concerning assignment that may include change of corporate ownership. License and Franchise Agreements

Look for correspondence concerning extension, expansion, disputes, and estoppels. Franchise relationships are likely to be stormy. Is there a franchise organization? Note assignment clauses and clauses that create a landlord’s lien. Are any prior consents required? Are these sufficient for the business’s requirements?


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Loan Agreements

Review terms, intention, and assignability provisions to identify any need to refinance or to obtain lenders’ consents to an acquisition. Schedules and exhibits should be reviewed to glean useful information regarding the company’s assets and structure. Shareholder Agreements

Review the provisions of these agreements and their effect on the proposed transaction. If an agreement will survive, determine its effect on future transactions, that is, registration rights and antidilution or dissenters’ rights. Sponsorship Agreements

Are these tax-deductible to the giver and tax-free to the receiver? In December 1991, the Internal Revenue Service said no to both questions, disappointing organizers and sponsors of the Mobil Cotton and John Hancock Bowls. Agreements with Labor

Obtain all agreements and study them for unusual provisions that would unduly constrain management’s options. Review benefits, severance, and plant-closing provisions. ■

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Will the agreements terminate at sale, or are they binding on the buyer? Do the agreements have provisions that restrict the buyer? Is the company currently in compliance with the agreements? Do the agreements expire soon? Will the buyer want them to be reopened? (Notice may be required.) Is a strike likely? Are there any grievances that raise general issues of contract interpretation?

Agreements with Management ■ ■

Are there golden parachutes? Is there excessive compensation? (Compare the existing compensation to current compensation studies by executive search firms such as Korn/Ferry International and executive compensation firms such as Hay Group or William L. Mercer.)


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Security Agreements or Other Agreements Giving Other Parties the Right to Acquire Assets of the Company

Review financing statements or other evidence of perfected security interests. Lien searches conducted by professional services that are engaged in this business are usually the most efficient way of uncovering UCC financing statements of record, but it is also sometimes necessary to check for third-party interests recorded against particular assets of the seller, rather than against the name of the seller itself. For example, security interests in assets such as vessels or aircraft are recorded in special registries (outside the scope of the usual UCC lien search) against the particular vessel or aircraft itself, rather than against the owning company. Sales and Product Warranty Agreements

Review these agreements for provisions that vary from the description or understanding of any such document that is provided or held by management. Review them for provisions that may be illegal and/or unenforceable. Also, review them for any indemnity obligations of the company. Selected Correspondence

This is a useful means of uncovering past problems that may recur. Acquisition Agreements

Review prior acquisition agreements for surviving provisions, that is, noncompete clauses and indemnification obligations. Pension and Profit-Sharing Plans

Check out the fine print in all plans and trust documents, and review the personnel handbook and any policy manual. In particular, review the following: ■ ■ ■ ■

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Form 5500 Summary Plan Description (SPD) Actuarial valuation Auditor’s report and accompanying management reports Investment manager agreements Fiduciary insurance and bonds


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Investment contracts Investment policy Accrued, unfunded liabilities Fringe benefits

Welfare Benefit Plans

Be aware that potential liabilities in this area can be substantial and that the valuation of plans requires expert guidance. Check out fiduciary insurance and bonds. Multiemployer Plans

These can be a major problem. See Chapter 12. Deferred Compensation Plan and Stock Option Plan

Is the candidate company in compliance with compensation reporting and disclosure standards issued by the Financial Accounting Standards Board and other authorities? Supplemental or Excess Pension Plan ■ ■ ■ ■ ■ ■ ■

Is the plan exempt from ERISA? Will future law affect costs or benefits? Are large claims anticipated? Are the reserves on the company books adequate? Can the plan be terminated or amended? Are there any benefits in pay status? Are the benefits in effect funded with insurance?

Insurance Policies

Review all policies and ask at least these questions: ■

■ ■ ■

Do the policies cover the areas of risk exposure? (Consider using a risk analysis consultant to review this very technical area.) What is the deductible? What are the liability limits per occurrence? In total? Are punitive or treble damages excluded by the policy or by state law?


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Are the policies written for “claims incurred” or “claims made”? Must a “tail” be purchased to extend coverage? Is there a “reservation of rights” clause? Is there a regulatory exemption clause? What about coverage for director and officer liability? What about environmental liability?

KEY INFORMATION FROM THE COMPANY’S MANAGEMENT Financial, Ownership, and Governance Information Financial Information

Perform an analysis of the company’s past operating and financial performance. Document any planned substantive changes. In conducting such an analysis, keep the latest tax and accounting changes in mind. Relative Profitability of the Company’s Various Classes of Products and Business Segments

Compare this information with the results of companies of similar size in the same industry. Ownership of the Company’s Securities

Trace the title of the present owners of the corporation (if it is privately held). Review for existing pledges or liens that must be released to permit the transaction. Governance Information

Does the company have a functioning board of directors? Does it have independent committees for audit, nomination, and compensation? Litigation Matters Potential Defaults under Existing Contracts or Potential Litigation

Identify as many potential issues as possible and obtain waivers, consents, and so on. Ask for a summary of all pending or threatened legal actions that are material:


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■ ■ ■ ■ ■ ■ ■ ■

Names and addresses of all parties The nature of the proceedings The date of commencement Current status Relief sought Estimated actual cost Insurance coverage, if any Any legal opinions rendered concerning those actions

Summaries should also be provided for the following: ■ ■ ■

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All civil suits by private individuals or entities Suits or investigations by governmental bodies Criminal actions involving the target or any of its significant employees Tax claims (federal, state, and local) Administrative actions All investigations All threatened litigation

Product Backlogs, Purchasing, Inventory, and Pricing Policies

Is the company accurately tracking the flow of goods within the company? Falsification of records can abet fraudulent schemes of massive proportions. Pending Negotiations for the Purchase or Disposition of Assets or Liens

The buyer may want to drop real property that it is planning to dispose of into another entity (such as an affiliated partnership) to avoid gain recognition or to provide a means of early investment return for the acquiring persons. Federal Tax Challenges

A number of issues may come up in the tax area. These fall into two basic categories: understatement of income and overstatement of deductible expenses.


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State and Local Tax Challenges

Does the company that is being acquired owe property taxes? If so, how will these be allocated between the acquirer and the seller? Is there room for negotiation with the municipality or township? If the acquirer is from outside the jurisdiction, it will not be in the best position to reach a settlement; this should be done through the selling company. The incentive for settlement could be a sharing of gain if the settlement is in favor of the debtor. Recent or Pending Changes in Federal Laws or Regulations That Might Affect the Company’s Business

Ask for copies of all material correspondence with government agencies during the past five years, including the following: ■

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Department of Justice (including the Antitrust Division) Department of the Treasury (including the Internal Revenue Service) Department of Labor (DOL) (working conditions, including pensions) National Labor Relations Board (labor disputes) Occupational Safety and Health Administration of the DOL (worker safety and health) Consumer Product Safety Commission (consumer safety) Environmental Protection Agency (environment) Equal Employment Opportunity Commission (employment fairness) Federal Trade Commission (commercial transactions) Securities and Exchange Commission (securities issues and exchanges)

In addition, acquirers in specific industries must be aware of their relevant regulators. These include ■ ■ ■

Federal Deposit Insurance Corporation Public utility commissions Federal Energy Regulatory Commission


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Ask legal counsel to check the latest version of the Code of Federal Regulations for relevant new laws affecting the candidate company’s business. These should be examined for compliance—and for the potential for lawsuits alleging noncompliance. For a complete list of CFR titles, see Appendix 4A in this book. KEY INFORMATION FROM OUTSIDE SOURCES Market and Capital Information Market and Product Studies

Whether or not the company has conducted market and product studies, consulting independent research is always a good idea. Also try to obtain product test data from regulatory agencies. Contact major customers to determine their level of satisfaction with the company’s products and copies of test programs that they have run. Capital Confirmation

Confirm the company’s outstanding capitalization with the company’s stock transfer agent. Lien Search

Acquirers will want to conduct searches of public records to confirm the absence of liens or judgments. Note that the names of debtors to be searched for are often difficult to determine. ■

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Prior names. There is a four-month rule regarding afteracquired collateral; you cannot rely on the creditor. Fictitious names or other false information. Continuation statements.

Sometimes a search must be conducted at the state or local level. In such cases, it may be necessary to do the following: ■

Coordinate between the search firm and the title company (sometimes not done).


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Consult the Uniform Commercial Code and Related Procedures, published by Register, Inc., to determine whether the state(s) at issue have additional or unusual search requirements. Obtain the lender’s or borrower’s approval.

Ordering a Search

Send a letter to the search firm or title company, listing the names, location, cost, and deadline and request copies of all liens found. Send a copy to the client and the lender’s or borrower’s counsel. Reviewing a Search

What is your client buying, selling, liening, or loaning against? Are certain pieces of equipment, goods, and intangibles supposed to be free and clear? Are they vital to the business? To the closing? If so, watch for liens against those items. ■

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If certain secured debts are to remain in place, one would expect related UCC-1s to show up on the search report. If secured debt is to be paid off at closing, the seller must produce UCC-3s or other required forms of release from the relevant parties. What does the appraisal say? What does the commitment/finance package say?

Check the report for names and jurisdictions. Review the UCC-1s that were sent for the following: ■ ■ ■ ■

Debtor Secured party Date (five-year rule) Description of collateral

Compare the report against the schedules that are to be incorporated into loan documents, contracts, and bills of sale. Often, local counsel will need copies of lien searches in order to deliver a priority opinion.


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Bringdown of Search

A search bringdown is a telegram or telephone update of lien searches and of corporate good-standing certificates. It is often difficult to get such a document closer than a few days before closing, but every effort should be made to close on the basis of the most recent bringdowns possible. Creditor Check Assumption of Debt

If secured debt is not to be paid off, get security documents to see whether, for example, incurring of acquisition debt, imposition of related liens, merger, change of control, or sale of assets is permitted. Are there burdensome covenants? Is prepayment permitted, with or without penalty? Confirm the absence of defaults from the principal lenders. Confirm the absence of defaults from lessors (landlords). Recognize unusual or potential problems. (The key here is detail and curiosity.) ■ ■

Is the affiliate of the seller named as a secured party? Are the names of the debtor not exactly right, but “must be” related?

Other Searches Patent and Trademark Searches for Possible Infringement of Products or Product Names Certificates of Good Standing for All Corporate Subsidiaries, Whether Active or Inactive Title Search/Acquisition of Title Insurance Appraisals of Company-Owned Real Property and Improvements Any Equipment Appraisals Made by or for Insurance Companies

LANDMARK AND RECENT DUE DILIGENCE CASES

Nothing focuses attention on key due diligence issues more squarely than a thorny legal case that was wisely decided. The following cases, which are organized by type, set forth some key legal concepts learned through hard M&A experience. In the following pages, we summarize significant cases from the U.S. Supreme Court, along with some from state, federal, and chancery (business) courts in the United States—especially the state of Delaware, which is the home of most large U.S. public companies. To maintain ease of reading, we use shorthand for well-known provisions of U.S. securities laws. (Please use this book’s index to find detailed definitions and discussions of these provisions.) These cases are organized by topic. Each section begins with one or more landmark cases from the last century, followed by one or more recent ones (since 2000), following the general outline of this book. Cases alleging negligence in an acquisition or stock offering (Chapters 1–4) Cases alleging fraud or negligence in the sale of a business (Chapters 1–4) Cases involving M&A agreements (Chapter 5) Cases alleging violation of ■ Securities laws (Chapter 6) ■ Tax laws and accounting regulations (Chapter 7) 401

Landmark and Recent Due Diligence Cases

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Antitrust and trade laws (Chapter 8) Intellectual property laws (Chapter 9) Consumer protection laws (Chapter 10) Environmental laws (Chapter 11) Health, safety, and labor laws (Chapter 12) Fiduciary duties (General)

The older cases featured here include many that have been used in previous books in the Art of M&A series (which, in turn, were based on multiple sources, cited therein). For the reader’s convenience, we have added a one-sentence headline, newspaper style. (Note: like the other contents of this book, these headlines do not constitute legal advice.) For our summaries of recent Delaware cases (2005 through 2010), we relied on the diligent spadework and analysis of attorneys in the securities litigation practice of Morris James, LLP, Wilmington, Delaware, with their generous permission.1 CASES ALLEGING NEGLIGENCE IN AN ACQUISITION OR STOCK OFFERING Landmark Cases

Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1975). An audit conducted in good faith according to accepted standards was unsuccessfully challenged under 10b-5 antifraud rules. Hochfelder was a customer of First Securities Company. The president of the company, Nay, convinced Hochfelder to invest funds in escrow accounts that would yield a high rate of return. Nay asked Hochfelder to write out checks in Nay’s name. When Nay committed suicide, Hochfelder learned that there were no escrow accounts—not even phony ones. Nay’s suicide note itself described First Securities as bankrupt, and the escrow accounts as “spurious.” Hochfelder filed suit in district court for damages against Ernst & Ernst under Section 10(b) of the Securities Exchange Act of 1934, charging that Ernst & Ernst had aided and abetted Nay by failing to conduct proper audits. The district court dismissed the case on the grounds that Ernst & Ernst’s accounting procedures conformed to those in general use. The U.S. Court of Appeals reversed this decision, holding Ernst & Ernst liable


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for a breach of the fiduciary duty of inquiry and disclosure under common law and statutory law. The U.S. Supreme Court disagreed. It held that mere negligence was not a “manipulative device,” and therefore was not a violation of Section 10(b), and that good faith was indeed a valid defense. Furthermore, the Court held that a private right of action is not possible under Section 10(b) or Rule 10b-5 unless there is an intent to deceive, manipulate, or defraud (scienter). Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). Company officers and others were held liable for detectable misstatements in a registration statement, even without intent to defraud. When BarChris Construction, a bowling alley builder, went bankrupt, bondholders accused its directors and officers of violating Section 11 by making material misstatements and omissions in their registration statement. The bondholders sued the auditors, the underwriters, and all those who had signed the statement—namely, the company’s directors (including five officers) and the company’s controller. The court found the auditing firm liable for not following generally accepted accounting principles. It also found the underwriters liable for failing to prevent the material misstatements. The court asked, “Is it sufficient to ask questions, to obtain answers which, if true, would be thought satisfactory, and let it go at that, without seeking to ascertain from the records whether the answers, in fact, are true and accurate?” Its answer: “The purpose of Section 11 is to protect investors. To that end, the underwriters are made responsible for the truth of the prospectus. If they may escape that responsibility by taking at face value representations made to them by management, then including the underwriters among those liable under Section 11 affords the investors no additional protection.” Citing Section 11, the court found that there were misstatements and omissions in both the expert and the nonexpert portions of the registration statement. It held the inside directors and financial officers responsible for the expert portions, declaring: “There is nothing to show that they made any investigation of anything which they may not have known about or understood. They have not proved their due diligence defenses.” Furthermore, the court held the outside directors liable for the nonexpert portions. The various directors showed different degrees of diligence, but none showed a high enough degree. One director, Coleman, who had been a part-

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ner with the company’s investment banker, had previously checked with the company’s lenders and Dun & Bradstreet, had read extensive documents, and had interviewed the underwriter. Once he became a director, however, he began to rely on others, including a junior associate from the company’s outside law firm. “When it came to verification,” said the court, “he relied upon his counsel to do it for him. Since counsel failed to do it, Coleman is bound by that failure.” Feit v. Leasco Data Processing Corp., 332 F. Supp. 544 (E.D.N.Y. 1971). Leaving a significant account out of a prospectus was found to violate Section 11—complications of accounting and valuation were no excuse. In 1968, Leasco Data Processing Equipment Corporation began negotiations to acquire Reliance Insurance Company. Leasco was particularly attracted by Reliance’s “surplus surplus,” the portion of the surplus beyond what is required by law to maintain the integrity of an insurance operation. Because insurance companies at that time were not permitted to engage in noninsurance businesses, the surplus surplus (as a highly liquid asset) had to be separated from the insurance operation. Leasco intended to form a parent holding company and to transfer the surplus surplus to it. After some initial disagreements between the two managements, Leasco obtained 90 percent of Reliance in a tender offer. None of the various prospectuses (a supplement was issued each time the tender exchange period was extended) made any mention of Reliance’s surplus surplus, an amount estimated by experts to have been between $100 and $125 million. Feit, a Reliance stockholder, brought a lawsuit to recover damages. The lawsuit centered on (1) the materiality of the surplus surplus question to the Leasco prospectus sent to holders of Reliance stock and (2) the accountability of Leasco’s directors for the decision to make no mention of the surplus surplus in the prospectuses. The defendants contended that they were unable to get a good estimate of Reliance’s surplus surplus because of poor relations with Reliance’s management. They further argued that, in any case, an estimate of the surplus surplus in the prospectuses would have only made Reliance shareholders more eager to tender, since Leasco was known to be aggressive in employing liquid assets. Finally, they asserted that this kind of information could have violated SEC standards for prospectuses and turned this one into a “selling document.”


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The court rendered a decision in favor of the plaintiff Feit, according him monetary damages pursuant to Section 11 of the Securities Act of 1933. Relying on the due diligence portions of Escott v. BarChris (1968), the court held that the director defendants “failed to fulfill their duty of reasonable investigation . . . and had no reasonable grounds to believe that an omission of an estimate of surplus surplus was not materially misleading.” Hanson Trust PLC v. SCM Corp., 774 F.2d 47 (2d Cir. 1985). Fiduciaries found no support under the business judgment rule for fast-track approval of a lockup. Hanson Trust PLC made a $60 per share tender offer for any and all shares of SCM Corp. The offer was followed by a counteroffer by the SCM board and its white knight, Merrill Lynch Capital Markets. Hanson then increased its offer to $72 per share, contingent upon SCM’s agreement not to enter into a lockup agreement. The SCM-Merrill counteroffer was revised to $74 along with a lockup option for one of SCM’s “crown jewels.” Hanson terminated its offer as a direct result of the lockup option. (A lockup option is an agreement that says that the option holder, Company A, will acquire all or part of Company B, and that Company A will realize an economic gain if another company buys Company B or a specified part of Company B.) The question before the court was whether SCM’s board of directors was protected under the business judgment rule when it approved the lockup option. The business judgment rule is a judicial doctrine under which informed decisions by directors are effectively insulated from secondguessing by the courts. The U.S. Court of Appeals for the Second Circuit denied protection under the business judgment rule on the grounds that SCM directors had a “paucity of information” and that the swiftness of their decision making strongly suggested a breach of the duty of care. Laven v. Flanagan, 695 F. Sup. 800 (D.N.J. 1989). The definition of “reasonable reliance” and “reasonable investigation” in a Section 11 case is measured largely by common practices. This case held that outside directors are “under a lesser obligation to conduct a painstaking investigation than an inside director” and may rely solely on representations from the company’s management and qualified advisors. Because the directors made a reasonable effort to seek verification of the truth of the registration statement, and as long as their

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advisors followed common professional practices, the court found no Section 11 liability. Software Toolworks Sec. Lit., 50 F.3d 615 (9th Cir. 1994). The court offered a list of red flags for due diligence. In this securities offering case, the court stated that suspicious facts or transactions require inquiry, and offered a list of “red flags” that should raise suspicion in a reasonable person. The court awarded a summary judgment to the underwriter after the underwriter provided extensive records showing its due diligence investigations. Smith v. Van Gorkom, Del. Supr., 488 A.2d 858 (1985). The business judgment rule fails to protect directors who make uninformed judgments. Shareholders brought a class action against the board of directors of Trans-Union Corporation, alleging that the board was grossly negligent in its duty of care to the shareholders for recommending that the shareholders approve a merger agreement at $55 per share. Although the price per share was well above current market values, the shareholders alleged that it was inadequate. The Delaware Court of Chancery granted the directors summary judgment, and the shareholders appealed. The Delaware Supreme Court indicated that it would closely scrutinize the process by which the board’s decision was made. Historically, courts generally did not interfere with the good faith business decisions of a corporate board; however, this case eroded that principle, and the court struck down the long-accepted practice of affording corporate directors the almost ironclad presumption that, in making business decisions, the directors acted on an informed basis. Instead, it held that the determination of whether the business judgment of a board of directors is informed turns on whether the directors have essentially followed certain procedures to inform themselves prior to making business decisions. The court went on to say that there is no protection under the business judgment rule for directors who have made uninformed judgments. Recent Cases

Certainteed Corp. v. Celotex Corp., et al., C.A. No. 471, 2005 WL 217032 (Del. Ch. Jan. 24, 2005). The Delaware Court of Chancery held that claims accrue upon receipt of an inquiry notice of a wrongful act.


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The plaintiff entered into an asset purchase agreement (APA) with the defendant. The defendant had assumed indemnification obligations relating to the assets sold. After the sale, the plaintiff experienced various losses that it believed fell to the defendant to cover. This suit then ensued. The plaintiff brought a breach of contract action against the defendant sellers under the APA for indemnification of losses and other related claims. The court dismissed some of these claims on account of late disclosures and the lateness of the complaint itself. However, it did accept environmental remediation work claims and a product liability claim involving third-party indemnification based on the plaintiff’s injuries incurred as a result ofdefendant’s sale of defective materials prior to the APA. Delaware Open MRI Radiology Associates, P.A. v. Kessler, C.A., No. 275-N, 2006 WL 1215096 (Apr. 26, 2006). The Delaware Court of Chancery found a remedy for breach of fiduciary duty identical to the appraisal award. This case was described by Vice Chancellor Strine as “another progeny of one of our law’s hybrid varietals: the combined appraisal and entire fairness action.” The court was given the task of determining whether the share price in a squeeze-out merger was fair, and, if not, what the extent of the underpayment to the minority shareholders was. The court found that the merger price was unfair and, finding no difference between the award that the petitioners/plaintiffs would receive in appraisal or in equity, awarded an amount equivalent to petitioners’ pro rata share of the company’s appraisal value on the date of the merger. Finkelstein v. Liberty Digital, Inc., 2005 WL 1074364 (Del. Ch. April 25, 2005). In this case, where parties had stipulated to all but one asset of the merging companies, the court called cash flow projections “incredible.” This appraisal case involved the fair value shares of a company, Liberty Digital, Inc., that was merged with an acquisition subsidiary of Liberty Media. The parties had stipulated the value of all but one of Liberty’s assets. The court found the appraiser’s discounted cash flow projection the court found to be “incredible” and “untethered to reality.” In re J.P. Morgan Chase & Co. S’holder Litig., 2005 WL 1076069 (Del. Ch. April 29, 2005), aff’d, 2006 WL 585606 (Del. Mar. 8, 2006). The

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Court of Chancery dismissed stockholders’ claims of merger overpayment because the claims were derivative and the demand was not excused. J.P. Morgan Chase & Co. (JPMC) and Bank One agreed to a business combination that was expected to create the second largest financial institution in the country. JPMC paid a premium over the market share price for Bank One, effectively making JPMC the acquirer and Bank One the target. After the merger was completed, the stockholders of the acquirer sued its directors, alleging breaches of fiduciary duty with regard to the acquisition. Their claims stemmed from the allegation that the directors had paid too much for the acquired bank. The defendants moved to dismiss the complaint on the basis that the claims were derivative, not direct, and that demand was not excused. The court granted the defendant’s motion to dismiss. Maxwell v. KPMG, No. 07-2819 (7th Cir. 2008). The court said that strategy is up to the company, not its auditors. In this case, the court held that KPMG was not liable for malpractice to a former audit client that collapsed a year after it acquired a much larger firm. The court rejected the former client’s claim that KPMG had committed malpractice in not uncovering its inability to carry out the acquisition successfully: By swallowing a larger company, and one concentrated in the dot.com business, Whittman-Hart assumed the risk of being injured, fatally as it turned out, by a downturn in that business. It wants to make its auditor the insurer against the folly (as it later turned out) of a business decision (the decision to try to acquire US Web) unrelated to what an auditor is hired to do.2

Omnicare. Inc. v. NCS Healthcare, Inc., Del. Sup., No. 605, 2002 (Apr. 4, 2003). Deal protection mechanisms that fully lock a merger and contain no fiduciary out are unenforceable and a breach of fiduciary duty. NCS Heathcare and Genesis Health Ventures had sought to protect their proposed merger through a lockup of the majority stockholders under a voting agreement, coupled with a merger agreement requirement that a stockholder vote be held even if the board withdrew its recommendation because it had received a superior offering. Subsequent to the signing of this agreement, Omnicare emerged with a superior proposal. In light of this new proposal, the NCS board of directors withdrew its prior recommenda-


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tion in favor of the Genesis transaction. Nevertheless, under the terms of the “force the vote” provision, NCS proceeded with the stockholders meeting and submitted the Genesis merger to its stockholders for their consideration. Since the lockup agreements committed more than a majority of the outstanding NCS shares to vote in favor of the Genesis merger, and since neither the merger agreement nor the lockup agreements contained “fiduciary out” clauses, stockholder approval of the Genesis merger was virtually assured. Omnicare subsequently instituted a lawsuit to enjoin the consummation of the Genesis merger. The Delaware Supreme Court held that the absence of a fiduciary out provision in the merger agreement made the deal protection measures (i.e., the “force the vote” provision coupled with the stockholder voting agreements that represented a majority of the votes on the merger) both preclusive and coercive, a violation of the Unocal test. UbiquiTel v. Sprint Corporation, C.A. No. 1489-N, 2005 WL 3533697 (Del. Ch. Dec. 14, 2005, rev’d Dec. 19, 2005). The court denied a motion to dismiss claims for tortious interference and civil conspiracy in connection with a telecommunications merger. UbiquiTel was the exclusive operator of Sprint’s wireless network in several states pursuant to a management agreement. In December 2004, Sprint announced that it intended to merge with Nextel and that Nextel or its successor entity would be taking over much of the work that had previously been performed by UbiquiTel. In response, UbiquiTel sued Sprint and Nextel, alleging a number of claims, including tortious interference and civil conspiracy against Nextel. Nextel moved to dismiss for failure to state a claim. CASES ALLEGING FRAUD OR NEGLIGENCE IN THE SALE OF A BUSINESS Landmark Cases

Credit Managers Ass’n of Southern Cal. v. Federal Co., 629 F. Supp. 175 (C.D. Cal. 1985). The court said that the sale of a thinly capitalized company is not necessarily a fraudulent conveyance. In 1980, Crescent Food Co., a cheese importation and distribution entity that was wholly owned by Federal Company, entered into a manage-

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ment-led leveraged buyout. The stock purchase price was over $1.4 million. Crescent received an additional loan of $189,000 from the new management, as well as approximately $10 million from General Electric Credit Corp. Crescent’s debt service increased significantly because of the buyout. Finding itself with insufficient cash to continue operations, Crescent eventually shut down and executed an assignment of its assets for the benefit of creditors. The plaintiff brought action against Federal, alleging that the buyout was a fraudulent conveyance. The question before the court was whether the transaction was a fraudulent conveyance. The U.S. District Court in California held that the law does not require that companies be sufficiently well capitalized to withstand any and all setbacks to their business; it requires only that the companies not be left with an unreasonably small amount of capital at the time of conveyance. In re Healthco International, Inc., Securities Litigation, 208 B.R. 288 (Bankr. D. Mass.1997). Directors who owned stock in a company that overshot its mark prevailed against 10b-5 claims by showing due care and loyalty. In the spring of 1990, Healthco was involved in a struggle for corporate control with Gemini Partners L.P. In June 1990, Gemini, a minority shareholder of Healthco, began a proxy contest to remove the incumbent board, alleging that the price of Healthco’s stock was undervalued. In September 1990, Healthco entered into a merger agreement with HMD Acquisition (an acquisition vehicle of Hicks Muse) subject to several conditions, including shareholder approval, realization of projected earnings, and the securing of financing. In January 1991, Healthco issued a proxy statement projecting unspecified losses, causing Gemini to withdraw its bid and leaving HMD as the sole bidder. HMD acquired Healthco for $15 per share— $4.25 per share less than Gemini’s highest offer. In March 1991, the new Healthco board, which included directors who were Healthco stockholders, experienced operating problems. Shareholders brought suit against Healthco, alleging material misstatement in the proxy statement. The question before the court was whether the projections of unspecified losses constituted fraud under Rule 10b-5 of the U.S. federal securities laws. Finding in favor of the defendants, the district court held that “optimistic, vague projections of future success which prove to be ill-founded” do not by themselves trigger Rule 10b-5 liability. This liabil-


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ity is triggered when such overly optimistic projections “imply certainty” or rely on “statements of facts which prove to be erroneous.” In June 1993, Healthco filed for relief under Chapter 11 of the U.S. Bankruptcy Code. Then, in September of that year, the case was converted to Chapter 7 and the company was liquidated, causing severe losses to the company’s creditors. In June 1995, the bankruptcy trustee for the creditors began legal action (independent of the previous securities lawsuit) in U.S. Bankruptcy Court against virtually all the participants in the company—65 defendants in all, including the company’s directors, who were accused of violating their duty of loyalty. The plaintiffs alleged that the directors’ ownership of stock in Healthco rendered them “interested” in its sale. The directors, citing legal precedent and documenting their decision-making process, argued that they had fulfilled their duties of loyalty and care. They asked the bankruptcy court for a summary judgment dismissal, but the court refused, holding that the directors were indeed “interested” parties by law. Two years later, the case came to trial again in U.S. District Court in Worcester, Massachusetts, where the court declined to adopt the bankruptcy court’s ruling and ordered a jury trial. The directors repeated their defense, this time bringing in an expert witness on behalf of the directors, Dr. Robert Stobaugh, emeritus professor at Harvard Business School. He testified that the Healthco directors had met generally accepted practice with respect to both their duty of loyalty and their duty of care. After a seven-week trial, the jury returned a verdict in favor of all the defendants on all the claims in the bankruptcy case. Humana v. Forsyth, USS 97-303, 1999. The high court cleared the way for a RICO case based on flawed due diligence. In this case, the plaintiffs sued Humana, a hospital system, and several hospitals that Humana had sold to Columbia-HCA Healthcare Corp. in 1993. Apparently, in conducting its due diligence study of the Humanaowned hospitals, Columbia had not discovered that some of the hospitals had failed to pass on an insurance discount that they were getting for certain customers. The class action suit against Humana and against the acquired hospitals (now owned by Columbia-HCA) alleged that the absence of the discount was an attempt to defraud the customers.

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The plaintiffs sued Humana and Columbia under a federal statute called the Racketeer Influenced and Corrupt Organizations Act (RICO), a criminal law that exacts triple damages from defendants who are found guilty. The RICO case went all the way to the Supreme Court, which had to decide whether the plaintiffs had standing to sue under this federal law. A trial court had said no, because the federal law allows more severe penalties than the applicable state law (Nevada). But the Appeals Court in San Francisco reversed the decision, saying that the difference was not great enough to matter. The Supreme Court upheld this view. Justice Ruth Bader Ginsburg, writing for the Court, said, “RICO’s private right of action and treble-damages provision appears to complement Nevada’s statutory and common law claims for relief.”3 Kupetz v. Wolf, 845 F.2d 842 (9th Cir. 1989). No fraudulent conveyance was found for belated claimants who had ample opportunity to learn more. In July 1989, the owners of Wolf & Vine decided to sell their company to David Adashek. Adeshek formed Little Red Riding Hood to purchase Wolf & Vine from its owners with financing from Continental Illinois National Bank. Little Red Riding Hood then merged into Wolf & Vine. Subsequently, Wolf & Vine could not meet its debt obligations and filed for Chapter 11 protection; it later changed its petition to Chapter 7. The bankruptcy trustee filed a complaint alleging that the original sale of Wolf & Vine to Little Red Riding Hood was a fraudulent conveyance. The previous owners sought summary judgment based on the argument that the business was sold in good faith for fair consideration. The U.S. District Court granted the summary judgment, and the trustee appealed to the Ninth Circuit Court of Appeals. The question before the court was whether the sale was a “fraudulent conveyance” within the meaning of the bankruptcy statute of California’s fraudulent conveyance law. The existing creditors had had the opportunity to gain knowledge of Wolf & Vine’s financial status and its heavy debt structure prior to extending credit to it. The creditors could easily have asked for financial information before extending credit. Moreover, the transaction was well publicized within the industry. To ask Wolf to underwrite the creditors’ losses, which were due at least partially to their own failure to inquire adequately, would not be just. Therefore, because no evidence of actual


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intent to defraud creditors was presented and because the claims of the existing creditors arose after the sale, the petition was denied. U.S. v. Gleneagles Inv. Co., 565 F. Supp. 556 (M.D. Pa. 1983), 571 F. Supp. 935 (1983), 584 F. Supp. 671 (1984), aff’d sub nom. United States v. Tabor Court Realty Corp., 803 F.2d 1288 (3d Cir. 1986). The court delved into the right to sue over bad mortgages under the Fraudulent Conveyances Act. This case had been the subject of two earlier opinions by the U.S. District Court for the Middle District of Pennsylvania. In the first opinion, the court concluded that certain mortgages granted by Institutional Investors Trust (IIT) were fraudulent conveyances within the meaning of Sections 354, 355, 356, and 357 of the Pennsylvania Uniform Fraudulent Conveyance Act, 39 Pa. Stat. 351, et seq. (United States v. Gleneagles Inv. Co., Inc., hereinafter Gleneagles I). In the second opinion, the court focused on Gleneagles’ subsidiary, Pagnotti Enterprises, which purchased the IIT mortgages and caused the assignment thereof to its subsidiary, McClelland Realty. The court concluded that the subsidiary was not a purchaser of the IIT mortgages for fair consideration without knowledge that they were fraudulent conveyances (United States v. Gleneagles Inv. Co., Inc., hereinafter Gleneagles II). The court also concluded in Gleneagles II that the Lackawanna County tax sales of the lands of Raymond Colliery in 1976 and 1980 and the consequent tax deed were void and ineffective to transfer title to the purchasers at those tax sales. The United States had sought the third action to set aside as fraudulent conveyances mortgages held by IIT on the lands of Raymond Colliery and to foreclose on tax liens against Raymond Colliery and its parent, Great American Coal Company, free and clear of the IIT mortgages. Those mortgages were delivered by Raymond Colliery on November 26, 1973, to IIT and assigned by IIT to defendant McClelland Realty. The U.S. District Court for M.D. Pennsylvania made three points in its decision. First, it held that one payment of $6.1 million would not place creditors of the mortgagor in the same or similar position that they had held prior to the fraudulent transaction. Second, it stated that settlement monies paid to the mortgagor’s creditors by former shareholders of the mortgagor could not be deducted from the recovery to which creditors were entitled from the mortgage assignee. Third, it stated that the assigned mortgages were not entitled to protection under the Fraudulent Conveyances Act. In

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later years, this case has been cited and challenged in matters involving statutes of limitation.4 Recent Cases

Abraham v. Emerson Radio Corp., C.A. No. 1845-N, 2006 WL 1879205 (Del. Ch. July 5, 2006). The Delaware Court of Chancery clarified the right to sell control. While it has long been the rule that a stockholder may deal with its shares as it sees fit, case law recognized that a controlling stockholder has a fiduciary duty to its company and the minority owners by virtue of the controller’s ability to control what the company does. This case addressed how that duty applies in a sale of control. This decision makes it clear that, in general, a controlling shareholder may sell control without fear of liability for the actions of the buyer after the transaction closes. Aby Parterns V.L.P., et al. v. F & W Acquisitions LLC, et al. C.A. No. 1756N. (Del. Ch. Feb. 14, 2006), published at 891 A. 2d 1032 (Cel. Ch. 2006). The Delaware Court of Chancery held that “antireliance” contract provisions cannot exclude liability for fraudulent misrepresentations. This is the plaintiffs’ suit for rescission of a corporate acquisition contract. The court focused on the law and policy of the bar to recessionary relief and limitations in damage recovery for misrepresentations through the contract’s exclusive indemnity-limiting provision. The court reconciled the power of privately ordered contracts allocating risk between the parties and Delaware’s public policy disfavoring a bar on recessionary remedies and damages for willful misrepresentations. Additionally, the court examined the elective remedies available to the plaintiff-buyer. In the end, the court held that “antireliance” contract provisions cannot exclude liability for fraudulent misrepresentations. Andaloro v. PFPC Worldwide, Inc., C.A., No. 20289, 2005 WL 2045640 (Del. Ch. Aug. 19, 2005). In an appraisal action, the Delaware Court of Chancery approved use of the discounted cash flow and comparable-companies’ methods to value shares purchased by and replacing with a majority owner. This was a consolidated appraisal and equitable fiduciary duty action (the court did not address the fiduciary claim in this opinion). It arose out


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of a merger in which PFPC Worldwide, Inc. (PFPC), was acquired by its parent, PFPC Holding Corp. (Holding), which held over 98 percent of PFPC’s stock before the merger. The merger was also approved by PFPC’s ultimate parent and Holding’s immediate parent, PNC Financial Services Group, Inc. (PNC). The merger resulted in the elimination of the minority shareholders’ position in PFPC for $34.26 per share. The court approved the methods used to set this price: discounted cash flow and comparable companies. Calpine Corporation v. The Bank of New York, C.A. No. 1669-N, 2005 WL 3454729 (Del. Ch. Nov. 22, 2005). A corporation’s use of sale proceeds violated language the in indenture agreements. The plaintiff, an energy company, attempted to use the proceeds from the sale of certain assets to fund a series of purchases of natural gas for burning in its power plants. The plaintiff ’s noteholders objected to those purchases because the relevant indenture agreements allowed the sale proceeds to be used only for certain purposes. In response to the noteholders’ objection, the indenture trustees refused to authorize the release of any additional monies to plaintiff for those purchases. The plaintiff subsequently sued the indenture trustees, seeking a declaration that the corporation’s past and proposed use of proceeds was permissible. Collins & Aikins Corp. v. Stockman, C.A. No. 07-265-SLR/LPS (D. Del. Sept. 30, 2009). The district court allowed the complaint of debtors in possession against the directors and officers of a bankrupt company to proceed, finding enough red flags to merit continued litigation. When Collins & Aikins went bankrupt, the debtors in possession sued the company’s directors, officers, and advisors, claiming that they had breached their fiduciary duties, among other legal violations. The district court did not concur with the report and recommendation issued by Magistrate Judge Leonard P. Stark. In particular, the court rejected Judge Stark’s assertion that the complaint did not contain adequately specific allegations that the defendants knew or should have known that the company’s financial statements were false in connection with a Rule 10b-5 claim. The court asserted that in fact, the complaint did identify red flags that could have alerted the defendants (the auditors) to accounting irregularities resulting from the fraudulent schemes asserted against the director and officer defendants. The red flags identified in the complaint included overstatement of the

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company’s deferred tax assets, the company’s improper reporting of relatedparty transactions, and the company’s failure to provide appropriate disclosure about its liquidity issues and its ability to continue as a going concern.5 Crescent/Mach I Partnership, L.P. v. Turner, C.A. No. 17455-NC, 2005 WL 3618279 (Del. Ch. Dec. 23, 2005). The Delaware Court of Chancery granted partial summary judgment with respect to claims that a former controlling stockholder extracted excess compensation from the acquirer in exchange for supporting the merger. Former stockholders who were cashed out in connection with the merger sued the corporation’s former controlling stockholder and the acquirer for breach of fiduciary duty and aiding and abetting the breach of fiduciary duty, respectively. Plaintiffs complained of numerous side deals, allegedly negotiated by the controlling stockholder. Plaintiffs also complained that the controlling stockholder breached his fiduciary duty by supplying growth projections that he knew to be unduly pessimistic and inconsistent with management’s view. The defendants moved for summary judgment, which the court granted in part and denied in part. Gantler v. Stephens, 965 A.2d 695 (Del. 2009). Just because stockholders approve a decision, that does not mean the board’s decision-making process is exempt from a review for fairness. The board of directors of First Niles, a publicly traded bank holding company with a record of slow growth, decided to seek bids for its sale. Three potential acquirers submitted bids for the company. The board engaged an investment banker to study the bids. The advisor found that the offers were reasonable. The board then decided to reclassify the company’s shares and take it private, rather than selling it, and a majority of shareholders approved this decision. But some shareholders sued the company’s officers and directors, alleging that they breached their fiduciary duties to the shareholders by rejecting bids and abandoning the sales process, disseminating a false and misleading reclassification proxy, and effecting the reclassification. The Delaware Court of Chancery dismissed all three claims, but the Delaware Supreme Court reversed this decision. The Supreme Court basically said that the business judgment level of review still applies to the directors’ actions; mere ratification does not necessarily extinguish any possible claim against directors for their actions.


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Gesoff v. IIC Indus. Inc., C.A. No. 19473, 2006 WL 1458218 (Del. Ch. May 18, 2006). The Delaware Court of Chancery found a merger between a controlling stockholder and a subsidiary unfair. The plaintiff filed a class action, claiming that a merger between a controlling stockholder and a subsidiary was the subject of unfair dealing and had produced an unfair price. Another plaintiff filed a statutory appraisal claim based on the same merger. The court found the merger unfair. Gilliland v. Motorola Inc., 873 A. 2d 305 (Del. Ch. 2005). The Delaware Court of Chancery outlined a quasi-appraisal remedy for minority shareholders that were cashed out in a short-form merger. Plaintiff sought a classwide “quasi-appraisal” remedy for minority stockholders eliminated in a short-form merger. Statutory appraisal was impractical for two reasons. First, as a formal matter, the minority stockholders no longer owned shares in the merged subsidiary, and without the shares, they could not make the demand required by the appraisal statute. Second, from a practical standpoint, the two-year delay made it impossible to recreate the factual context necessary to have statutory appraisal. Therefore, Vice Chancellor Lamb granted the quasi-appraisal remedy and outlined its procedure. Homan v. Turoczy, C.A. No. 19220, 2005 WL 2000756 (Del. Ch. Aug. 12, 2005). The Delaware Court of Chancery held that purchasers of a small business failed to prove that sellers had defrauded them. The plaintiffs bought a small printing and copying business from the defendants, who had run the business successfully for 19 years. However, the plaintiffs were not as successful. A year after the sale, they filed for bankruptcy and liquidated the company’s assets, and found no fraud. In their complaint, the plaintiffs alleged that the defendants and their agent had fraudulently misrepresented the condition of the business and thus sought rescission of the sales agreement. The court held that by waiting more than a year before suing, the plaintiffs had forfeited any right to seek actual rescission. As a result, the court’s opinion after trial considered only whether the plaintiffs were entitled to an award of damages for fraud, and found no fraud. In re Emerging Communications, Inc., WL 1305745 (Del. Ch. 2004). In a “going private” transaction sought by a majority shareholder, conflict of

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interests among directors subjected the transaction to a more searching analysis by a reviewing court, including a consideration of a director’s particular expertise in evaluating the transaction. This case involved a two-step “going private” acquisition of the publicly owned shares of Emerging Communications, Inc. (“ECM”) by Innovative Communications Corporation, L.L.C. (“Innovative”), ECM’s majority stockholder. The court held that a particular director should not have relied on the fairness opinion of the board’s advisor because the director had industry experience equivalent or superior to the advisor’s experience. The court applied a gross negligence standard, comparing the director’s actions with what a reasonable person of his background and experience would have done in the same circumstances. In this case, the presence of the conflicts resulted in the determination of loyalty and good faith violations by the interested directors. In merger situations, the absence of director independence concerns is critical to the evaluation of the transaction by a reviewing court. In re LNR Property Corp. Shareholders Litigation, C.A. No. 674-N, 2005 WL 3418631 (Del. Ch. Nov. 4, 2005, rev’d Dec. 14, 2005). The entire fairness approach was applied to a third-party merger transaction where the controlling shareholder acquired a minority stake in the resulting company. Former shareholders filed a fiduciary class action in connection with a cash-out merger, naming the corporation and its former directors as defendants. The complaint alleged that the corporation’s controlling shareholder negotiated to sell the company to a third-party investment firm in an all-cash deal. The complaint further alleged that, as part of the transaction, the controlling shareholder and other members of company management agreed to invest approximately $184 million to acquire a 25 percent equity stake in the surviving entity. Defendants moved to dismiss for failure to state a claim. Kosseff v. Ciocia, C.A. No. 188-N, 2006 WL 2337593 (Del. Ch. Aug. 3, 2006). The Delaware Court of Chancery sustained a complaint attacking a settlement that included spin-offs. In this decision, the court dealt with a complaint attacking the transaction implemented to settle a proxy contest. The proxy contest was settled by an agreement that put the dissidents on the board and had the CEO resign. However, the CEO was given the right to buy certain lucrative busi-


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nesses of the company, a right that he later exercised. The complaint alleged that this deal was improvident. After reviewing the complaint, the court allowed the case to proceed. Minnesota Invco of RSA #7, Inc. v. Midwest Wireless Holdings LLC, C.A. No. 1887-N, 2006 WL 1596675 (Del. Ch. June 7, 2006). The Delaware Court of Chancery upheld drag-along rights. In this case, the Court of Chancery was required to interpret complex agreements between the members of a Delaware limited liability company. The court held that the defendant holding company had the right to “drag along” holders of a minority interest in an operating subsidiary of the holding company in connection with the sale of the holding company. Oliver v. Boston University, C.A. No. 16570-NC, 2006 WL 1064169 (Del. Ch. Apr. 14, 2006). The Delaware Court of Chancery awarded $4.8 million, plus interest, to minority shareholders for damages suffered from director defendants’ breach of the fiduciary duty of loyalty. Defendant Boston University (BU) was the controlling shareholder of Seragen, a financially troubled biotechnology company. Plaintiffs, a group of former minority stockholders of Seragen’s common stock, challenged certain transactions before Seragen was merged and the process by which the merger proceeds were divvied up. The plaintiffs contended that BU breached its fiduciary duties to Seragen’s common shareholders by approving various financial transactions that were not fair to the common shareholders as a matter of price and process. The court of chancery awarded damages in excess of $4.8 million plus interest for breaches of the fiduciary duty of loyalty.

CASES INVOLVING M&A AGREEMENTS AND RELATED CONTRACTS (CHAPTER 5) Landmark Cases

Revlon Inc. v. McAndrews & Forbes Holdings, Inc., Del. Supr., 506 A.2d 173 (1986). The court held that once the sale of a company has become inevitable, the directors of that company must seek to maximize the sale price for stockholders’ benefit.


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In June 1985, Pantry Pride approached Revlon to propose a friendly acquisition. Revlon declined the offer. In August 1985, Revlon’s board recommended that shareholders reject the offer. Revlon then initiated certain defensive tactics. It sought other bidders. Pantry Pride raised its bid again. Revlon negotiated a deal with Forstmann Little that included a lockup provision. Revlon also provided Forstmann with additional financial information that it did not provide to Pantry Pride. Eventually, an increased bid from Pantry Pride prompted an increased bid from Forstmann Little. The new bid was conditioned upon, among other things, the receipt by Forstmann Little of a lockup option to purchase two Revlon divisions at a price that was substantially lower than the lowest estimate of value established by Revlon’s investment banker. It also included a “no shop” provision that prevented Revlon from considering bids from any third party. The board immediately accepted the Forstmann Little offer, even though Pantry Pride had increased its bid. The questions before the court were (1) whether the lockup agreements were permitted under Delaware law, and (2) whether the Revlon board had acted prudently. The Delaware Supreme Court held the following: ■

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Lockups and related agreements are permitted under Delaware law if their adoption is untainted by director interest or other breaches of fiduciary duties. The actions taken by the directors in this case did not meet that standard. Concern for various corporate constituencies is proper when addressing a takeover threat. Proper concern for multiple constituencies is limited by the requirement that there be some rationally related benefits accruing to the stockholders. There were no such benefits in this case. When the sale of a company becomes inevitable, the duty of the board of directors changes from preservation of the corporate entity to maximization of the company’s value at a sale for the stockholders’ benefit. (This has come to be called the Revlon doctrine.)


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The board’s actions are not protected by the business judgment rule.

Texaco Inc. v. Pennzoil Co., 729 S.W.2d 768 (Tex. App. 1987). The court held that an agreement in principle can be enforced as a contract. In December 1983, Pennzoil announced a tender offer for 16 million shares of Getty Oil common stock at $100 per share. Subsequently, Pennzoil met with Getty Oil representatives to discuss the tender offer and the possible sale of Getty Oil to Pennzoil. Then, over a period of several days, the following occurred: ■

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On January 2, 1984, as a result of the meetings, Pennzoil and Getty Oil representatives signed a memorandum of agreement for the sale of Getty Oil to Pennzoil, subject to approval by the board of directors of Getty Oil. On January 3, Pennzoil revised its offer to $110 per share, plus a $3 stub. Getty Oil’s board of directors rejected the offer, but made a counterproposal for a $5 stub. Pennzoil agreed, and a memorandum of agreement was executed. On January 4, both parties issued a press release. On January 5, Texaco contacted Getty Oil representatives to inquire about a possible sale to Texaco for $125 per share. On January 6, Getty Oil’s board of directors voted to withdraw its Pennzoil proposal and accept Texaco’s offer. Texaco purchased Getty Oil stock, and Pennzoil brought an action for tortious interference. The question before the court was whether Pennzoil and Getty Oil had a binding agreement in the absence of a definitive purchase agreement. On approval, the Court of Appeals for Texas, citing the language in the prospective stock buyer’s draft and the term agreement in principle in the press release, found that there was a binding agreement.

Judgment was not rendered because Texaco won in a competitive tender offer situation. Rather, it was rendered pursuant to the jury’s finding that Texaco had tortiously interfered with a binding agreement. A judgment based upon such a finding will not deter the “invitation of contests for cor-

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porate control throughout the country”; however, it should deter tortious interference with a binding agreement between parties.

Recent Cases

Appriva Shareholder Litigation Co. v. ev3, Inc., C.A. No. 05C-11-208 JOH, 2006 WL 2555348 (Del. Super. Ct. Aug. 24, 2006). The Delaware Superior Court dismissed a suit by a corporation representing former shareholders. An entity controlled by certain former stockholders of an acquired corporation sued the acquirer, alleging breach of merger agreement and fraud. Upon a motion by the defendant acquirer, the court dismissed the action on the grounds that the plaintiff lacked standing. The court noted that the merger agreement appointed two individuals as shareholder representatives who were required to act in concert, one of whom, the complaint reflected, was not affiliated with the plaintiff in any way. The court also noted that the merger agreement did not permit assignment of the shareholder representatives’ rights without the defendants’ consent, which was never given. Finally, the court rejected the plaintiff ’s argument that it be permitted to bring the action as a third-party beneficiary as inconsistent with the merger agreement’s express terms. ATS, Inc. v. Bachmann, C.A. No. 2374-N (Del. Ch. October 11, 2006). Delaware’s Court of Chancery interpreted a “no talk” merger clause. This case interpreted a fairly common clause found in merger agreements that is tantamount to a “no talk” provision. The court held that as the directors do have a fiduciary duty to consider alternatives to a merger, and in light of the negotiations that had led to this particular clause, the agreement did not bar the board from considering a competing merger offer. Given the wording of the clause in question, this conclusion was not free from doubt and provides guidance to drafters of such merger agreements. Facchina v. Malley, C.A. No. 783-N, 2006 WL 2328228 (Del. Ch. Aug. 1, 2006). The Delaware Court of Chancery affirms the application of Delaware law to an LLC.


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A California corporation merged with a Delaware corporation, and the California corporation ceased to exist. Stockholders of the California corporation wanted to enforce an agreement that had been signed prior to the merger. The Delaware Court of Chancery affirmed that Delaware law applied to the internal affairs of any Delaware LLC. In this case, the LLC was the result of a merger of a California corporation into a Delaware LLC. The California entity had a stockholders’ agreement that the defendants wanted to enforce. The court rejected their arguments because the California entity had ceased to exist as a result of the merger. Flight Options Int’l, Inc. v. Flight Options, LLC, C.A. No. 1459-N, 2005 WL 2335353 (Del. Ch. Sept. 20, 2005). The Delaware Court of Chancery enjoined the consummation of a purchase agreement pending arbitration. Plaintiff sought a preliminary injunction against the consummation of a purchase agreement pending arbitration of its substantive disputes with defendant. Accordingly, the court enjoined the transaction. Frontier Oil Corporation v. Holly Corporation, 2005 WL 1039027 (Del. Ch. April 29, 2005). The Delaware Court of Chancery found that substantial litigation expenses are not a sufficient material adverse effect to rescind a contract. Frontier Oil Corporation and Holly Corporation were petroleum refiners that sought to merge. In conducting its due diligence review of Frontier, Holly discovered that activist Erin Brockovich was planning to bring a toxic tort suit claiming that an oil rig that had been operating for decades on the campus of Beverly Hills High School had caused the students to suffer a disproportionately high incidence of cancer. This raised concerns for Holly because a subsidiary of Frontier had previously operated the Beverly Hills drilling facility. Although the terms of the merger agreement were modified to address the situation, including broadening the representation to apply to litigation that would reasonably be expected to have a material adverse effect (MAE) on Frontier, the court found that substantial litigation costs were not an MAE, and therefore the contract could not be rescinded. Great American Opportunities Inc. v Cherrydale Fundraising LLC., C.A. 3718-VCP (January 2010). The court said that when an acquirer buys a

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company with valuable employees, it has a right to enforce a valid noncompete agreement. On April 24, 2008, Great American closed on an asset purchase agreement (the APA) with Kathryn Beich, Inc. (KB), whereby Great American purchased substantially all of KB’s assets for $9.3 million. Great American claimed that Cherrydale and its representatives had tortiously interfered with KB’s value during the months leading up to and following that acquisition. The court held that Cherrydale had tortiously interfered with various provisions of KB’s employment contracts and had willfully and maliciously misappropriated certain of KB’s trade secrets. Based on that misconduct, the court awarded Great American $61,538 in compensatory damages, an additional $61,538 in exemplary damages, and one-half of its attorneys’ fees associated with litigating this action. This decision was an important case in Delaware law on noncompete agreements with employees. Great American claimed that it was entitled to damages because it reasonably expected that the KB customer segments serviced by Southern, Fisher, and Johnson would remain with Great American following execution of the APA. Among other new precedents, this case held that it is possible to assign an employee noncompete agreement in connection with an asset sale. Perhaps the most significant part of the decision is its discussion on how to calculate damages when an at-will employee is lured away by a competitor and then violates his noncompete agreement. Damages are not, under this decision, what the new employer won in new business with the purloined employee. Instead, calculating damages in such a case is much more complicated and requires a careful reading of this decision. Horizon Personal Communications, Inc. v. Sprint Corp., C.A. No. 1518N, 2006 WL 2337592 (Del. Ch. Aug. 4, 2006). In a postmerger setting, the Delaware Court of Chancery expanded the duty to act in good faith. Prior to its 2005 merger with Nextel, Sprint had made certain promises to its affiliates. In this case, the Court of Chancery examined the contract between the parties, determined what was required to act in good faith, and awarded an injunction to preclude a breach of that duty. As a result, the court’s analysis provides a road map for how to honor contracts made prior to a merger.


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In re IBP Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001). The court held that the party that is seeking to terminate an agreement on the grounds that the other party has suffered a material adverse event (MAE) has the burden of proving that the MAE in fact occurred. Also, a broad MAE clause protects an acquirer only from “unknown events” that “substantially threaten” the target’s earnings ability in a “durationally-significant manner.” IBP Inc. and Tyson Foods Inc. entered into a merger agreement whereby Tyson agreed to acquire IBP in a cash-out merger. In conducting its due diligence of IBP, Tyson learned of several potential issues with IBP’s business going forward. These potential issues included the likelihood that IBP was heading into a downturn in its beef business, and that there might be significant accounting issues at one of IBP’s subsidiaries. Tyson nonetheless proceeded to sign the agreement to acquire IBP. After signing the agreement, however, for a variety of reasons, Tyson sought to terminate the agreement. IBP resisted these attempts. Because Tyson was aware of the subsidiary’s accounting problems and the cyclical nature of the livestock industry, these risks could not qualify as “unknown risks” for the purposes of establishing whether IBP had suffered an MAE. Furthermore, the short-term drop in IBP’s earnings did not “substantially threaten” its overall earnings potential and thus did not constitute an MAE. In addition, the court granted IBP the remedy of specific performance, ordering Tyson’s acquisition of IBP to go forward. In re Toys “R” Us Shareholder Litigation, C.A. No. 1212-N, 877 A.2d 975 (Del. Ch. June 24, 2005). The Delaware Court of Chancery denied a motion for a temporary injunction where a breakup fee was alleged to be too high. The Court of Chancery considered a motion to enjoin a vote of the stockholders of Toys “R” Us, Inc., to consider approving a merger with an acquisition vehicle formed by a group led by Kohlberg Kravis Roberts & Co. Pursuant to the terms of the merger agreement, the Toys “R” Us stockholders would receive $26.75 per share for their shares. The $26.75 per share merger consideration constituted a 123 percent premium over the price of TRU stock when merger negotiations began in January 2004. The plaintiffs charged that the board did not act reasonably in pursuit of the highest attainable value. The court of chancery denied the motion to enjoin a stockholder vote on the proposed merger, saying that stockholders could stop the merger by voting against it if they thought that it was unfair.

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In re PNB Holding Co. Shareholders Litigation, C.A. No. 28-N (Del. Ch. August 18, 2006). The Delaware Court of Chancery awarded both appraisal and equitable relief in a merger. As it has several times in recent years, the Court of Chancery decided a case combining appraisal rights and a class claim for inequitable treatment in a merger. The court held that when directors get together to freeze out the other stockholders, the entire fairness test applies even when they do not own a majority of the stock. This follows because the interests of those directors in remaining shareholders differs from the interests of the other shareholders who will be frozen out. Absent some insulating procedure such as a majority of the minority vote, the directors have the burden of proving the merger was entirely fair. Lyondell Chemical Co. v. Ryan, Del. Supr. (March 25, 2009). The Delaware Supreme Court reversed the Chancery Court denial of summary judgment for the directors of Lyondell regarding whether or not they had duties under the Revlon doctrine, and whether Lyondell directors acted in good faith in conducting the $13 billion sale of Lyondell. The Delaware Supreme Court held that the directors’ Revlon duty was triggered only after the board decided to actively pursue a change of control transaction. Furthermore, the court set a high bar for negligence: absent self-interest or an intent to do harm, the directors could not be penalized for their imperfect attempt to carry out their Revlon duty. This would result in a breach of the duty of loyalty based on a lack of good faith only if the directors demonstrated a “conscious disregard” toward such duty. Since such conscious disregard on behalf of the Lyondell directors could not be established by the record, and since a duty of care claim was dismissed by virtue of an exculpatory provision contained in Lyondell’s charter, the court concluded that the Lyondell directors were entitled to the entry of summary judgment. Mehiel v. Solo Cup Co., C.A. No. 1596-N, 2005 WL 3074723 (Del. Ch. Nov. 3, 2005). The Delaware Court of Chancery enforced provision in a merger agreement permitting the arbitration of disputed representations and warranties and working capital claims. Following the closing on a merger, several disputes involving working capital adjustment issues and the accuracy of the seller’s representations


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and warranties developed between the shareholder representative of an acquired company and the acquirer. The merger agreement contained two separate arbitration provisions for working capital adjustment disputes and for disputes regarding the parties’ respective representations and warranties. The acquirer first attempted to submit its disputes with the shareholder representative to arbitration as working capital claims. The arbitrator refused to consider those claims, however, based on the acquirer’s failure to comply with certain procedural requirements. In response, the acquirer submitted the same claims to the separate arbitrator for representations and warranties claims. The shareholder representative subsequently filed a complaint asking the court to issue an injunction barring the second arbitrator from hearing the disputed claims. OSI Systems, Inc. v. Instrumentarium Corp., C.A. No. 1374-N, 2006 WL 656993 (Del. Ch. Mar. 14, 2006). The Delaware Court of Chancery found that violation of a GAAP claim was subject to arbitration because the claim was actually a breach of warranties and representations. In this case, the plaintiff buyer and defendant seller in the sale of a business argued over the type of contractual arbitration that should be used to solve a disagreement over the form of arbitration that each preferred. The Court of Chancery granted the seller’s motion on the pleadings because the buyer’s claims were for breaches of representations and warranties, which fell under the indemnity provisions of the contract, and so the buyer must use the form of arbitration set forth in those provisions. Shamrock Holdings v. Arenson, C.A. 06-62-SLR, 2006 WL 2802913 (D. Del. Sept. 29, 2006). The district court applied an exception to the Tooley test and rejected the argument that exculpatory provisions create contractual obligations. This case involved a dispute between the Class A and Class B members of a Delaware LLC called ALH Holdings. The dispute arose after ALH faced financial trouble and the Class A members voted to sell the company over the objections of the Class B members, who eventually threatened to sue. To preempt such a suit, the Class A members brought an action for a declaratory judgment that, among other things, they did not breach their fiduciary duties or the LLC’s operating agreement. In response, the Class

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B members counterclaimed, alleging breaches of the same. Plaintiffs subsequently moved for summary judgment as to four of the counts in their complaint, and they moved to dismiss the defendants’ counterclaim. The court denied the motion to dismiss and denied the motion for judgment on the pleadings in part (and granted it in part). W.L. Gore & Associates, Inc. v. Wu, C.A. No. 263-N (Del. Ch. September 15, 2006). The Delaware Court of Chancery granted a 10–year injunction in a trade secret case. The extent to which a court will enjoin the violation of a confidentiality agreement covering trade secrets is often questioned. In this decision, the Court of Chancery issued an injunction that for 10 years barred the defendant from working in a business that might permit him to use the trade secrets that he had stolen from his employer. In part, the remedy was based on the useful life of the stolen materials.

CASES ALLEGING VIOLATION OF SECURITIES LAWS (CHAPTER 6) Landmark Cases

Basic, Inc. v. Levinson, 485 U.S. 224 (1988). When a company is asked about a material nondisclosed merger transaction, denial is misleading; the best answer is, “No comment,” says the Court. The plaintiff was a group of shareholders who had sold stock in Basic, Inc., prior to the formal announcement of a merger that caused Basic stock to rise. Basic spokespersons had denied that the merger was under consideration. The stockholders brought an action under Rule 10b-5, alleging material misrepresentation. The question before the court was whether the public statements denying merger talks constituted material misrepresentation. The U.S. Supreme Court ruled that it is not proper for a company to deny that it is engaged in merger talks when, in fact, it is so engaged. In handing down its ruling, the Supreme Court rejected the “bright line” test for materiality offered in an earlier Sixth Circuit Court of Appeals decision. Materiality must be decided on a case-by-case basis, opined the Court. The standard for determining materiality is basically whether a reasonable


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investor’s decision would have been affected had he or she known the true facts. Materiality in the merger context depends on a balancing of the probability that a transaction will be consummated and the significance of its potential impact on the company itself. In this instance, the negotiations were material, even though the talks had not yet resulted in any agreement on the price and structure of the transaction. The Supreme Court said that the appropriate response to an inquiry about undisclosed merger talks is either “no comment” or disclosure that the talks are taking place. Koppers Co., Inc., v. American Express Co., 689 F. Supp. 1371 (W.D. Pa. 1988). The Williams Act does not require that a tender offeror disclose all information that it possesses about itself or about the target company. Koppers Co., Inc., brought an action against American Express, Shearson Lehman Brothers, and others, seeking to enjoin the parties’ hostile tender offer based upon Koppers’ allegations that the tender offer violated federal securities laws (more specifically, certain disclosure requirements). American Express and the other defendants requested a preliminary injunction ordering Koppers to correct allegedly misleading statements regarding the tender offer. The U.S. District Court for the Western District of Pennsylvania went to great lengths in the opinion to state that the case was difficult, the facts were intricate and complicated, and the law was unclear. The court stated that it would not hesitate to enjoin a tender offer until compliance with securities laws could be determined. Citing the purpose and intent of Congress in enacting the various securities laws and regulations, the court also concluded that “it is more prudent to err on the side of disclosure than obfuscation.” But the court also noted that the Williams Act (of 1968, regarding tender offers) does not require that a tender offeror disclose all information that it possesses about itself or about the target company. Rather, it is required to disclose only those material objective factual matters that a reasonable stockholder would consider important in deciding whether to tender shares. CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69. This case opened the floodgates for state antitakeover statutes.

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Dynamics Corp. of America announced a tender offer for CTS Corp., an Indiana corporation. Six days prior to the tender offer, the State of Indiana had revised its business corporation law to include a provision affecting change of control via acquisition. The revised law allowed Indiana corporations to condition the acquisition of control of the business on the approval of the majority of the preexisting disinterested shareholders. Dynamics brought suit to enjoin the enforcement of this statute, citing Edgar v. MITE.6 The question before the court was whether the Indiana Act was preempted by the federal securities laws as amended by the Williams Act or by the commerce clause of the U.S. Constitution. The U.S. Supreme Court, approving the legality of the statute, held that the Indiana Act would be preempted by the federal securities laws only if it frustrated the purposes of those laws. In effectively overturning Edgar v. MITE, the CTS case allowed states to reenact, with some changes, the antitakeover laws that MITE had struck down. Edelman v. Fruehauf Corp., 798 F.2d 882 (6th Cir. 1986). Once it becomes apparent that a takeover target will be acquired by new owners, including managers in an MBO, directors must strive to obtain the best possible price for shareholders. In February 1986, the Edelman Group began acquiring Fruehauf stock on the open market. Edelman attempted a friendly acquisition, but Fruehauf ’s board of directors rejected it. Subsequently, members of Fruehauf’s management negotiated a two-tier leveraged buyout along with Merrill Lynch. A special committee of Fruehauf ’s outside directors approved the management-led buyout. Edelman sought a preliminary injunction restraining Fruehauf from completing the buyout. The question before the court was whether the outside directors breached their fiduciary duty to the company. The Sixth Circuit Court of Appeals held that Fruehauf’s board of directors, in using corporate funds to finance the buyer, did not act in good faith to negotiate the best deal for shareholders and thus breached their fiduciary duty to the shareholders. Moreover, the court, consistent with the Revlon court, stated that once it becomes apparent that a takeover target will be acquired by new owners, it becomes the duty of the directors to see that the shareholders obtain the best possible price.


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Gollust v. Mendell, 498 U.S. 1023 (1991). Plaintiffs need not continue to own stock to sue under securities laws in all cases; they can still come back to haunt acquirers and their advisors. Mendell filed a §16(b) (insider trading) complaint against a collection of limited partnerships, general partnerships, individual partners, and corporations, alleging that these entities, acting as one, were liable for §16(b) violations with regard to their trading activities in Viacom stock. Six months after the complaint was filed, Viacom was acquired by another company, and Mendell exchanged his Viacom stock for the new stock. The question before the court was whether a §16(b) action can be pursued by any party other than an issuer or holder of a security. The U.S. Supreme Court held that it was not necessary for a plaintiff to continue to hold the stock of the issuer in order to maintain a §16(b) action when the plaintiff has a financial stake in the parent corporation of the issuer. A shareholder whose shares in an issuer are converted by a business restructuring into the shares of a newly formed parent corporation that owns all of the stock of the issuer does not lose standing to maintain a previously instituted §16(b) suit. However, the Court also stated that the plaintiff who seeks to recover insider profits must own a security of the issuer whose stock is traded by the §16(b) defendant. Litton Industries, Inc. v. Lehman Brothers Kuhn Loeb Inc., 967 F.2d 742 (2nd Cir. 1992). This case examines the ripple effect of insider trading. In 1982, Litton Industries, Inc., decided to expand its business through an acquisition. Litton retained Lehman Brothers to assist in its search for a suitable target. After Litton had decided upon Itek Corporation as its target, Litton acted upon Lehman Brothers’ acquisition strategy. Information regarding Litton’s plans to acquire Itek was passed from Ira Sokolow, a member of the Lehman Brothers team working on the acquisition, to Dennis Levine, who began purchasing large blocks of Itek stock through offshore banks. Litton brought an action against Lehman Brothers, Sokolow, Levine, and the offshore banks, alleging that if they had not engaged in insider trading, Litton could have acquired Itek at a lower purchase price. The question before the court was whether the insider trading, aside from its illegality, caused Litton harm with respect to its merger with Itek. More specifically, was the purchase price artificially inflated as a result of

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the insider trading? To recover, Litton must establish three “links”: (1) the trader appellees purchased stock on the basis of misappropriated information; (2) this trading inflated the market price of Itek stock; and (3) Itek’s board of directors would have accepted a lower offer from Litton, had it not been for the artificially inflated market price of Itek stock. The Second Circuit Court of Appeals found that there was a genuine issue of material fact concerning whether Litton would have acquired Itek at a lower price absent the insider trading, and remanded the case back to the district court. Martin Marietta Corp. v. Bendix Corp., 549 F. Supp. 623 (D.C. Md. 1982). In a takeover disclosure case, the court cuts the acquirer a break, holding that understating plans is no worse and possibly better than overstating them. In August 1982, the Bendix Corp. announced a tender offer for approximately 45 percent of Martin Marietta Corp.’s common stock. On August 30, 1982, as a direct response to Bendix’s tender offer, Martin Marietta announced its tender offer for approximately 51 percent of Bendix’s common stock. In September 1982, United Technologies Corp. jumped into the fray and announced its tender offer for approximately 51 percent of Bendix’s common stock. All three tender offers were considered hostile. All three corporations brought actions in federal court to enjoin each other’s tender offers. Each alleged that the tender offer in question was a violation of the antitrust laws. Martin Marietta sought a preliminary injunction against the Bendix tender offer on the grounds that Bendix had made misrepresentations and omissions in its disclosures of material in violation of the Williams Act. The question before the court was whether Bendix’s disclosures violated the Williams Act. The U.S. District Court said that they did not, counseling the parties to bear in mind the oft-quoted words of Judge Henry Friendly: Probably there will no more be a perfect tender offer than a perfect trial. Congress intended to assure basic honesty and fair dealing, not to impose an unrealistic requirement of laboratory conditions that might make the new statute a potent tool for incumbent management to protect its own interests against the desires and welfare of the stockholders. It would be as serious an infringement of these regulations to overstate the definiteness of the plans as to understate them.


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Paramount Communications Inc. v. QVC Network Inc., Del. Supr., 637 A.2d 34. In a change of control, the directors have the burden of proving that they were adequately informed and that they acted reasonably. On September 12, 1993, the board of Paramount Communications Inc. announced a proposed merger with Viacom Inc. Viacom was offering $69.14 per share in cash for a controlling interest, with the remainder of the purchase price to be paid in stock. On September 27, Paramount directors rebuffed a comparably structured $80 per share bid from QVC Network Inc., saying that they would not talk unless QVC could show evidence of financing. On November 15, Paramount directors refused a revised $90 per share offer on the grounds that it was too conditional. Meanwhile, Paramount and Viacom continued to plan their merger. As Viacom’s offer rose to the $85 per share level, Paramount granted Viacom an option to buy Paramount stock and promised to pay a termination fee in the event that Paramount rejected Viacom as a bidder. Paramount also made plans to redeem a shareholder rights (“poison pill”) plan. QVC sued Paramount and Viacom in the Chancery Court of Delaware, seeking to prevent these actions. The court upheld the termination fee, which it found to be a “fair liquidated amount to cover Viacom’s expenses,” but it handed QVC a victory on the other two points. The Chancery Court decision was upheld by the Delaware Supreme Court in a December 9 order, followed by a formal opinion on February 4, 1994. In its opinion, the Delaware Supreme Court, concurring with the Chancery Court, stated repeatedly that in a “sale or change of control,” directors must seek to obtain “the best value reasonably available to the stockholders.” In cases that do not involve a sale or change of control, however, the court recognized “the prerogative of a board of directors to resist a third party’s acquisition proposal or offer.” (The Paramount decision spurred Paramount directors to set forth bidding rules in a contest to be decided by shareholders by a certain date. Viacom offered shareholders $105 per share, with certain protections against loss in share value. QVC offered $107 per share, but without such protections. The market chose Viacom, and the rest is history.) When change of control is not at issue, the court gives great deference to the substance of the directors’ decision and will not invalidate the decision, will not examine its reasonableness, and will not substitute its views for those of the board if the latter’s decision can be attributed to any

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rational business purpose. In a sale or change of control situation, directors have the burden of proving that they were adequately informed and that they acted reasonably. Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991). The Court said that proxy solicitation statements made for public relations do not necessarily trigger Section 14 liability. This case occurred as part of a proposed “freeze-out” merger, in which First American Bank of Virginia (Bank) was to be merged into petitioner Virginia Bankshares, Inc. (VBI), a wholly owned subsidiary of petitioner First American Bankshares, Inc. (FABI). The Bank’s executive committee and board approved a price of $42 a share for the minority stockholders, who would lose their interests in the Bank after the merger. Virginia law required only that the merger proposal be submitted to a vote at a shareholders’ meeting, preceded by the circulation of an informational statement to the shareholders. Nonetheless, Bank directors solicited proxies for voting on the proposal. This solicitation urged the adoption of the proposal and stated that the plan had been approved because of the opportunity it provided for the minority shareholders to receive a “high” value for their stock. Respondent Sandberg did not tender her proxy and filed suit in District Court after the merger was approved. She sought damages from petitioners for, among other reasons, soliciting proxies by means of materially false or misleading statements in violation of Section 14(a) of the Securities Exchange Act of 1934 and the Securities and Exchange Commission’s Rule 14a-9. Among other things, Sandberg alleged that the directors believed that they had no alternative but to recommend the merger if they wished to remain on the board. At trial, she obtained a jury instruction, based on language in Mills v. Electric Auto-Lite Co., 396 U.S. 375, 385, that she could prevail without showing her own reliance on the alleged misstatements, so long as they were material and the proxy solicitation was an “essential link” in the merger process. Sandberg was awarded an amount equal to the difference between the offered price and her stock’s true value. The remaining respondents prevailed in a separate action raising similar claims. The Court of Appeals affirmed, holding that certain statements in the proxy solicitation, including the one regarding the stock’s value, were mate-


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rially misleading, and that respondents could maintain the action even though their votes had not been needed to effectuate the merger. The U.S. Supreme Court ruled that the misstatements were material, but that if the solicitation of proxies was done purely for public relations purposes, the solicitation would not be an “essential link” in the merger process, and the misstatements would, thus, not be actionable. Treadway Companies, Inc. v. Care Corp., 638 F.2d 357 (2d Cir. 1980). This case examined the directors’ duty of loyalty in a takeover. In 1978, Care Corp. started acquiring shares of stock in Treadway Co., leading Treadway to believe that Care was mounting a hostile takeover. In response to this action, Treadway put certain officers of Care on its board. Then, without fully informing the Care representatives, the Treadway board sought other merger candidates and struck a deal with Fair Lanes. Care filed an action alleging violations of Section 13(d) of the 1934 Securities Exchange Act, breach of fiduciary duties, and misuse of confidential information. The question before the U.S. District Court for the Southern District of New York was whether the directors had acted improperly in their actions arising out of a struggle for control of their company. The District Court entered a judgment in favor of Care Corp., two of its directors, and another individual. The U.S. Court of Appeals for the Second Circuit held that a director does not breach his or her fiduciary duty merely by supporting an effort or promoting a change of management. Moreover, a director does not owe his or her fiduciary duty directly to shareholders with respect to shares of stock they own and has no obligation to afford other shareholders an opportunity to participate in the sale of stock. Time Incorporated v. Paramount Communications Inc., 517 A.2d 1140 (Del. 1990). The Delaware Chancery Court allows directors to just say no if they have a better plan. In July 1989, the Delaware Chancery Court ruled that Time Inc. should be allowed to proceed with its planned $14 billion acquisition of Warner Communications, Inc., despite a protest from would-be hostile acquirer Paramount alleging violation of various securities laws. In a landmark 79-page decision affirmed later by the Delaware Supreme Court, Chancellor William T. Allen declared that “corporation law does not oper-

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ate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares. In fact, directors, not shareholders, are charged with the duty to manage the firm.” The court found that if directors reject a transaction based on a strategic plan that they believe will deliver value, they are within their rights to just say no. This decision was widely considered to be an affirmation of the socalled business judgment rule, a judicial doctrine that protects the decisions of directors, in their exercise of discretion based on informed judgment, from second-guessing by plaintiffs and judges. On the other hand, several legal commentators noted at the time of the decision that it did not necessarily cover instances of a sale or change of control, as in the classic case of Revlon (1985). Sure enough, in a 1994 case involving Paramount and QVC, the court drew this change of control distinction, denying the protections of the business judgment rule to Paramount directors because the transaction they were considering did involve a change of control. (See QVC Network Inc. v. Paramount Inc., Viacom Inc., et al. (Del. 1994), above.) Recent Cases

Merck & Co. Inc., et al. v. Richard Reynolds, et al., No. 08-905, U.S. Sup. This High Court decision involving statutes of limitations could increase exposure to securities litigation, because it starts the clock not at the action, but at the discovery of the action, which occurs later. The Supreme Court held that the starting point in a two-year statute of limitations for a private lawsuit alleging securities fraud begins to run when a plaintiff discovers or, with reasonable diligence could have discovered, the “facts constituting the violation,” whichever came first. These facts include those concerning the defendant’s knowledge (scienter) of fraud or intent to commit it. In re Transkaryotic Therapies, Inc., 954 A.2d 346, 362 (Del. Ch. 2008). Sometimes a complaint against directors and officers in a securities case can be too little too late. In this case, the Delaware Court of Chancery attempted to settle the largely unsettled Delaware law as to when damages may be awarded for


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failing to make proper disclosures to stockholders in a proxy statement. The court held that it “cannot grant monetary or injunctive relief for disclosure violations in connection with a proxy solicitation in favor of a merger three years after that merger has been consummated and where there is no evidence of a breach of the duty of loyalty or good faith by the directors who authorized the disclosures.” The court reacted largely to the shareholders’ decision to wait nearly two years after completion of the merger to file the disclosure claims and the simple fact that requiring supplemental, corrective disclosures now would be an exercise in futility. While the net effect was that the appropriate remedy for negligent disclosure violations is an injunction, one would be hard pressed to conclude that under different factual circumstances, if the shareholders had brought suit shortly after the consummation of the merger, the court would not have reached a different result and granted some form of relief. Additionally, as the opinion made clear, damages may still be available in circumstances where there is a conflict of interest by the directors or they acted in bad faith.

CASES ALLEGING VIOLATION 0F TAX LAWS AND ACCOUNTING REGULATIONS (CHAPTER 7) Landmark Cases

Indopco, Inc. v. C.I.R., 503 U.S. 79 (1992). This case shows that not all merger expenses are created equal. In 1977, Indopco, formerly named National Starch and Chemical Corporation, and Unilever United States, Inc., entered into a “reverse subsidiary cash merger” that was specifically designed to be a tax-free transaction for National Starch’s largest shareholders. In its 1978 federal income tax return, National Starch claimed a deduction for the approximately $2.3 million in investment banking fees that it paid to Morgan Stanley & Co. as ordinary and necessary expenses under Section 162(a) of the U.S. Tax Code. The Internal Revenue Service disallowed the deduction, and National Starch sought a redetermination, including the $490,000 legal fees that it paid its attorney as well.

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The question before the court was whether National Starch could deduct its expenses as ordinary and necessary business expenses. The U.S. Tax Court and the Third Circuit Court of Appeals denied the deduction, saying that the expenses did not “create or enhance . . . a separate or distinct additional asset.” The U.S. Supreme Court granted certiorari and held that investment banking, legal, and other costs incurred by the acquired corporation were not deductible as ordinary and necessary business expenses, but instead should be capitalized as long-term benefits to the corporation. Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993). An asset is depreciable if its value is provable and diminishes over time. In 1976 the Herald Company purchased substantially all the outstanding shares of Booth Newspapers, Inc. The Herald Company, which was succeeded by the Newark Morning Ledger Co., claimed depreciation in the amount of $67.8 million, which represented the depreciable value of the future income stream from the newspaper’s current subscribers. The question before the U.S. Supreme Court was whether an intangible asset such as a subscriber list can be depreciated. The District Court entered a judgment in favor of Newark Morning Ledger Co., and the Court of Appeals for the Third Circuit reversed. The Supreme Court reversed the Court of Appeals, stating that an asset is depreciable if it is capable of being valued and if the asset’s value diminishes over time. The Court concluded that if a taxpayer can prove that a particular asset can be valued, and that the asset has a limited useful life, the taxpayer may depreciate the asset’s value over its useful life regardless of how much the asset appears to reflect the expectancy of continued patronage.7 Recent Case

Wells Fargo & Company and Subsidiaries v. United States, 105 AFTR 2d 2010 (Ct. Fed. Cl. 01/08/2010). Wells Fargo’s refund claim on 26 leveraged lease deals did not pass muster in tax court, and the company was “condemned” for having the audacity to go forward with such abusive shelters. Wells Fargo & Co. claimed $115,174,203 in depreciation, interest, and transaction cost deductions for 2002. These deductions stemmed from the financial-services company’s participation in 26 “leveraged lease” trans-


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actions—specifically, “sale-in lease-out,” or SILO, transactions. SILOs are set up to suggest that a “sale” of property has taken place, that the property has then been “leased back” to the original owner, and that a “loan” has been created to finance the transaction. With one exception, several courts have considered the tax treatment of SILOs and their close relatives, LILOs (lease-in, lease-out), and have concluded that the taxpayer is not entitled to any of the claimed tax benefits.8

CASES ALLEGING VIOLATION OF ANTITRUST AND TRADE LAWS (CHAPTER 8) Landmark Cases

Olin Corporation v. Federal Trade Commission, 986 F.2d. 1295 (9th Cir. 1993). The court said that the FTC has the right to force divestitures. In 1985 the Olin Corporation entered into an agreement with the FMC Corporation to purchase FMC’s swimming pool chemicals business. Since the late 1970s, Olin had been experiencing considerable difficulties in the manufacture of certain swimming pool sanitizing chemicals. The FMC assets that Olin was purchasing included the manufacturing plant for sanitizers. The Federal Trade Commission challenged the acquisition on the grounds that it would violate federal antitrust laws. The FTC ordered Olin to divest itself of the assets that it had acquired from FMC. An administrative law judge agreed with the commission and concluded that the acquisition would be likely to result in a substantial lessening of competition in the sanitizer marketplace. Olin appealed the FTC’s divestiture order. The issue before the Court of Appeals for the Ninth Circuit was whether the FTC had the right to order Olin to divest itself of assets acquired through a merger and whether the acquisition would be likely to result in substantial lessening of competition. The Court of Appeals affirmed the FTC’s ruling that Olin’s acquisition of the assets would result in a substantial lessening of competition in the relevant markets. As such, the deal would violate Section 7 of the Clayton Act, 15 U.S.C. 18, and Section 5 of the Federal Trade Commission Act (FTC Act),


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15 U.S.C. 45. The court went on to state that the FTC acted within its proper authority in ordering Olin to divest itself of the assets. United States v. Philadelphia National Bank et al., 374 U.S. 321(1963). A merger’s social benefits do not exempt the transaction from antitrust laws. In November 1960, the Philadelphia National Bank and the Girard Trust Corn Exchange Bank were the second and third largest commercial banks in the city of Philadelphia. The boards of directors for the two banks approved a merger of Girard into Philadelphia. The U.S. Department of Justice enjoined the merger, alleging that the consolidation violated the Sherman Antitrust Act and the Clayton Act. The U.S. District Court for the Eastern District of Pennsylvania ruled in favor of the banks, and the United States appealed. The question before the Supreme Court was whether a merger that created anticompetitiveness and a monopoly violated the Clayton Act. The Supreme Court rejected the banks’ arguments that the merger did not violate the antitrust laws if it promoted the social good. A merger that substantially lessens competition is not saved from violation of the Clayton Act because, “on some ultimate reckoning of social or economic debits and credits, it may be deemed beneficial.” The Court also stated that growth by internal expansion is “socially preferable to growth by acquisition.” Recent Case

Texaco Inc. v. Dagher et al. and Shell Oil Co. v. Dagher et al., Docket Nos. 04-805 and 04-814. Reversed: the Ninth Circuit. Argued: January 10, 2006; Decided: February 28, 2006. Pricing decisions of a legitimate joint venture were not found to be unlawful per se under the Sherman Act. In this case, the court vindicated a joint venture’s price setting using the following logic9: Is it per se10 illegal under Section One of the Sherman Act for a lawful, economically integrated joint venture to set the prices at which the joint venture sells its products? No. Per se liability is reserved for only those agreements that are “so plainly anticompetitive that no elaborate study of the industry is needed to establish their illegality.” . . . Price-fixing agreements between two or more competitors, otherwise known as horizontal price-fixing agreements,


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fall into the category of arrangements that are per se unlawful. . . . These cases do not present such an agreement, however, because Texaco and Shell Oil did not compete with one another in the relevant market—namely, the sale of gasoline to service stations in the western United States—but instead participated in that market jointly through their investments in Equilon [the joint venture]. In other words, the pricing policy challenged here amounts to little more than price setting by a single entity—albeit within the context of a joint venture—and not a pricing agreement between competing entities with respect to their competing products.

CASES ALLEGING VIOLATION OF INTELLECTUAL PROPERTY LAWS (CHAPTER 9) Landmark Cases

Electro Optical Industries v. White, 1999 Cal. App. LEXIS 1042 (Nov. 30, 1999). When a key employee left and went to work for a competitor, his employer tried to stop him from certain activities in his new place of employment, arguing that he would divulge trade secrets, but the court disagreed. The plaintiff, Electro Optical Industries (EOI), supplied infrared testing devices to the military and to defense contractors. A key employee, Stephen White, abruptly left after 15 years to join Santa Fe Barbara Infrared, Inc. (SBIR), one of EOI’s direct competitors. EOI asked the trial court for a preliminary injunction precluding White from participating in sales or development of infrared testing devices at SBIR. EOI argued that White knew trade secrets and, if permitted to work for SBIR, would inevitably use them. The trial court denied a preliminary injunction, and EOI appealed. In a California Appeals Court decision, the court adopted the doctrine of “inevitable disclosure,” but said that instances must be decided on the basis of fact, and that the facts in this case favored the defendant. The court acknowledged that White possessed knowledge of certain EIO information. Some of the information was technical—namely, existing and future product designs, production methods, materials and process, and the status of patent applications. The court agreed that this information was a trade secret, but it stated that (1) White lacked the training to pass on the infor-

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mation, and (2) SBIR did not need the information. Some of the information was nontechnical, such as customer lists, sales prices, production costs, marketing plans, and sales strategies. But the court said these did not constitute trade secrets. As for customer preferences and specifications, the court said that this information was not a trade secret and, if it were, it would belong to the customer. Feltner v. Columbia Pictures Television, Inc., 523 U.S. 340 (1998). The Court held that there is no statutory right to a jury trial when a copyright owner elects to recover statutory damages. It also held that juries may determine the amount of statutory damages, if any, awarded to the copyright owner. Respondent Columbia Pictures Television, Inc., terminated agreements licensing several television series to three television stations owned by petitioner Feltner after the stations’ royalty payments became delinquent. When the stations continued to broadcast the programs, Columbia sued Feltner and others for, among other actions, copyright infringement. Columbia won partial summary judgment as to liability on its copyright infringement claims and then exercised the option afforded by Section 504(c) of the Copyright Act (Act) to recover statutory damages in lieu of actual damages. The District Court denied Feltner’s request for a jury trial and awarded Columbia statutory damages following a bench trial. The Ninth Circuit affirmed, holding that neither Section 504(c) nor the Seventh Amendment provides a right to a jury trial on statutory damages. The Supreme Court reversed this decision. It held that there is no statutory right to a jury trial when a copyright owner elects to recover statutory damages. However, the Seventh Amendment of the Constitution provides a right to a jury trial on all issues pertinent to an award of statutory damages. Further, the Seventh Amendment applies to both common law causes of action and to statutory actions. The Court found close 18th-century analogues to Section 504(c) statutory damages actions. Before the adoption of the Seventh Amendment, the common law and statutes in England and this country granted copyright owners causes of action for infringement. More important, copyright suits for monetary damages were tried in courts of law, and thus before juries. There is no evidence that the first federal copyright law, the Copyright Act of 1790, changed this practice; and damages actions under the Copyright Act of 1831 were consis-


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tently tried before juries. The Court was unpersuaded by Columbia’s contention that, despite this undisputed historical evidence, statutory damages are clearly equitable in nature. Finally, the Court found that the right to a jury trial includes the right to have a jury determine the amount of statutory damages, if any, awarded to the copyright owner. State Street Bank & Trust Co. v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998). This case explored the patentability of computer software ad business processes. The Federal Circuit reaffirmed the patentability of computer software and business processes, so long as these types of inventions meet other patent statutory requirements, such as being new, useful, and nonobvious. This case also showed that patentability does not turn on whether the claimed method does “business” instead of something else, but rather turns on whether the method, viewed as a whole, meets the requirements of patentability as set forth in Sections 102, 103, and 112 of the Patent Act. Niton Corp. v. Radiation Monitoring Devices, Inc., 27 F. Supp. 2d 102 (D. Mass. 1998). A misuse of trademarked metatags violated trademark laws. In this case, the court enjoined a certain use of metatags as a trademark infringement. Metatags are a hidden code that is detected by search engines looking for Web sites on a particular topic. The issue in question was using metatags in a way that could make Web searchers believe, incorrectly, that the defendant and the plaintiff, or their Web sites, are related. Publications International, Ltd. v. Landoll, Inc., 164 F.3d 337 (7th Cir. 1998). Trade dress serves the same function as a trademark in the eyes of the law. The court found that certain attributes of books—large pages and print, wipe-off covers, and gilt-edged pages—were aesthetically functional and not protectable as “trade dress.” This weakened the protection of trade dress and boosted the doctrine of aesthetic functionality. The term trade dress refers to the appearance of a product when that appearance is used to identify the producer. To function as an identifier, the appearance must be distinctive by reason of the shape, color, texture, or other visible or otherwise palpable feature of the product or its packaging.

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If it isn’t distinctive, it won’t be associated in the mind of the consumer with a specific producer. If it is distinctive, and if as a result it comes to identify the producer, the danger arises that the duplication of this appearance, this “trade dress,” by a competing seller will confuse the consumer regarding the origin of the product; the consumer may think that it is the product of the producer whose trade dress was copied. Trade dress thus serves the same function as a trademark, and is treated the same way by the Lanham Act and the cases interpreting it. Pfaff v. Wells Electronics. Inc., 525 U.S. 55 (1998). This case explained the bar on patenting an invention that has been on sale or in use for more than a year. In this case, the Supreme Court resolved longstanding confusion about the “on-sale bar,” which prevents patenting an invention that was “in public use or on sale in this country more than one year prior to the date of the application.” The Supreme Court concluded that the on-sale bar applies when two conditions are satisfied: (1) the product must be the subject of a commercial offer for sale, and (2) the invention must be “ready for patenting” by having been reduced to practice or the subject of a disclosure (i.e., a drawing) from which a person skilled in the art could practice the invention. Qualitex Co. v. Jacobson Products Co., Inc., 514 U.S. 159 (1995). The Lanham Act permits the registration of a trademark that consists, purely and simply, of a color For years Qualitex Company had colored the dry-cleaning press pads it manufactured with a special shade of green gold. After respondent Jacobson Products (a Qualitex rival) began to use a similar shade on its own press pads, Qualitex registered its color as a trademark and added a trademark infringement count to the suit it had previously filed, challenging Jacobson’s use of the green gold color. Qualitex won in the District Court, but the Ninth Circuit set aside the judgment on the infringement claim because, in its view, the Lanham Trademark Act of 1946 does not permit registration of color alone as a trademark. The Supreme Court ruled unanimously that the Lanham Act permits the registration of a trademark that consists, purely and simply, of a color. The Court held that


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Color alone can meet the basic legal requirements for use as a trademark is demonstrated both by the language of the Lanham Act, which describes the universe of things that can qualify as a trademark in the broadest of terms, 15 U.S.C.§1127, and by the underlying principles of trademark law, including the requirements that the mark “identify and distinguish [the seller’s] goods . . . from those manufactured or sold by others and to indicate [their] source,” ibid., and that it not be “functional,” see, e.g., Inwood Laboratories, Inc. v. Ives Laboratories, Inc., 456 U.S. 844, 850, n. 10. The District Court’s findings (accepted by the Ninth Circuit and here undisputed) show that Qualitex’s green gold color has met these requirements. It acts as a symbol. Because customers identify the color as Qualitex’s, it has developed secondary meaning, and thereby identifies the press pads’ source. Also, the color serves no other function. (Although it is important to use some color on press pads to avoid noticeable stains, the Court found no competitive need in the industry for the green gold color, since other colors are equally usable.) Accordingly, unless there is some special reason that convincingly militates against the use of color alone as a trademark, trademark law protects Qualitex’s use of its green gold color.

Recent Case

Shadewell Grove IP, LLC v. Mrs. Fields Franchising, LLC, C.A. No. 1691-N, 2006 WL 1375106 (Del. Ch. May 8, 2006). The Delaware Court of Chancery denied plaintiff’s motion for declaratory judgment, specific performance, and damages resulting from alleged breaches of licensing agreements. Plaintiff Shadewell Grove IP, LLC, sought declaratory judgment, specific performance, and damages resulting from defendant Mrs. Fields Franchising, LLC’s alleged breaches of three licensing agreements. Plaintiff and defendant were parties to three trademark license agreements that provided plaintiff with the exclusive right to develop and distribute products utilizing Mrs. Fields trademarks, service marks, and trade names. The first two agreements allowed the defendant to terminate the agreements after 30 days’ notice if the plaintiff defaulted on any payments due under the agreements. These agreements contained no cure provisions. Unlike the first two agreements, the third agreement allowed the plaintiff to cure a default within five days of notice of default. The plaintiff consistently had difficulty making the necessary payments on time. In July

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2005, the defendant sent a notice of default and termination to the plaintiff. Following this notice, the principals of the plaintiff and the defendant spoke on the telephone. The plaintiff claimed that the parties agreed on the call that payment in full by a certain date would cure all of the agreements and sent an e-mail requesting written confirmation of the agreement the next day. The defendant claimed that no such agreement had been reached and sent a letter stating that payment would cure only breaches of the third agreement. The plaintiff paid the amount it owed and acted as if the license agreements had not been terminated. The defendant sent a letter stating that while the third license agreement remained in effect, the other two agreements would terminate 30 days after the notice of default and termination. At trial, the plaintiff claimed that the parties had orally modified the license agreements so that they could all be cured after default and that the plaintiff had so cured its breaches. The plaintiff also argued that the defendant had waived its right to strict compliance with the terms of the license agreements and that the amount it had paid prior to the notice of default should be applied to the second and third agreements. Applying Utah law, the court rejected the plaintiff’s arguments. The court held that (1) the parties had not modified the agreements to allow the plaintiff to cure a default because the plaintiff had failed to meet its burden of showing mutual consent by a preponderance of the evidence; (2) the defendant had not waived strict compliance with the terms of the agreements because the agreements contained nonwaiver provisions and the defendant had consistently sought payment when the plaintiff was late in the past; and (3) the payments should be allocated ratably to all three agreements.

CASES ALLEGING VIOLATION OF CONSUMER PROTECTION LAWS (CHAPTER 10) Landmark Cases

Geier v. American Honda Motor Company, Inc., USS 98-1811, 2000. The Court held that federal safety laws trump state laws. In 1992, Alexis Geier, driving a 1987 Honda Accord, collided with a tree and was seriously injured. The car was equipped with manual shoulder and lap belts, which Geier had buckled up at the time. However, the car


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was not equipped with airbags or other passive restraint devices. Geier and her parents sued the car’s manufacturer, American Honda Motor Company, Inc., and its affiliates under District of Columbia tort law, claiming, among other things, that American Honda had designed its car negligently and defectively because it lacked a driver’s-side airbag. The District Court dismissed the lawsuit, noting that the Federal Motor Vehicle Safety Standard gave car manufacturers a choice as to whether to install airbags. The court concluded that the National Traffic and Motor Vehicle Safety Act of 1966 preempted petitioners’ lawsuit because it sought to establish an airbag requirement. The Court of Appeals affirmed. The Supreme Court held that a common law “no airbag” action conflicted with the Federal Motor Vehicle Safety Standard and was, therefore, preempted. The state tort law favored by petitioners stood as an “obstacle” to the accomplishment of the Federal Motor Vehicle Safety Standard’s objective of developing a mix of alternative passive restraint devices for safety-related reasons. Honda Motor Company Co., Ltd., et al. v. Oberg, 512 U.S. 415 (1994). The Court found that large punitive damages do not necessarily violate due process. After finding petitioner Honda Motor Co., Ltd., liable for injuries that respondent Oberg received while driving a three-wheeled all-terrain vehicle manufactured and sold by Honda, an Oregon jury awarded Oberg $5 million in punitive damages, more than five times the amount of his compensatory damages award. In affirming, both the State Court of Appeals and the State Supreme Court rejected Honda’s argument that the punitive damages award violated due process Citing precedent, the U.S. Supreme Court reversed the lower courts’ decisions, holding that Oregon’s denial of review of the size of punitive damages awards violated the Fourteenth Amendment’s due process clause. The Court held the following: (a) The Constitution imposes a substantive limit on the size of punitive damages awards . . . The opinions in these cases [case names and cites deleted] strongly emphasized the importance of the procedural component of the Due Process Clause, and suggest that the analysis here should focus on Oregon’s departure from traditional procedures.

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(b) Judicial review of the size of punitive damages awards was a safeguard against excessive awards under the common law, and in modern practice in the federal courts and every State, except Oregon, judges review the size of such awards. (c) There is a dramatic difference between judicial review under the common law and the scope of review available in Oregon. Oregon law has provided no procedure for reducing or setting aside a punitive damages award where the only basis for relief is the amount awarded. No Oregon court for more than half a century has inferred passion or prejudice from the size of a damages award, and no court in more than a decade has even hinted that it might possess the power to do so. If courts had such power, the State Supreme Court would have mentioned it in responding to Honda’s arguments in this very case. The review that is provided ensures only that there is evidence to support some punitive damages, not that the evidence supports the amount actually awarded, thus leaving the possibility that a guilty defendant may be unjustly punished. (d) The court said that in the past it has found violation of due process where a party has been deprived of a well established common law protection against arbitrary and inaccurate adjudication. Punitive damages pose an acute danger of arbitrary deprivation of property, since jury instructions typically leave the jury with wide discretion in choosing amounts and since evidence of a defendant’s net worth creates the potential that juries will use their verdicts to express biases against big businesses. Oregon has removed one of the few procedural safeguards that the common law provided against that danger without providing any substitute procedure and without any indication that the danger has in any way subsided over time. (e) The safeguards that Oberg claims Oregon has provided—the limitation of punitive damages to the amount specified in the complaint, the clear and convincing standard of proof, preverdict determination of maximum allowable punitive damages, and detailed jury instructions—do not adequately safeguard against arbitrary awards. Nor does the fact that a jury’s arbitrary decision to acquit a defendant charged with a crime is unreviewable offer a historic basis for such discretion in civil cases. The Due Process Clause says nothing about arbitrary grants of freedom, but its whole purpose is to prevent arbitrary deprivations of liberty or property.


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Saratoga Fishing Co. v. J. M. Martinac & Co., et al., 520 U.S. 875 (1997). The Court said that resales do not immunize a manufacturer from liability. This complex case involved many parties and many issues. One issue was the liability of a manufacturer for a product that has been resold. The Supreme Court said that a series of resales should not progressively immunize a manufacturer from liability for foreseeable physical damage that would otherwise fall upon it. Such immunization could occur, since the end user does not contract directly with the manufacturer, and it is more difficult for such a consumer to obtain the appropriate warranty on used products. Although nothing prevents a reseller from offering a warranty, said the Court, this does not often occur. The ordinary rules of a manufacturer’s tort liability should not be supplanted merely because the user/reseller may in theory incur an overlapping contract liability. Recent Cases

Millett v. Truelink, Inc., 2008 WL 345937 (D. Del. Feb. 7, 2008). District court granted summary judgment on consumer fraud and breach claims. In this opinion, the district court granted the provider of a credit report monitoring service summary judgment on claims that it had violated state consumer protection provisions and contractual obligations. The plaintiffs, who were spouses, had purchased a subscription to the defendant’s service, and alleged that the defendant had failed to alert them to activity that resulted from theft of the husband’s social security number. The plaintiffs alleged that the defendant had violated Kansas’s Consumer Protection Act (KCPA) as well as breached the Credit Monitoring Member Agreement (Member Agreement) that the plaintiffs had entered into when they purchased the service. The plaintiffs moved for class certification and summary judgment on their KCPA claims, and the defendant moved for summary judgment on the KCPA and several breach of contract claims. The court found that neither the activity nor the advertising and marketing activities of the defendant were in violation of the KCPA provisions on unconscionable acts and practices, and that defendant was not in breach of the Member Agreement.

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State ex rel. Brady v. Pettinaro Enterprises, 870 A.2d 513 (Del. Ch. 2005). The Delaware Court of Chancery dismissed the attorney general’s claims under the Consumer Fraud Act and the Deceptive Trade Practices Act as being time barred, but sustained a claim under the Health Spa Regulation. The attorney general brought a consumer protection action against the developer of a condominium complex under the Consumer Fraud Act, the Deceptive Trade Practices Act, and the Health Spa Regulation, alleging, among other things, that the developer had misled condominium purchasers into believing that the clubhouse was part of the complex. The developer moved to dismiss the action on the basis that the statute of limitations barred the attorney general’s claims and for failure to state a claim under the Deceptive Trade Practices Act. The court granted in part and denied in part the defendant’s motion to dismiss.

CASES ALLEGING VIOLATION OF ENVIRONMENTAL LAWS (CHAPTER 11) Landmark Cases

Delaware County Redevelopment Authority v. McLaren/Hart, E.D. Pa. No. 97-3315, 1998 WL 181817 (April 16, 1998). The court found a middle ground in a dispute between a redevelopment authority and the consultant who gave them a flawed report. A redevelopment authority that purchased property in Pennsylvania relied on a consultant’s report filed with the Resolution Trust Corporation (RTC). After purchasing the property, the redevelopment authority entered into a contract to sell the property. Prior to closing, the buyer and seller realized that the cost of the asbestos abatement at the site would be substantially higher than that anticipated based on the consultant’s report. The redevelopment authority sued the consultant, with partial success. The court recognized the validity of the development authority’s claim (as a thirdparty beneficiary) for breach of contract, but dismissed the plaintiff’s claims for negligence and lost profits. Grand Street Artists v. General Electric Co., D.N.J. 19 F. Supp. 2d 242 (August 25, 1998) and 28 F. Supp. 2d 291 (December 21, 1998). The court


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held that the relevant date for determining “innocent purchaser” status was the acquisition of units, not the entire property. In August 1998, the U.S. District Court denied summary judgment to an environmental consultant who had provided consulting services to a prior operator of the site in connection with its closure of operations. Pursuant to state law, the closure of operations was required to be conducted under the oversight of the New Jersey Department of Environmental Protection. As part of that process, the consultant’s report was filed with the state. The current owner reviewed the filed report in conducting its preacquisition due diligence. The report failed to mention the site’s prior history of manufacturing involving mercury. After closing, the purchaser, a partnership of artists, learned that the building’s interior was heavily contaminated with mercury and would be unsuitable for its intended use as residential condominiums. The court held that by participating in the process that resulted in its report being filed with the state, thereby making it available to the public, the consultant could have foreseen that future purchasers would rely on it. In December 1998, the court denied summary judgment to the individual property owners, who had acquired units in the condominium from the partnership in which they were partners. The court ruled that the individuals were not innocent purchasers under the Superfund law and therefore were strictly liable for cleanup. Even though the partnership had acquired title to the property before the mercury contamination was discovered, the individual unit owners knew of the contamination when they acquired their units. The court held that the relevant date for determining innocent purchaser status was the acquisition of units by the individual owners, not the acquisition of the entire property by the partnership. Marsh v. New Jersey Department of Environmental Protection, New Jersey Supreme Court, 703 A.2d 927 (1997). This court held that the due diligence provisions were an element of a defense to liability, rather than a duty imposed by law The New Jersey Department of Environmental Protection sued Marsh, a landowner, for leaking underground storage tanks on a property that Marsh had acquired. Counsel for Marsh established that she did not know of the leaking underground storage tanks when she purchased the property, and noted that the law’s provisions relating to due diligence were enacted

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after the purchase. The court held that the due diligence provisions were an element of a defense to liability, rather than a duty imposed by law, and that therefore the timing was not relevant to the disposition of this case. The New Jersey Supreme Court’s ruling overturned an Appellate Division decision that allowed reimbusrsement from the state’s Spill Compensation Fund. Marsh had to pay the cleanup costs herself. Recent Case

Flowserve Corp. v. Burns Int’l Servs. Corp., C.A. No. 04-1294-JJF, 2006 WL 739886 (D. Del. Mar. 22, 2006). The district court enjoined a plaintiff from initiating third-party proceedings against the defendants and from pursuing a global settlement strategy in pending asbestos cases. The plaintiff filed a complaint seeking a declaratory judgment of its right to indemnification in asbestos litigation under the terms of a stock purchase agreement executed by its predecessor-in-interest, which had acquired a subsidiary of Borg-Warner Corp. (BWC). Defendant Burns International Services Corp. (Burns), which had purchased BWC’s insurance assets at a liquidation sale, filed a counterclaim alleging that its indemnification obligations to the plaintiff arose only out of a later letter agreement, and that once BWC’s insurance was exhausted, the plaintiff had to pay the costs of defending and resolving the asbestos claims. During the pendency of the instant case, the plaintiff informed Burns that (1) it had terminated the counsel chosen by Burns to defend the asbestos claims; (2) it was choosing its own counsel; and (3) it was directing its new counsel to file third-party complaints against the defendants and to pursue global settlements in the underlying asbestos cases (together, the threatened actions). Burns then sought a temporary restraining order and a preliminary injunction to enjoin plaintiffs from taking the threatened actions.

CASES ALLEGING VIOLATION OF HEALTH, SAFETY, AND LABOR LAWS (CHAPTER 12) Landmark Cases

Accardi v. Control Data, 836 F.2d 126 (2d Cir. 1987). A company has a right to deny benefits for which employees are no longer eligible following a merger.


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The plaintiffs were former employees of International Business Machines (IBM) who worked for the BTSI division. In accordance with the Employee Retirement Income Security Act of 1974 (ERISA), they received certain benefits. When IBM sold a predecessor of BTSI to Control Data Corporation (CDC), they entered into a “benefits agreement” under which CDC agreed to continue making benefits payments to the former employees of the division. On June 30, 1985, CDC sold BTSI to Automatic Data Processing (ADP), and the benefits payments stopped. The former BTSI employees requested continuation of their benefits. The question before the court was whether the plaintiffs were entitled to continued overall benefits under the IBM/CDC benefits agreement, and whether the denial of the plaintiffs’ request for continued benefits was arbitrary and capricious. The U.S. Court of Appeals for the Second Circuit stated that the plaintiffs were no longer eligible employees according to the terms of the benefits agreement. The court ruled that the denial of continued benefits was not arbitrary and capricious. Adcock v. Firestone Tire & Rubber Co., 822 F.2d 623 (6th Cir. 1987). This court found that the postmerger termination pay plan was consistent with a fair reading of the plan. The plaintiffs were nonunion salaried employees of Bridgestone Tire and Rubber Co. On January 1, 1983, Firestone Tire & Rubber Co. sold its Lavergne plant to Bridgestone for $55 million. The 75-page sales agreement included an “employee termination pay plan” stating that Firestone would not terminate the employment of any employee prior to the sale. It also stated that if Bridgestone reduced its workforce, any employee who lost his or her job would receive termination pay. At the time of the suit, Bridgestone had not reduced its workforce, so the plaintiffs remained employed. Nonetheless, they sought to receive termination pay. The question before the court was whether Firestone’s interpretation of the termination pay plan was arbitrary and capricious. The U.S. Court of Appeals for the Sixth Circuit stated that Bridgestone’s application of the termination pay plan was consistent with a fair reading of the plan, and that Firestone’s interpretation and application of the termination pay plan was not arbitrary and capricious.

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Because the separation policy described in the manager’s manual of the original employer and accepted by its successor did not address the issue of severance benefits in the context of the sale of a division, but rather discussed only voluntary resignation, mutual agreement resignation, and dismissal, and under the former employer’s separation policy, payment of severance benefits was discretionary and available only in cases of mutually agreed resignation or dismissal for substandard performance. Blau v. Del Monte Corp., 748 F.2d 1348 (9th Cir. 1984). This court found that employees did have a right to benefits, which were denied improperly following a sale of the company. In 1966, Del Monte Corp. purchased Granny Good, which became a wholly owned subsidiary of Del Monte. The employees of Granny Good became eligible for coverage under various Del Monte pension and benefit plans. In December 1980, Del Monte sold Granny Good to a group of investors. The new owners kept all but four employees. The four severed employees sued Del Monte for their severance benefits. The question before the court was whether the denial of the severance benefits violated ERISA and whether the denial was arbitrary and capricious. The Ninth Circuit Court of Appeals held that the actions by Del Monte were arbitrary and capricious, that they violated ERISA, and that ERISA preempted the employees’ state common law theories of breach of contract. Blessit v. Retirement Plan for Employees of Dixie Engine Co., 817 F.2d 1528 (11th Cir. 1987) rec’d in part and rem’d 836 F.2d 1571 (11th Cir. 1988), vacated 848 F.2d 1164 (11th Cir. 1988). ERISA requires payment of benefits provided for under the plan, but no more. The plaintiffs were employees of Dixie Engine Co. when it established an ERISA plan in 1972. Dixie Engine Co. was sold in 1982, and the ERISA plan was terminated. The employees brought action against their employer for violation of ERISA, claiming that upon the termination of a defined-benefits plan, they were entitled to receive the full, unreduced pension benefits that they would have received had they continued to work until normal retirement age. The question before the court was whether ERISA requires the defined-benefits plan to pay an employee the full, unreduced benefits that


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the employee would have received had he or she continued to work until normal retirement age. The U.S. Court of Appeals for the Eleventh Circuit held that when a plan is terminated, ERISA does not require that the employees receive full benefits, but only the benefits provided for under the plan (i.e., the benefits calculated on the basis of their actual years of service as of the termination date). Fall River Dyeing and Finish Corp. v. NLRB, 482 U.S. 27, (1987). A successor employer’s obligation to bargain with the acquired company’s union depends in part on whether a majority of its employees were employed by its predecessor. Sterlingwale began operating a textile dyeing plant in 1952, and the plant continued to run for the next 30 years. For nearly its entire existence, the production and maintenance personnel of Sterlingwale were members of a union. Sterlingwale, along with the entire textile dyeing industry, began to suffer adverse economic conditions in late 1979. In February 1982, Sterlingwale laid off its employees and made an assignment for the benefit of its creditors. In the fall of 1982, a former officer of Sterlingwale, together with the president of a creditor, formed an entity called Fall River Dyeing and Finish Corp. that purchased the assets of Sterlingwale from the auctioneer. Over time, the entity employed many former employees of Sterlingwale. The union requested that the entity recognize it as the bargaining agent for the employees, and the entity refused. The union then filed unfair labor practice charges with the National Labor Relations Board. The question before the court was whether a successor employer is obligated to bargain with a union representing its predecessor’s employees. The U.S. Supreme Court held that the successor employer’s obligation to bargain with the union representing its predecessor’s employees is contingent not only upon certification of the union, but also upon whether a majority of its employees were employed by its predecessor. B.E. Tilley v. Mead Corp., 927 F.2d 756 (4th Cir. 1991). This decision set limits on what benefits an employee may receive under ERISA under conditions of early retirement. The plaintiffs were employees of Lynchburg Foundry Company prior to its buyout by Mead Corporation. The employees then fell under the Mead

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retirement plan, which provided for early retirement benefits commencing at age 55. Subsequently, Mead sold off the foundry and terminated the plan. The plaintiffs received a sum of money equal to their portion of the present value of the plan, reduced by 5 percent for each year that the participant was under the age of 65. The plaintiffs sued Mead in Virginia state court, alleging that Mead’s failure to pay the present value of the unreduced early retirement benefits violated ERISA. Mead removed the case to the Federal District Court for the Western District of Virginia, where the court granted Mead summary disposition, holding that the plaintiffs were not entitled to the unreduced early retirement benefits. The Court of Appeals for the Fourth Circuit reversed the district court, and the Supreme Court reversed the appellate court and remanded the case back to the Court of Appeals. The Court of Appeals held that, under the terms of ERISA, unreduced early retirement benefits that employees would have been eligible for upon reaching age 62 were “contingent liabilities” that had to be satisfied prior to reversion of the plan’s surplus assets to the employer upon termination of the plan. They were not “accrued benefits” that employees had a vested right to receive in full upon plan termination. Recent Cases

Halliburton Co. Benefits Committee v. Graves, 463 F.3d 360 (5th Cir. 2006). A merger agreement constituted an amendment of the target’s welfare plan under ERISA, and therefore the merger agreement’s no-thirdparty-beneficiaries clause did not apply. Halliburton acquired Dresser Industries in 1998 via a forward triangular merger. Dresser’s retiree medical benefits were superior to Halliburton’s at the time of the merger. In order to preserve Dresser’s superior benefits, the merger agreement provided that Dresser’s nominees to the combined companies’ board would maintain such benefits for Dresser employees for three years following the transaction. The parties included a standard no-third-parties-beneficiaries clause, meaning that the clause did not create rights for any party other than the two constituent corporations (e.g., employees and retirees). Halliburton sought a declaratory judgment in 2003 in the U.S. federal court in the Southern District of Texas to affirm its right to reduce Dresser


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retirees’ benefits to those of Halliburton’s. The district court held that the Halliburton-Dresser merger agreement constituted an amendment to Dresser’s welfare plan under ERISA. Because of this amendment, the nothird-party-beneficiaries rule did not apply. The constituent corporations had placed specific time limits on the benefits that active Dresser employees were to receive, but they had not imposed such limitations on retirees’ medical benefits. Accordingly, the court concluded that the provision of the merger agreement that allowed Halliburton to change retirees’ medical benefits only if the company made similar changes to medical benefits for current employees was a revision to the retiree medical program plan documents that restricted Halliburton’s otherwise unfettered right to make changes to the Dresser retiree medical program. The Fifth Circuit Court of Appeals upheld the lower court’s decision. Yolton et al. v. El Paso Tennessee Pipeline Co. and Case Corporation, (January 2006). The courts examined a claim of “lifetime retiree benefits” under a collective bargaining agreement. Tenneco served as the plan administrator for a medical benefits plan that covered a closed group of retirees of the Case Corporation who retired on or before June 30, 1994. Case was formerly a subsidiary of Tenneco, Inc., but was spun off prior to El Paso’s acquisition of Tenneco in 1996. In connection with the Tenneco-Case Reorganization Agreement of 1994, Tenneco assumed the obligation to provide certain medical and prescription drug benefits to eligible retirees and their spouses. El Paso assumed that obligation as a result of its merger with Tenneco. However, El Paso believed that its liability for these benefits was limited to certain maximums, or caps, and that costs in excess of these maximums should be assumed by plan participants. In 2002, Tenneco and Case were sued by individual retirees in federal court in Detroit, Michigan, in an action entitled Yolton et al. v. El Paso Tennessee Pipeline Co. and Case Corporation. The suit alleged that El Paso and Case were required to pay all amounts above the cap, as the retiree medical plan was a vested lifetime benefit. Case further filed claims against El Paso asserting that El Paso was obligated to indemnify, defend, and hold Case harmless for the amounts that it would be required to pay. In separate rulings in 2004, the court ruled that, pending a trial on the merits, Case must pay the amounts above the cap and that El Paso must reimburse

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Case for those payments. In January 2006, these rulings were upheld on appeal before a three-member panel of the U.S. Court of Appeals for the Sixth Circuit. Tenneco plans to file for a review of this decision by the full panel of the U.S. Court of Appeals for the Sixth Circuit as a result of conflicting precedent within the circuit as well as with other circuit courts. It has indemnified Case for any payments that Case has made above the cap. Although such amounts will vary over time, the amounts above the cap are currently about $1.7 million per month. Also, as a precaution, it recorded in the fourth quarter of 2005 an after-tax charge of approximately $200 million ($350 million on a pretax basis). A Supreme Court Case is pending. (El Paso Tennessee Pipeline Co. v. Yolton, et al. No. 06-201 Supreme Court of the United States.) CASES ALLEGING VIOLATION OF FIDUCIARY DUTIES (GENERAL) Landmark Case

In re Caremark International 698 A.2d 959 (Del. Ch.1996). The Delaware Chancery Court set a higher bar for oversight of corporate legal compliance. The board of directors’ role in ensuring corporate compliance with applicable law has expanded significantly in the last several years; this case advanced that trend. Under the historic notion of the board of a large enterprise as merely a policy-making entity, as suggested by the Delaware Supreme Court in its now infamous 1963 ruling in Graham v. AllisChalmers Manufacturing Co. (188 A,2d 125 ([Del. 1963]), the board traditionally had no legal duty to enact a legal compliance program in the absence of certain illegality warning signals. Today, the board’s responsibilities in this respect are viewed entirely differently. The federal Organizational Sentencing Guidelines, imposed more lenient treatment on companies having compliance manuals and programs. More importantly, Caremark imposed an affirmative duty on a board to create some kind of compliance mechanism, boards that fail to establish effective corporate compliance procedures may face substantial liability. In Caremark, Chancellor William Allen essentially overruled Graham, holding that a board, as part of its duty of care, has an obligation to “exercise a good faith judgment that the corporation’s information and


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reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.” Caremark directors were not found liable in this case, because they fulfilled this new standard—one that boards can meet through proactive oversight of compliance. Recent Case

Stone v. Ritter 911 A.2d .362 (Del. 2006). This case affirmed the Caremark standard for compliance oversight and broadened the interpretation of the duty of loyalty. In this 2006 decision, the Delaware Supreme Court effectively affirmed the board’s responsibility for compliance outlined in In Re Caremark International. It also gave further refinement to the director’s fiduciary duty of “good faith” first outlined in Caremark. Good faith was not found to be an independent legal duty, but a subset of the historic duty of loyalty. Accordingly, based on this case, violations of the duty of loyalty may stem not only from lack of director independence, but also from poor decision-making processes.


THE FEDERAL CIRCUIT COURTS

The Federal District Courts are divided into 11 regional circuits, as well as the United States Court of Appeals for the Federal Circuit. Each regional circuit has several district courts, and each district court has a bankruptcy court as well as a U.S. attorney and a U.S. marshal.459 1st Circuit

4th Circuit

Maine District Massachusetts District New Hampshire District Rhode Island District Puerto Rico District

Maryland District North Carolina Eastern District North Carolina Middle District North Carolina Western District South Carolina District Virginia Eastern District Virginia Western District West Virginia Northern District West Virginia Southern District

2nd Circuit

Connecticut District New York Eastern District New York Northern District New York Southern District New York Western District Vermont District 3rd Circuit

Delaware District New Jersey District Pennsylvania Eastern District Pennsylvania Middle District Pennsylvania Western District Virgin Islands District

5th Circuit

Louisiana Eastern District Louisiana Middle District Mississippi Southern District Texas Eastern District Texas Northern District Texas Southern District Texas Western District

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6th Circuit

Kentucky Eastern District Kentucky Western District Michigan Eastern District Michigan Western District Ohio Northern District Ohio Southern District Tennessee Eastern District Tennessee Middle District Tennessee Western District

The Federal Circuit Courts

California Northern District California Southern District Guam District Hawaii District Idaho District Montana District Nevada District Northern Mariana Islands District Oregon District Washington Eastern District Washington Western District

7th Circuit

Illinois Central District Illinois Northern District Illinois Southern District Indiana Northern District Indiana Southern District Wisconsin Eastern District Wisconsin Western District 8th Circuit

Arkansas Eastern District Arkansas Western District Iowa Northern District Iowa Southern District Minnesota District Missouri Eastern District Missouri Western District Nebraska District North Dakota District South Dakota District

10th Circuit

Colorado District Kansas District New Mexico District Oklahoma Eastern District Oklahoma Northern District Oklahoma Western District Utah District Wyoming District 11th Circuit

Alabama Middle District Alabama Northern District Alabama Southern District Florida Middle District Florida Northern District Florida Southern District Georgia Middle District Georgia Northern District Georgia Southern District

9th Circuit

Alaska District Arizona District California Central District California Eastern District

12th Circuit

U.S. Court of Appeals for the FederalCircuit

NOTES

Introduction

1. Source for 2010 numbers is Mergers & Acquisitions Review, Thomson Reuters, First Half 2010. See http://online.thomsonreuters .com/DealsIntelligence/Content/Files/2Q10_MA_Financial_ Advisory_Review.pdf. 2. For a litany of the due diligence failings at WorldCom, see http:// news.lp.findlaw.com/hdocs/docs/worldcom/bkexmnr60903rpt2d.pdf. 3. See http://www.nysscpa.org/cpajournal/2004/1104/perspectives/ p6.htm. 4. Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007). 5. U.S. District Court, Northern District of California. Master File No. CV-99-20743 RMW. 6. For examples, see http://www.allbusiness.com/company-activitiesmanagement/company-structures-ownership/7814697-1.html or http://www.softsearch.com/ac4/pages/archive/doc1/index.htm. 7. For a list of all the other scandals of the era, see http://www.forbes .com/2002/07/25/accountingtracker.html.

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Notes for Chapter 1

8. See http://www.sigtarp.gov/. 9. For example, see http://www.delawarebusinesslitigation.com/Ryan%20Lyondell.pdf. Chapter 1

1. Black’s Law Dictionary, 8th ed. (New York: Thomson/West, 2008). 2. Ibid. 3. 1622 Malynes. Auc. Law Merch. 407. “The diligences which are requisite to be done herein are . . . to be obserued accordingly.” Sic irregular spelling, as cited in The Compact Edition of the Oxford English Dictionary (Oxford: Oxford University Press, 1971), at “diligence.” 1781 Sir W. Jones Est. Bailment 16 1848 Wharton Law Lex s.v., cited in the Oxford English Dictionary (Oxford: Oxford University Press, 1973), p. 364. 4. Words and Phrases: Permanent Edition. 1658 to Date. All Judicial Constructions and Definitions of Words and Phrases by the State and Federal Courts from the Earliest Times, Alphabetically Arranged and Indexed. Kept to Date by Cumulative Annual Pocket Parts (St. Paul, Minn: West Publishing, 1965). 5. Slemons v. Paterson, Cal. App., 92 P. 2d 956, 958. Superseded 96 O.2d 125, 14 Cal.2d 612. 6. Louisville, N.A. & C. Ry. Co. v. Red, 47 Ill. App. 662. 7. Brand v. Schenectady & T.R. Co., 8. Barb. 368, 378. 8. See Valerie Ford Jacob, ed., Conducting Due Diligence in a Securities Offering (New York: Practicing Law Institute, 2009). Ms. Jacob is a partner with Fried, Frank, Harris, Shriver & Jacobson LLP in New York City. 9. “The opposite of Negligence is Diligence, vigilance, attention, which, like Negligence, admits of an infinite variety of gradations.” The Elements of Roman Law by Gaius, with a Translation by Edward Poste (Oxford: Clarendon Press, 1894), p. 452. “If the interests of

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the parties are not identical, the Roman law, at least, requires extraordinary diligence.” 1845 Poste Gains 477, cited in the Oxford English Dictionary, op cit., note 3. 10. State v. Scott, 34 So. 479, 481, 110, La. 369. 11. Highland Ditch Co. v. Mumford, 5 Colo. 325, 336, citing Ophir Silver Min. Co. v. Carpenter, 4 Nev. 534, 97 Am. Dec. 550. 12. See “Records and Information Management (RIM) Checklist for Mergers Acquisitions Divestitures and Closures,” http://www .armaedfoundation.org/pdfs/Checklist_for_Mergers_Acquisitions _Divestitures_and_Closures.pdf, a project sponsored by the Twin Cities Chapter of ARMA International and ARMA International Educational Foundation Endowment Fund. 13. In this book, we will use the term seller to represent the individual or group with the authority to sell the company being sold. 14. In re International Rectifier Securities Litigation 1997 WL 529600 at *7 (C.D. Cal. March 31, 1997), quoting In re Software Toolworks Inc., 50 F.3d 615, 621 (9th Cir. 1994). A foreign subsidiary’s premature recognition of revenue from product sales led to earnings restatements, triggering shareholder lawsuits. In February 2010, the court approved a settlement of $90 million. See In re International Rectifier Corporation Securities Litigation, No. CV 07-02544-JFW (VBKx) (C.D. Cal.). 15. See “Note on Private Placement Memoranda” (2003), http://mba.tuck. dartmouth.edu/pecenter/research/pdfs/Private_placement_memo.pdf. For a sample private placement memorandum, see http://www.vcaonline .com/files/private_placement_sample.pdf. 16. This classic quote is from William F. Alderman and John Kanberg, “Due Diligence in the Securities Litigation Reform Era: Some Practical Tips from Litigators on the Effective Conduct, Documentation, and Defense of Underwriter Investigation,” Conducting Due Diligence 1999 (New York: Practicing Law Institute, 1999), p. 198. Mr. Alderman, a prominent member of the defense bar, has been making presentations at Practicing Law Institute (PLI) events on due dili-

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gence for more than a decade. For example, he was one of the featured presenters in the eight-credit July 2009 Webinar on due diligence produced by the PLI. See http://www.pli.edu/product/ clenow_detail.asp?id=49546. See his bio at http://www.orrick.com/ lawyers/Bio.asp?ID=840. 17. See “Self-Regulatory Organizations; Notice of Filing and Immediate Effectiveness of Proposed Rule Change by New York Stock Exchange LLC Amending the Exchange’s Timely Alert Policy,” Release No. 34-59823, File No. SR-NYSE-2009-40, April 27, 2009; http://www.sec.gov/rules/sro/nyse/2009/34-59823.pdf. 18. See Rule 1-02(p) of Regulation S-X [17 CFR 210.1-02(p)] and Exchange Act Rule 12b-2 [17 CFR 240.12b-2]. In this release, the definitions are being moved to new paragraph (a)(4) of Rule 1-02. 19. Securities and Exchange Commission, 17 CFR Parts 210 and 240 [Release Nos. 33-8829; 34-56203; File No. S7-24-06] RIN 3235AJ58, “Definition of the Term Significant Deficiency.” To read the full case, see http://lawprofessors.typepad.com/files/nacchio-certpetition.pdf. 20. This high court opinion establishes that “internal predictions and interim operating results are immaterial as a matter of law unless they establish a very strong likelihood that the company’s eventual reported performance will be substantially below what the market is expecting.” This sensible opinion holds wisdom for the conduct (and, if needed, subsequent defense) of a due diligence review of a transaction. To read the full case, see http://lawprofessors.typepad.com/files/nacchio-cert-petition.pdf. 21. See http://www.sec.gov/interps/account/sab99.htm. 22. SEC Release Nos. 33-9089; 34-61175; IC-29092; File No. S7-13; http://sec.gov/rules/final/2009/33-9089.pdf. 23. See, for example, Tousa Inc. v. Citicorp (2009). This case is still in the lower courts and is being appealed, but it does show what a nightmare fraudulent conveyance claims can bring to a seller. See http://www.kccllc .net/documents/0810928/0810928091014000000000003.pdf.

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24. Alderman and Kanberg, op. cit. (note 16), p. 191. 25. Note: The acquisition agreement shown on the Web site is a sample, not a model. Acquirers can draft their own forms to make them more suitable to their transactions. One useful source for drafting acquisition agreements and more than 500 types of forms is the five-volume series Contemporary Corporation Forms (New York: Aspen Law and Business, 2009) and the Contemporary Corporation Forms, 2009-2 Supplement, with CD-ROM and Tab (IL) This reference work includes a “clause locator” that enables form drafters to find key paragraphs to use in drafting their own forms. http://www .aspenpublishers.com/AspenPublishersUpdateProgram.pdf. 26. This list of forms was originally provided by Mark Schonberger, who is currently with the law firm of Paul Hastings Janofsky & Walker LLP, New York. 27. See http://www.27001-online.com. One VDR that is ISO-certified is Merrell Data Site of the Merrill Corporation; http://www.merrilldatasite.com/. For a good article on VDRs written by this leading vendor, see http://www.datasite.com/cps/rde/xbcr/datasite/WP_5_Keys_to_ Ironclad_Security_mds.pdf. Other vendors include Deal Interactive, http://www.dealinteractive.com/. See also eKnow.com (E-Know, Inc.). 28. See http://www.aicpa.org/download/members/div/auditstd/AU00324.pdf and http://www.pcaobus.org/standards/interim*standards/ auditing*standards/au*324.html. 29. Alderman and Kanberg, op. cit. (note 16), p. 191. 30. The attorney-client privilege can protect confidential communications between attorneys and clients. “The privilege extends to an accountant hired by an attorney to assist in understanding the client’s financial information. U.S. v. Adelman, 68 F.3d 1495 (2nd Cir. 1995). Privileged attorney-client communications include expressions conveyed through conversations, documents, records, and internal memoranda. Even billing and travel records and expense reports may be protected if they relate to a privileged matter.” Source: David J. Silverman, J.D., LL.M., “Attorney-Client Privilege in Tax Disputes,”

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March 25, 2010. http://nytaxattorney.com/2010/03/25/ attorney-client-privilege-in-tax-disputes/ 31. Guidelines effective January 1, 2000, from the American Institute of Certified Public Accountants require auditing firms to (1) communicate internally a list of client companies as “restricted,” (2) set up a database that shows all restricted” investments in auditing clients, and (3) establish independent policies governing financial relationships, such as loans and brokerage accounts, between restricted companies and the auditing firm, its benefit plans, and its staff members, as well as staff members’ close relatives. 32. SEC rules under Section 208 of Sarbanes-Oxley specify nine kinds of work that audit firms may not perform for their audit clients. See “Strengthening the Commission’s Requirements Regarding Auditor Independence,” www.sec.gov/rules/final/33-8183.htm. 33. http://www.sec.gov/rules/final/33-8183.htm. For an expanded list of independence considerations, see The Panel on Audit Effectiveness: Report and Recommendations (the “O’Malley Panel Report”), at ¶ 5.6 (Aug. 31, 2000). Cited in Note 20 in this SEC Rule Revision of the Commission’s Auditor Independence Requirements, effective date February 5, 2001; http://www.sec.gov/rules/final/33-7919.htm #P360*142462. 34. Glassman v. Computervision Corp., 90 F.3d 617 (1st Cir. 1996), citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 208, 96 S.Ct. 1375, 1388, 47 L.Ed.2d 668 (1976); In re Software Toolworks Inc. Secs. Litig., 50 F.3d 615, 621 (9th Cir.1994), cert. denied,—U.S.—, 116 S.Ct. 274, 133 L.Ed.2d 195 (1995). 35. The primary source for this section on due diligence under federal securities laws is Joseph McLaughlin, Partner, Sidley Austin, LP, and coauthor with Charles J. Johnson, Jr. of Corporate Finance and the Securities Laws, 4th ed. (New York: Aspen Law & Business, 2006, supplemented 2008). 36. Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579, 113 S.Ct. 2786, 125 L.Ed. 2d 469 (U.S. Jun 28, 1993) (NO. 92-102).

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37. See Frederic D. Lipman and L. Keith Lipman, Corporate Governance Best Practices: Strategies for Public, Private, and Not-for-Profit Organizations (Newark, N.J.: Wiley, 2006), Chapter 15, Note 50. 38. Comshare Inc. Sec. Litig., 183 F.3d 542 (6th Cir. 1999), cited in “Due Diligence of 1031 Offerings,” Snyder Kearney LLC, Columbia, Md.; http://www.snyderkearney.com/Portals/0/pdf/1031%20Due%20 Diligence%20White%20Paper%20*(vfinal4*)%204.pdf. (This article is about certain real estate transactions that are exempt from the registration provisions of the 1933 Act, so Section 11 and 12 liability cannot apply in such cases. 39. For a case study in due diligence “breakdown,” see Jane Wareham and Oliver Assersohn, “Investing in Hedge Funds—Red Flags and Spotting the Real Storm Warnings” posted on the Web site of the Cayman Alternative Investment Management Association, http://www.aima-cayman.org/index.html. 40. For cases involving the role of underwriters, see “Landmark and Recent Due Diligence Cases” at the end of this book. 41. For an up-to-date guide to D&O insurance, see Mark A. Sargent and Dennis R. Honabach, D & O Liability Handbook: Law—Sample Documents—Forms, 2009-2010 ed., Securities Law Handbook Series (St. Paul, Minn: West Publishing, 2010).

Chapter 2

1. Authoritative, current guides for public company valuation include Benjamin Graham and David Dodd, Security Analysis, 6th ed. (New York: McGraw-Hill, 2009); and Robert A. G. Monks and Alexandra R. Lajoux, Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Stock Price, Governance, and Special Situations (New York: Bloomberg Press/Wiley, 2011). 2. The SEC has identified these two financial statements as being the most important ones for public companies. Section 13(b)1, in describing the SEC’s powers to require reports, says that the SEC “may prescribe . . . the items or details to be shown in the balance

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sheet and the earnings statement, and the methods to be followed in the preparation of reports, in the appraisal or valuation of assets and liabilities, in the determination of depreciation and depletion, in the differentiation of recurring and nonrecurring income, and in the preparation . . . of separate and/or consolidated balance sheets or income accounts of any person under direct or indirect common control with the issuer.” No other financial statements are mentioned in this key section. See http://www.law.uc.edu/CCL/34Act/sec13.html. 3. See letter from the Private Company Financial Reporting Committee regarding Accounting Standards for Private Companies, dated November 2, 2009; http://www.privatecompanyfinancialreporting.org/downloads/ PCFRC_FinalLettertoFAFonPrivCoStds_110209.pdf. 4. In 2007, responding to concerns about the illiquid nature of auctionrate securities (ARS), accounting authorities said that these securities could no longer be considered current assets. See minutes of the March 21, 2007, meeting of the FASB http://www.fasb.org/board _meeting_minutes/03-21-07_fsp.pdf, and the (next day) March 22, 2007, meeting of the IASB, at http://www.iasb.org/NR/rdonlyres/ 58BF2A4E-B650-423D-BA13-29D2EB1DE05B/0/Upd0703.pdf. These new accounting standards caused companies and banks carrying these securities on their balance sheets to reclassify them as noncurrent. This, in turn, drove down the value of ARSs. By late 2009, at least eight banks had been forced to buy back the securities that they had sold investors, or otherwise settle with investors. For details on one settlement, see “State Securities Regulators Announce $1.3 Billion Settlement with Wells Fargo Investments in Auction Rate Securities Investigations,” November 18, 2009; http://www .nasaa.org/NASAA_Newsroom/Current_NASAA_Headlines/ 11514.cfm. Regarding disaggregation, see also notes from four January 2010 meetings on “Disaggregation by Function and Nature and Segment Disclosures, Financial Services Entities, and Costs and Benefits,” at http://www.fasb.org/cs/ContentServer?c=FASBContent _C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid =900000011108

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5. With regard to investment reporting, if the company that is being acquired has made significant investments in other companies, the acquirer will want to know how these investments are being accounted for—in consolidation with other results, or separately? There are several key documents here: the Financial Accounting Standards Boards (FASB) “Exposure Draft on Consolidation Policies,” “Accounting for Unconsolidated Investees,” and pronouncements stemming from deliberations of the Emerging Issues Task Force (EITF) on the subject of consolidations. 6. In April 2009, the FASB issued three new standards on asset impairment. For an overview, see the press release of April 9, 2009, “FASB Issues Final Staff Positions to Improve Guidance and Disclosures on Fair Value Measurements and Impairments”; http://www.fasb.org/news/nr040909.shtml. In November 2009, the IASB followed suit with its own examination of this issue. See the November 2009 Exposure Draft of the International Accounting Standards Board, “Financial Instruments: Amortised Cost and Impairment”; http://www.iasb.org/NR/rdonlyres/9C66B0E5-E1774004-A20B-C0076FCC3BFB/0/vbEDFIImpairmentNov09.pdf. On July 6, 2010, the IASB hosted a live Webcast on the board’s project to replace IAS 39 Financial Instruments: Recognition and Measurement. Discussion topics included an update on the main outcomes of the Expert Advisory Panel on impairment of financial assets measured at amortized cost. See http://www.iasplus.com/index.htm. 7. See http://www.law.uc.edu/CCL/34Act/sec21E.html. 8. Analysts ignore this ratio at their peril. Consider this cautionary tale. Conventional wisdom in the investment banking world says that the average debt/equity ratio should not be more than 20 percent as a rule of thumb—but this is a rule that investment banks themselves ignored. The average for major investment banks was 20 percent in 2003, but it had reached 30 percent by 2007. The highest levels of leverage were seen in firms that later failed—Bear Stearns and Lehman Brothers. The lowest levels were seen in a firm that was widely regarded as the best-run investment bank, Goldman Sachs.

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For an analysis of this problem, see “The Role of Valuation and Leverage in Procyclicality,” report prepared by a joint Working Group of the Financial Stability Forum and the Committee on the Global Financial System, April 2009. This joint Working Group was chaired by Jean-Pierre Landau of the Bank of France. See http://bis.org/publ/cqfs34.pdf. 9. “Embedded leverage depends on the specific characteristics of each structured instrument, which makes it difficult to assess aggregate embedded leverage for one institution or the financial system as a whole. Clearly, the growth in structured products with embedded leverage has made traditional balance sheet leverage less meaningful as a measure of risk.” See “The Role of Valuation and Leverage in Procyclicality,” ibid. 10. This checklist and the one for insurance companies that follows are both provided by John C. Fletcher, author of the publication and course “Getting Behind the Numbers.” Mr. Fletcher heads the Delta Control Group, http://deltacontrolgroup.com/. 11. This list of ratios and annotations is provided by F. Michael Hruby, President, Technology Marketing Group, Inc., Acton, Massachusetts. 12. A 0.44 debt-to-sales ratio for a high-tech company is considered high. To see the quality of the leverage, analysts will need to look at why the debt was incurred: Is it an expense or a capital investment? The debt ratio (total liabilities/total assets) can help. See http://deadtreeedition.blogspot.com/2010/03/quadgraphics-wasprofitable-in-2009.html. 13. Managing the Business Risk of Fraud: A Practical Guide, a publication sponsored jointly by the Institute of Internal Auditors (IIA), the American Institute of Certified Public Accountants (AICPA), and the Association of Certified Fraud Examiners (ACFE). See http://www.acfe.com/documents/managing-business-risk.pdf. See also notes 14–16. (Note: some frauds involved more than one type of fraud, so percentages add up to more than 100 percent.) 14. According to the 2009 Report to the Nation on Occupational Fraud and Abuse from the Association of Certified Fraud Examiners, in

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2008, 88.7 percent of frauds involved asset misappropriation, for an average cost of $150,000; http://www.acfe.com/documents/2008 -rttn.pdf. 15. In 2008, 27.4 percent of fraud cases involved corruption, for an average cost of $375,000. 16. In 2008, 10.3 percent of frauds were classified as financial misstatements; the average cost incurred per case was $2 million. 17. Report of the NACD Blue Ribbon Commission on Audit Committees: A Practical Guide (Washington, D.C.: National Association of Corporate Directors, 2000/2004), pp. 44–45. 18. For example, beware of intracompany transactions—especially subcontracts and transfers of assets, including cash and credits. Such transfer payments might not have been audited either internally or externally for years. 19. Another example: a high percentage of purchased parts in the cost of goods sold. At 85 percent, this calls for lots of attention; at 10 percent, it calls for very little. 20. William F. Alderman and John Kanberg, “Due Diligence in the Securities Litigation Reform Era: Some Practical Tips from Litigators on the Effective Conduct, Documentation, and Defense of Underwriter Investigation,” Conducting Due Diligence 1999 (New York: Practicing Law Institute, 1999). 21. Section 13(b)(2) states that “every issuer . . . shall (A) Make and keep books, records, and accounts, which, in reasonably detail, accurately and fairly reflect the transactions and disposition of the assets of the issuer; and (B) Devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: (i) transactions are executed in accordance with management’s general or specific authorization; (ii) transactions are recorded as necessary: (I) to permit preparation of financial statements in conformity with generally accepted financial principles or any other criteria applicable to such statements, and (II) to maintain accountability for such assets; (iii) Access to assets is permitted only in accordance with management’s general or specific authorization; and (iv) The

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recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. Source: Securities and Exchange Act of 1934, as Amended, Law Text (New York: Bowne & Co., Inc., July 15, 1999), p. 49. We will return to these points in Chapter 6. 22. Howard E. Berkenblit, Sullivan & Worcester LLP, “Small Businesses Can Comply with SEC Internal Control Rules Before It’s Too Late,” Mass. High Tech: The Journal of New England Technology, December 8, 2009; http://www.masshightech.com/stories/2009/12/07/ daily12-Small-businesses-can-comply-with-SEC-internal-controlrules-before-its-too-late.html. 23. See http://www.coso.org/IC-IntegratedFramework-summary.htm; undated Web site posting accessed December 8, 2009, and current as of that date. 24. As mentioned above (note 5), the source of U.S. accounting standards is the FASB. In addition, private companies can consult guidance from the AICPA. Certified public accountants (CPAs) are generally aware of all new FASB and AICPA pronouncements, so CPAs should be consulted when assessing compliance. 25. Report of the NACD Blue Ribbon Commission on Audit Committees, op. cit. (note 17), p. 1. 26. Ibid., p. 2. 27. http://www.aicpa.org/download/members/div/auditstd/AU-00316.PDF. 28. The note to this standard reads, “Intent is often difficult to determine, particularly in matters involving accounting estimates and the application of accounting principles. For example, unreasonable accounting estimates may be unintentional or may be the result of an intentional attempt to misstate the financial statements. Although an audit is not designed to determine intent, the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether the misstatement is intentional or not.”

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29. The note to this standard reads, “Reference to generally accepted accounting principles (GAAP) includes, where applicable, a comprehensive basis of accounting other than GAAP as defined in section 623, Special Reports, paragraph .04.” 30. The note to this standard reads, “Frauds have been committed by management override of existing controls using such techniques as (a) recording fictitious journal entries, particularly those recorded close to the end of an accounting period to manipulate operating results, (b) intentionally biasing assumptions and judgments used to estimate account balances, and (c) altering records and terms related to significant and unusual transactions.”

Chapter 3

1. See http://www.coso.org/IC-IntegratedFramework-summary.htm; undated Web site posting accessed December 8, 2009, and current as of that date. 2. Here are the Google hits for these phrases, each within quotes, as of June 3, 2010: “culture due diligence” and/or “cultural due diligence,” a total of 43,340; “environmental due diligence,” 86,600; “IT due diligence,” 238,000; and “marketing due diligence,” 317,000. 3. This list is based on a June 2010 Web site advertisement from the Power Decisions Group of Sausalito, California, http://www .powerdecisions.com/marketing-due-diligence-research.cfm. Other experts in this area include Mark N. Clemente, David S. Greenspan, and John Coldwell. 4. This list is based on an advertisement from Tech Republic, http://articles.techrepublic.com.com/5100-10878_11-1040541.html. Tech Republic is part of CBS Interactive, a unit of CBS Corporation. 5. This discussion of cultural due diligence is adapted from Alexandra R. Lajoux, The Art of M&A Integration: A Guide to Merging Resources, Processes, and Responsibilities (New York: McGrawHill, 2006), p. 118.

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6. John J. Clarke, Jr., “Potential Liabilities in Initial Public Offerings” (New York: Practicing Law Institute, 2006), citing In re International Rectifier Sec. Litig., 1997 WL 529600, *7 (C.D. Cal. Mar. 31, 1997) (citing In re Software Toolworks Sec. Litig., 789 F. Supp. 1489, 1496 (N.D. Cal. 1992), aff’d in part and rev’d in part, 38 F.3d 1078 (9th Cir. 1994)); see also Picard Chem. Inc. Profit Sharing Plan v. Perrigo Co., 1998 WL 513091, *15 (W.D. Mich. June 15, 1998); Phillips v. Kidder, Peabody & Co., 933 F. Supp. 303, 322 (S.D.N.Y. 1996); Weinberger v. Jackson, 1990 WL 260676, **34 (N.D. Cal. 1990); http://www.dlapiper.com/files/upload/PLI%20 Materials%202006.pdf. 7. Committee of Sponsoring Organizations of the Treadway Commission, Internal Control—Integrated Framework (Jersey City, N.J.: American Institute of Certified Public Accountants, 1992, 1994). 8. That is, reports on Form 10-KSB and Form 10-QSB, pursuant to Item 303 of Regulation S-K and S-B under the Securities Exchange Act of 1934. Note also that some companies conduct what is in effect a “continuous due diligence” after a new issuance or shelf registration. These diligent companies provide their underwriters with a continuous flow of information updating statements in their original registration statements. Such information can give acquisition investigators a head start in their own due diligence work. See Joseph Kieran Leahy, “What Due Diligence Dilemma? Re-Envisioning Underwriters’ Continuous Due Diligence after WorldCom,” Brooklyn Law School Legal Studies Paper No. 106, Cardozo Law Review 30, May 2009, pp. 2001, 2009; available at SSRN: http://ssrn.com/abstract=1126863 or http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=1126863##. 9. The Securities and Exchange Commission has designated these firms as Nationally Recognized Statistical Rating Organization (NRSRO) Standard. They are considered to be “market recognized credible rating agencies.” On December 4, 2009, the SEC passed a rule to ensure the independence and objectivity of these agencies; effective date, February 1, 2010; compliance date: June 2, 2010. See “Amendments to Rules for Nationally Recognized Statistical Rating Organizations,” http://www.sec.gov/rules/final/2009/34-61050fr.pdf.

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10. The main search engine in 2009 was Google, which conducted more than 70 percent of all Web searches that year. A distant second was Yahoo.com, which conducted approximately 20 percent of searches. The remaining 10 percent of searches were divided among a variety of providers. See http://www.seoconsultants.com/search-engines/. 11. Public corporations must make such disclosures (as “line of business” reports) for units generating 10 percent or more of corporate revenues. In addition, the MD&A report must include such information if it is material. Materiality is determined on a case by case basis. Thus, the overall quality of information on company units in any due diligence investigation depends on whether the company is private or public and, if it is public, what percentage of its revenues comes from a particular subsidiary. Private corporations may not have to make any public disclosure of subsidiary or divisional performance, depending on their states of incorporation (some states do require the filing of such data). Some companies, private and public, make voluntary public disclosure of all subsidiary and divisional financials, however, and all well-managed companies report such results on an internal basis. For an explanation of the rules, see http://research.thomsonib.com/help/sec_guide04-03-02.htma. 12. Under rules promulgated under the Sarbanes-Oxley Act, companies must disclose more about off-balance sheet financing. See “Final Rule: Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations”; effective date, April 7, 2003; http://www.sec.gov/ rules/final/33-8182.htm. 13. http://content.lawyerlinks.com/default.htm#http://content .lawyerlinks.com/sec/S_K/sk_303.html. 14. For a model approach to random sampling used in the assessment of loan portfolios, see Robert Peck Christen and Mark Flamings, “Due Diligence Guidelines for the Review of Microcredit Loan Portfolios: A Tiered Approach,” 2009; http://cgap.org/gm/document-1.9.36521/ DueDiligenceGuidelines.pdf. 15. See, for example, Peter Howson, Checklists for Due Diligence (London: Ashgate, 2009). Note, however, that acquirers can create

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their own checklists based on other sources. Gordon Bing’s writings, for example, lend themselves to checklist creation. See, for example, Gordon Bing, Due Diligence: Planning, Questions, Issues (London: Praeger, 2008). 16. Weinberger v. Jackson, 1990 U.S. Dist. LEXIS 18394 at *6-9 (N.D. Cal. Oct. 11, 1990). For a recent commentary on this standard, see In Re Refco Inc. Securities Litigation, Memorandum of Law of Amicus Curiae the Securities Industry and Financial Markets Association in Opposition to Lead Plaintiff’s Motion for Partial Summary Judgment, May 6, 2009; http://www.sifma.org/regulatory/ briefs/2009/Refco-litigation5609.pdf. 17. Updated from due diligence guidelines used at Sullivan and Cromwell PC, New York, when Charles Elson conducted due diligence investigations for the firm. 18. Picard Chemical Inc. Profit Sharing Plan v. Perrigo Co. (1998), 1998 U.S. Dist. LEXIS 11783 (W.D. Mich. June 15, 1998). 19. See Jamal Ahmad, David Jansen, and Jonny Frank, “Fraudulent Financial Reporting Schemes; Misappropriation of Assets; Revenue and Assets Obtained by Fraud and Expenditures and Liabilities for an Improper Purpose; Other Economic Frauds and Misconduct,” unpublished paper, http://www.som.yale.edu/faculty/Sunder/ FinancialFraud/Frank-Common%20Financial%20Fraud %20Schemes%207May%2003v1.doc. 20. For a list of the biggest bank frauds of 2009, see http://www .bankinfosecurity.com/articles.php?art_id=2001&opg=1. 21. See materials from the American Bar Association Task Force on Attorney-Client Privilege, http://www.abanet.org/buslaw/ attorneyclient/home.shtml. 22. See “WorldCom Decision Puts Spotlight on Due Diligence by Underwriters,” Securities Law, Summer 2005; http://www .heenanblaikie.com/fr/publications/item?id=561. In Hong Kong, there is a bright-line standard. See “Due Diligence Recordkeeping: What the Regulators Expect,” http://www.herbertsmith.com/

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NR/rdonlyres/3D926225-0F95-4C25-A8B1EF7CC7765ECF/ 13416/1112DuediligenceMDJGJLTM.htm. 23. For a thorough discussion of the role of experts in due diligence see Clarke, op. cit. (note 6). 24. Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579, 113 S.Ct. 2786, 125 L.Ed.2d 469 (U.S. June 28, 1993) (No. 92–102). 25. General Electric Company, et al., Petitioners, v. Joiner. 118 S.Ct. 512, No. 96-188, 1997. 26. Kumho Tire Company, Ltd., et al., Petitioners v. Patrick Carmichael, etc., et al. on Writ of Certiorari to the United States Court of Appeals for the Eleventh Circuit, 119 S.Ct. 1167 143 L.Ed.2d 238 No. 97 1709 (March 23, 1999). 27. See http://www.law.cornell.edu/rules/fre/rules.htm#Rule702. For a service that can “track” level of expertise based on the Daubert standard, see http://www.dauberttracker.com/. 28. The authors extend appreciation to John L. Verna, CEO, Navigator Associates, Crownsville, Maryland; http://www.navigatorassociates .com/prod02.htm. 29. See http://www.kroll.com. 30. Source: K. W. Stephen Cheung, Conflict Management Consultants Inc., Ontario, Canada; International Academy of Mediators, http://www.iamed.org/scheung/. 31. Mitchell Lee Marks, “Adding Cultural Fit to Your Due Diligence Checklist,” Mergers & Acquisitions, November/December 1999, pp. 14–20. 32. One well-known audit firm (operating before it became illegal for audit firms to offer nonaudit services) administered the MyersBriggs test to all its partners and learned that the ones who were engaged in auditing were INTJs and the ones who were engaged in consulting were ENFPs. This discovery helped the firm make the decision to divide into two separate companies. Clearly, the personality types of individuals can help to determine the functions they

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serve and the organizations they build. 33. Myers-Briggs Foundation, http://www.myersbriggs.org/. 34. As of January 2010, TDF International is affiliated with M&A Partners in Dallas, Texas. 35. http://www.tdfinternational.net/about_tdf/ See also “Cashing in on Culture” at http://www.mapartners.net/Cashing_in_on_culture.pdf. 36. Brian Friedman, James A. Hatch, and David M. Walker, Delivering on the Promise: How to Attract, Manage, and Retain Human Capital (New York: Free Press, 1998). 37. http://www.bmcgroup.com/support/privacy.htm. See also http://www .bowne.com/ir/annualreports/2009/pdf/Bowne_2009_Annual_10K _Combo.pd.

Chapter 4

1. See the annual Tillinghast series titled Directors and Officers Liability: Survey of Insurance Purchasing Trends. Tillinghast recently streamlined the scope of the series, but past surveys reported that one-quarter of all claims filed pertained to mergers. For ongoing research, see http://www.towerswatson.com/. 2. For example, in the 2008 Tillinghast survey (ibid.), only 430 of the 2,599 respondents (16.5 percent) reported any claims in the past 10 years, but sources of claims (employees, shareholders, government, etc.) totaled 1,009. Tillinghast says, “Note that one claim situation may produce more than one type of claim.” 3. There is also constitutional law, but it generates no laws. Rather, a constitution asserts fundamental rights and limits the ability of any law to abridge those rights. The U.S. Constitution also describes the U.S. government, with its legislative, judicial, and executive branches, and its relation to state governments. A second tier of law is composed of the constitutions of each of the 50 states in the United States. Therefore, it is fair to say that the system of U.S. constitutional law has “51 parts.”

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Constitutional law, then, asserts values, marks boundaries, and describes processes. It does not actually generate laws. That is the function of common law, statutory law, and regulatory law. 4. Source: New York State Unified Court System, Law Libraries Glossary of Legal Terms; http://www.courts.state.ny.us/law libraries/glossary.shtml. 5. Delaware, Mississippi, and New Jersey have one chancery court for the entire state. Tennessee has multiple chancery courts located at its 31 district courts. Here are the links to the chancery courts: Delaware, http://courts.delaware.gov/courts/court%20of %20chancery/; Mississippi, http://www.mssc.state.ms.us/trialcourts/ chancerycourt/chancerycourt.html; New Jersey, http://www.judiciary .state.nj.us/essex/csguide/chancery.htm; Tennessee, http://www.tsc .state.tn.us/GENINFO/courtinfo.htm. 6. See http://www.archives.gov/exhibits/charters/constitution.html. 7. See blog by Edward Harrison, “The Fed and Executive Branch’s Creeping Power Grab,” posted November 9, 2009. The bipartisan commentary featured on this page does not dispute the trend, but only how far back it goes; http://seekingalpha.com/article/171032 -the-fed-and-executive-branch-s-creeping-power-grab. 8. For commentary on this development, see our affirmation of due diligence as an important component of free markets and federalism in the conclusion to this book. 9. Source: Legal Information Institute, Cornell University (citing the U.S. Constitution, Article VI.) 10. See http://www.gpoaccess.gov/CFR/. 11. http://www.bna.com/products/corplaw/cps.htm. 12. http://www.abanet.org/. 13. http://www.acc.com/. 14. http://www.governanceprofessionals.org/society/default.asp. 15. http://www.law.cornell.edu/.

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16. For example, one private publisher (Government Institutes of Rockville, Maryland) sells an index to the CFR, and then multivolume sets covering each of the 50 parts of the CFR. For example, it sells a 32-volume CFR set for Environmental, Health, and Safety—a large component of federal law. http://www.govinstpress.com/ Catalog/SingleBook.shtml?command=Search&db=^DB/CATALOG. db&eqSKUdata=1605904457. For state law, this same publisher sells state legal codes: http://www.govinstpress.com/ browsebysubject/cfrs.shtml. 17. http://www.abanet.org/buslaw/tbl/home.shtml. 18. For access to any FASB standard, go to http://www.fasb.org. 19. For example, according to Larry Rittenberg and Patricia Miller, in “Sarbanes Oxley Section 404 Work: A Look at the Benefits” (January 2005), HealthSouth reportedly “covered up much of its fraudulent reporting by making thousands of journal entries well below $5,000 and across many operating entities to keep the threshold below materiality guidelines.” For more details on the nature of the fraud, see Securities & Exchange Commission, Plaintiff v. HealthSouth Corporation and Richard M. Scrushy, Defendants, at www.findlaw.com, Civil Action No. CV-03-J-0615-S. 20. Source: African American Environmentalist Association, http://www .aaenvironment.com/Asbestos.htm. 21. For a discussion, see http://www.cfo.com/printable/article.cfm/ 9358291/c_2984378?f=options. 22. There is no general rule. Amounts spread very evenly across the spectrum, and appear to be correlated with the size of entities issuing the standards. To get an anecdotal sense of common limits, we used “authorization limit” (hereafter AL) or “materiality threshold” (hereafter MT) in quotes, coupled with specific dollar amounts, as search terms on google.com on June 3, 2010. (Note: some organizations use the term “authorization threshold” or “materiality limit,” but these terms are relatively rare. Here are the results from googling the most common terms with some common rounded amounts of money:

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$5,000, AL 2,340 and MT 3,450; $10,000, AL 3,180 and MT 4,690; $25,000, AL 1,890 and MT 3,060; $50,000, AL 3,270 and MT 4,010; $100,000, AL 3,620 and MT 6,130; $150,000, AL 1,110 and MT 1,720; $250,000, AL 1,320, MT 2,570; $500,000, AL 2,500, MT 3,640; $1 million, AL 2,800, MT 7,180. 23. “Staff Accounting Bulletin No. 108 Disclosures: Descriptive Evidence from the Revelation of Accounting Misstatements,” Accounting Horizons, accepted February 2009; “Measuring Stockholder Materiality,” Accounting Horizons. January 2003, http://goliath.ecnext.com/ coms2/gi_0199-2951101/Measuring-stockholder-materiality.html; and Brad Tuttle et al., “The Effect of Misstatements on Decisions of Financial Statement Users,” Auditing: A Journal of Practice and Theory, March 2002, cectivhttp://home.business.utah.edu/actmp/sec/ Tuttle_coller_plumlee.pdf. 24. The list for SCI Co., identifying the U.K. regulatory source for each matter that cannot be delegated for approval below board level, can be found at http://corporate.sci.co.uk/downloads/SCi_Schedule_of_ Matters_reserved_for_the_Board.pdf. 25. For example, consider this excerpt from the Teppco Partners, L.P., “Review and Approval of Transactions with Related Parties,” Item 13, “Management Authorization Policy”: “Under our Boardapproved management authorization policy, our General Partner’s officers have authorization limits for purchases and sales of assets, capital expenditures, commercial and financial transactions and legal agreements that ultimately limit the ability of executives of our General Partner to enter into transactions involving capital expenditures in excess of $15.0 million without Board approval. This policy covers all transactions, including transactions with related parties. For example, under this policy, the chairman may approve capital expenditures or the sale or other disposition of our assets up to a $15.0 million limit and the CEO may approve capital expenditures

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or the sale or other disposition of our assets up to $5.0 million. These officers have also been granted full approval authority for commercial, financial and service contracts.” 26. In July 2006, the SEC issued Item 404, “Transactions with Related Parties, Promoters and Certain Control Persons,” of Regulation S-K. To fall under the requirement, the transaction must be “material.” The SEC stated that a “materially complete picture of financial relationships with a company involves disclosure regarding related party transactions.” See Title 17: “Commodity and Securities Exchanges, Part 229—Standard Instructions for Filing Forms under Securities Act of 1933, Securities Exchange Act of 1934 and Energy Policy and Conservation Act of 1975—Regulation S-K Subpart 229.400— Management and Certain Security Holders,” 71 FR 53252, Sept. 8, 2006, as amended at 73 FR 964, Jan. 4, 2008; http://ecfr.gpoaccess.gov/cgi/t/text/textidx?c=ecfr&sid =8eae4a97831b94e3e584385f5646e9e4&rgn=div8&view=text&node =17:2.0.1.1.11.5.31.4&idno=17. 27. One legal scholar, Jerry Phillips, has argued that a narrow interpretation of each of these standards makes it too easy to escape successor liability. Phillips advocated collapsing the product line and de facto merger doctrines into a single doctrine—called product line continuity—featuring a multiplicity of factors, no one of which would be dispositive. He said the key to successor liability is “whether the purchaser has paid for intangible items having what might be described as ongoing business value.” See George W. Kuney, “Jerry Phillips’ Product Line Continuity and Successor Liability Corporation Liability: Where Are We Twenty Years Later?” 72 Tennessee Law Review 777 (2005). In the process, Phillips encouraged expansion and consolidation of the mere continuation, continuity of enterprise, and product line theories advanced in three cases: Cyr v. B. Offen & Co., 501 F2d 1145 (1974); Turner v. Bituminous Casualty Co., 397 Mich. 406, 244 N.W.2d 873, 880 (1976); and Ray v. Alad Corp., 19 Cal. 3d 22, 28 (1977), respectively. 28. Fizzano Brothers Concrete v. XLN, Inc., successor in interest to System Development Group, Inc. v. Shore Consultants, Ltd., Gregg A. Montgomery, David Binder, and XLNT Software; Solutions Inc.

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(appeal of XLNY Software Solutions, Inc.). A26010/08 2009 PA Super 89. In this case, LNT Software Solutions, Inc. (XLNT) appealed the trial court’s judgment in favor of Appellee Fizzano Brothers Concrete Products, Inc. The trial court had applied the de facto merger doctrine to impose successor liability on XLNT for the debts of a company whose assets XLNT had purchased. In so ruling, the trial court excepted this asset sale from the general rule that the purchaser of assets is not liable for the debts of the transferor. The higher court concluded that the record in this case did not support application of the de facto merger doctrine, and reversed the trial court’s order; http://www.pacourts.us/OpPosting/Superior/out/ a26010_08.pdf. 29. “Transactions with Related Parties, Promoters, and Certain Control Persons,” op. cit. (note 26). 30. Delaware is one of 40 states that have adopted this uniform law. See http://delcode.delaware.gov/title6/c013/index.shtml/. 31. Sources for the following include Michael J. O’Neill, CPCU, ARM, Executive Vice President, American Contractors Insurance Group; and Ty Sagalow, Executive Vice President, Zurich Insurance, New York. For an excellent presentation, see “Navigating Mergers & Acquisitions Risks,” International Risk Management Inc., October 28, 2008; http://www.irmi.com/conferences/crc/Handouts/Crc28/ Workshops/T4-NavigatingMergerAndAcquisitionRisks.pdf.ec. 32. The Zurich Form U-UMB-103-B CW policy form says that Insured means: “You: and any person or organization included as an insured in the underlying insurance.” 33. Source: Insurance Services Office; ISO language from http://www.iso.com/Products/Overview-of-ISO-Products-andServices/ISO-s-Policy-Language-and-Rules.html, quoted at http://www.irmi.com/conferences/crc/Handouts/Crc26/Workshops/ NavigatingMergerandAcquisitionRisks.pdf. 34. For a recent treble damages case, see “FINRA Panel Awards Elderly Investor Treble Damages Under Financial Elder Abuse Law,” Dispute Resolution Journal, February 1, 2010.

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35. The Department of Health and Human Services, Office of the Inspector General, has created the “HHS Model Compliance Plan for Clinical Laboratories,” which can be used by a variety of healthcare organizations. Also, HCA, having suffered as a result of a weak compliance function, has created a very strong program, with the help of Alan Yuspeh, an ethics specialist who created classic guidelines for the defense industry. For details on the program, see John M. Franck II, “Energize Your Organization with a World-Class Compliance Program,” Director’s Monthly, March 1999, pp. 1-4. The same issue features a roundtable discussion including Mr. Yuspeh (pp. 8–12). 36. See the following Heritage Foundation legal memoranda: “The Unlikely Orchid Smuggler: A Case Study in Overcriminalization,” July 27, 2009; John S. Baker, “Revisiting the Explosive Growth of Federal Crimes,” June 16, 2008; and Henry Aaron and Brian Walsh, “What We Have Here Is Failure to Cooperate: The Thompson Memorandum and Federal Prosecution of White-Collar Crime,” November 6, 2006; http://www.heritage.org/Research/index_lm.cfm. See also http://www.overcriminalized.com/. Creation of new laws is a dangerous trend considering the threat of a lower pleading standard. See Darpana Sheth, “Overturning Iqbal and Twombly Would Encourage Frivolous Litigation and Harm National Security,” June 4, 2010, also at heritage.org. 37. See the Corporate Compliance Series (St. Paul, Minn.: The West Group, 2009). This series, each one written by a specialist in the relevant area of law, has 11 volumes covering a wide range of legal areas; http://west.thomson.com/productdetail/2704/13460398/ productdetail.aspx. 38. The figures in this section are based on historical trends reported by Tillinghast, a unit of Towers-Watson. Trends cited are for the United States only, unless otherwise noted. For more detailed coverage, it is possible to evaluate a company’s book of business by “examining trends in claim frequency and severity” through research in the insurance industry, such as Insurance Services Office: http://www .iso.com/Products/Information-from-ISO-s-Database/StatisticalInformation-for-Claims-Professionals.html.

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39. This list is based on Tillinghast figures (ibid.), with some consolidation and rearrangement of categories. 40. Fortunately, the judiciary has set stricter limits on the credentials of witnesses called to testify as experts. In Daubert v. Merrell Dow Pharmaceuticals (1993), (cited in Chapter 1, note 36, and Chapter 3, note 24), the U.S. Supreme Court held that the testimony of witnesses in science-related cases must rest on “a reliable foundation” and be “relevant to the task at hand.” Chapter 5

1. See Gregory G. Gosfield, “Letters of Intent,” white paper dated September 7, 2006, http://www.klehr.com/C7756B/assets/files/law articles/September%202006%20Letters%20of%20Intent.pdf. See also Aldred M. Myerson and Thad H. Armstrong, “Letters of Intent—Enforceability Issues,” white paper dated Spring 2003, http://www.abanet.org/rppt/meetings_cle/spring2003/rp/letterofintent /meyersonarmstrong.pdf. 2. See Pennzoil v. Texaco case in “Landmark and Recent Due Diligence Cases.” 3. David F. Gross, “Material Adverse Changes Lessons from the Tyson Foods IBP Acquisition,” May 12, 2002, posted at DLA Piper, http://www.dlapiper.com/global/publications/detail.aspx?pub=780. 4. Frontier Oil v. Holly Corp, C.A. No. 20502 (Del. Ch. Apr. 29, 2005). 5. In Re: IBP, Inc. Shareholders Litigation, 789 A.2d. 14 (Del. Ch. 2001); also called IBP v. Tyson. 6. “In both cases, the MAC clause contained a qualifier that a given effect ‘would reasonably be expected to’ have a MAC. The ‘reasonably expected’ qualifier continues to make a frequent appearance in the drafting of MAC clauses today.” Jeffrey Rothschild, “Drafting Material Adverse Change Clauses in Light of Delaware Case Law,” white paper, http://www.thefreelibrary.com/Drafting+Material +Adverse+Change+Clauses+In+Light+Of+Delaware+Case...a0173725394. The authors acknowledge this white paper as the source of this discussion.

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7. Gross, op. cit. (note 3). 8. For guidance, see “Goodwill Valuations for Financial Reporting Under SFAS 142 (FASB ASC 350).” http://www.cambridgepartners.com/SFAS_142.html. 9. This applies only when the seller will realize a taxable gain from the sale—that is, where the tax basis of the assets in the acquired company is lower than the selling price, necessitating a “step-up” to the selling price. 10. The bulk sales law, which is subject to variations among states, applies to acquirers of businesses dealing in bulk sales—the sale of merchandise from inventory. If a purchaser buys a major part of the material, supplies, merchandise, or other inventory of any such company, the purchaser is to give at least 10 days’ advance notice of the sale to each creditor of the seller. The notice must identify the company and its buyer, and must state whether or not the debts of the company will be paid as they fall due. If orderly payment will not be made, further information must be disclosed. In addition, many states require the buyer to ensure that the seller of the company uses the proceeds from the sale to satisfy existing debts, and to hold in escrow an amount sufficient to pay any disputed debts. 11. See http://www.theapchannel.com/accounts-payable/files/Capital _Expenditure_Policy.doc. 12. SEC Rule 15c2-11, promulgated under the Securities Exchange Act of 1934, lists certain categories of issuer information that a brokerdealer must have in its possession before posting a quotation for the issuing company’s stock. The broker must submit this information to the Financial Industry Regulatory Authority (FINRA) on Form 211. For a typical list of information requested by a sponsoring brokerdealer firm, including information about merger transactions, see http://www.huntlawgrp.com/sec-law/finra-form-15c2-11-filings. 13. This response is quoted verbatim from Stanley Foster Reed, Alexandra Reed Lajoux, and H. Peter Nesvold, The Art of M&A: A Merger/Acquisition/Buyout Guide (New York: McGraw-Hill, 2007). The original version of these passages was written by Richard

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Perkal, Esq., when he was an attorney with Lane and Edson in Washington, D.C. Mr. Perkal is currently a Partner of Irving Place Capital, the firm formerly known as Bear Stearns Merchant Banking, LLC, and an affiliate of the controlling shareholder of New York & Company, Inc. 14. The Sarbanes-Oxley Act of 2002 states as follows, in Section 304, Forfeiture of Certain Bonuses and Profits: If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for— (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

http://www.sec.gov/about/laws/soa2002.pdf. 15. The Emergency Economic Stabilization Act of 2008 includes “a provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.” http://frwebgate.access.gpo.gov/cgi-bin/ getdoc.cgi?dbname=110_cong_bills&docid=f:h1424enr.txt.pdf. 16. For an excellent discussion of data management, see Robert D. Brownstone and Todd R. Gregorian, “Information Management for Mergers and Acquisitions—Wrangling, Lassoing and Roping at the M&A Corral,” Fenwick & West, LLP; http://www.fenwick.com/ docstore/Publications/Corporate/Data_Wrangling_Lassoing_and_ Roping.pdf. Our discussion owes a debt to this article. 17. Ibid. 18. These have been codified at 18 U.S.C. §1519 and 18 U.S.C.

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§1512(c), http://uscode.house.gov/download/pls/18C73.txt. 19. For an annotated text of the general provisions of the Uniform Commercial Code, see http://www.law.cornell.edu/ucc/1/article1.htm.

Chapter 6

1. In 2008, shareholder/investor claims accounted for 18 percent of all reported claims overall. This was 12 percent for private companies and 20 percent for public companies. Source: Tillinghast-Towers Perrin, 2008 Directors and Officers Liability Survey: U.S. and Canadian Results (New York: Tillinghast-Towers Perrin, 2009); http://www.towersperrin.com/tp/showdctmdoc.jsp?country=usa&url =Master_Brand_2/USA/News/Spotlights/2009/sept/2009_09_03_ spotlight_do_survey.htm. As of 2010, Towers Perrin has merged with Watson Wyatt to form Towers Watson. 2. 2008 Directors and Officers Liability Survey, op. cit. (note 1). 3. This entire chapter draws heavily from a much longer chapter that appears in Stanley Foster Reed, Alexandra Reed Lajoux, and J. Peter Nesvold, The Art of M&A: A Merger/Acquisition/Buyout Guide (New York: McGraw-Hill, 2007). 4. Some court decisions have supported the notion that when a company is nearly insolvent—that is, when it is in the “zone of insolvency”—directors owe primary fiduciary duty to creditors rather than to shareholders (who under normal conditions enjoy priority). But in Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020 (2009), the California Court of Appeal for the Sixth Appellate District held that creditors may sue for a breach of the duty of care only when the corporation is actually insolvent and the director has “diverted, dissipated, or unduly risked” corporate assets that might otherwise be used to pay creditors’ claims. See Dale E. Barnes, et al., “California Court of Appeal Clarifies Fiduciary Duties Owed by Directors to Creditors of Insolvent Corporation,” December 9, 2009; posted at Bingham Consulting, http://www.bingham.com/Media .aspx?MediaId=10019.

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5. Trust Indenture Act of 1939, as amended through P.L. 111-72, approved October 13, 2009, http://www.sec.gov/about/laws/ tia39.pdf. 6. Howell E. Jackson and Mark J. Roe, “Public and Private Enforcement of Securities Law: Resource-Based Evidence,” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1000086&rec =1&srcabs=1513408. 7. Uniform Securities Act, National Conference of Commissioners on State Law. As of July 2010, the most recent version is 2002 as amended in 2005; see http://www.law.upenn.edu/bll/archives/ulc/ securities/2002final.htm. 8. For example, the American Bar Association has announced amendments pertaining to the ability of shareholders to place their nominees on a company’s proxy. See “Corporate Laws Committee Adopts New Model Business Corporation Act Amendments to Provide for Proxy Access and Expense Reimbursement.” Press release dated December 17, 2009. http://www.abanet.org/abanet/media/release/ news_release.cfm?releaseid=848. 9. Some rules are promulgated under both the 1933 and 1934 Acts, and are numbered in yet another way. For example, Regulation S-X, Form and Content of Financial Statements, is numbered from Rule 1-01 on up. 10. This list represents the authors’ own selections from securities regulations developed and disclosed by the U.S. Securities Commission. The authors acknowledge the great utility of the Securities Deskbook from the University of Cincinnati Law School in viewing the overall structure of securities regulations and in locating their full text for further study. See http://www.law.uc.edu/CCL/index.html. 11. Previously, such events were exempt from registration under a “no sale” theory promulgated under Rule 133. 12. See http://www.law.uc.edu/CCL/regM-A/index.html. 13. Regulation M-A, Mergers and Acquisitions. For the text of the rule, see “Regulation of Takeovers and Security Holder Communications,”

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at http://www.sec.gov/rules/final/33-7760.htm. See also Division of Corporation Finance: Manual of Publicly Available Telephone Interpretations, http://www.sec.gov/interps/telephone/ phonesupplement3.htm. 14. For a brief description of these new rules, see Release No. 33-7760; 34-42055; IC-24107, dated October 22, 1999, effective January 24, 2000. The full text is available from the SEC or from Bowne Publishing, 800-370-8402. Ask for Cross-Border Tender and Exchange Officers, Business Combinations and Rights Offerings, and Regulation M-A (165 pages). 15. E. H. I. of Florida, Inc. d/b/a Horizon Hospital, Appellant, v. Insurance Company of of North America 652 F.2d 310. See http://ftp .resource.org/courts.gov/c/F2/652/652.F2d.310.80-2545.html. 16. Ibid. 17. See the full text of the Securities Exchange Act of 1933, Rule 13e-4 at http://www.law.uc.edu/CCL/34ActRls/rule13e-4.html. 18. A tender offer must remain open continuously for at least 20 business days. In addition, a tender offer must remain open for at least 10 business days following an announced increase or decrease in the tender offer price or in the percentage of securities to be bought [Rule 14e-1(b)]. If any other change in the tender offer terms is made, the offeror should keep the offer open for five business days to allow dissemination of the new information in a manner reasonably designed to inform shareholders of such changes. The offering period may be extended, but the buyer must announce the extension not later than 9:00 a.m. on the business day following the day on which the tender offer expires [Rule 14e-1(d)]. Shareholders who tender shares may withdraw them at any time during the tender-offer period unless the shares are actually purchased [Rule 14d-7(a)]. Tendered shares may also be withdrawn at any time after 60 days from the date of the original tender offer if those shares have not yet been purchased by the bidder (Section 14d-5). 19. A tender offer premium is the “plus factor” in an offer—it is the incremental amount paid for securities in excess of an established

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market price as of a stated date. In academic practice, premiums were traditionally measured five days before the announcement. This was to prevent distortions in the stock price resulting from trading on the basis of rumors, guesses, or nonpublished inside information (i.e., illegal insider trading). Such trading tends to boost the target’s stock price prior to a merger, so that premiums—unless they are measured well in advance—can appear to be smaller than they really are. 20. Boyle v. United States, U.S. Supreme Court (2009), focused on whether it is necessary for a group to have a structure to be sued under RICO. The court held, among other things, that to have a structure, there must be “a purpose, relationships among the associates, and longevity sufficient to permit the associates to pursue the enterprise’s purpose.” No. 07–1309, argued January 14, 2009, decided June 8, 2009; http://www.supremecourtus.gov/opinions/ 08pdf/07-1309.pdf. 21. See John F. Grossbauer and Jeannine M. Solomon, “Entire Fairness Standard of Review Does Not Apply in Short-Form Mergers,” describing the verdict in Glassman v. Unocal Exploration Corp., Del. Supr. C. A. No. 12453, Berger, J., July 25, 2001; http://www. potteranderson.com/news-publications-40-57.html. See also Richard T. Hosfeld, “Short-Form Mergers after Glassman v. Unocal Exploration Corp.: Time to Reform Appraisal,” Duke Law Journal Vol. 53 (2004); http://www.questia.com/googleScholar.qst; jsessionid=LtvD8d2KZ6lHJwnZLGQYpNdpqcpVlNDBh14rL1k 1CXvw8mv6bvyS!2144018255!2064974013?docId=5007028129. See also John P. Stigi, “Delaware Supreme Court Holds That Minority Stockholders in a Short Form Merger Are Entitled to ‘Quasi-Appraisal’ Remedy When Material Facts Are Not Disclosed,” August 4, 2009, http://www.martindale.com/corporate-law/article_ Sheppard-Mullin-Richter-Hampton-LLP_766440.htm. 22. In the stock lockup, the bidder receives an option to purchase authorized but unissued shares. This option favors the bidder in two ways: if the option is exercised, the bidder may vote the shares in favor of the transaction, or, if another bidder wins the contract for the company, the favored bidder may realize a profit by tendering the stock

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to the higher bidder. If the purpose of the lockup agreement is to stifle competitive bidding by definitively preferring one bidder over another, however, the board is likely to be found to have breached its duty of loyalty to the shareholders. See Revlon, Inc. v. MacAndrews & Forbes Holdings (1986). 23. “Filing persons may, in order to avoid unnecessary duplication, answer items on the schedules (Schedule 13D, 13G, or TO) by appropriate cross references to an item or items on the cover page(s).” Source: “Schedule 13G—Information to Be Included in Statements Filed Pursuant to Rule 13d-1(b), (c) and (d) and Amendments Thereto Filed Pursuant to Rule 13d-2.” See http:// law.uc.edu/CCL/34ActRls/rule13d-102.html. 24. See http://research.thomsonib.com/help/sec_guide04-03-02.htm #FORM3. 25. “Unorthodox” transactions—such as option transactions, stock conversions and reclassifications, mergers of a target into a white knight, and other corporate reorganizations—are frequently judged by a pragmatic or subjective test that may enable an insider to avoid liability when the automatic rules of Section 16(b) might otherwise apply. Under this alternative test, liability may be avoided if the insider did not have access to inside information or if the insider did not have a control relationship with the issuer of the securities. For the full text of Rule 16b-7, see http://www.law.uc.edu/CCL/ 34ActRls/rule16b-7.html. 26. Holders of options have special issues to consider. For a guide to stock options and the function of an options clearinghouse, see the following document from the Options Clearing Corporation (OCC): http://www.cboe.com/LearnCenter/pdf/understanding.pdf. For information about the OCC, see http://www.optionsclearing.com/about/ corporate-information/default.jsp. Under SEC jurisdiction, the OCC clears transactions for put and call options on common stocks and other equity issues, stock indexes, foreign currencies, interest-rate composites, and single-stock futures. A typical example of how the OCC would advise option holders regarding short tendering compliance in a merger transaction can be found at http://www.theocc.com/ components/docs/market-data/infomemos/2010/feb/26937.pdf.

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27. Basic, Inc. v. Levinson, 485 U.S. 224 (1988). 28. Jackvony v. IHT Financial Corporation, (1989) 873 F2d. at 415. For more on this topic, see Martin Lipton and Erica H. Steinberner, Takeovers and Freezeouts (New York: Law Journal Press, 1978 to present, i.e., 2010). This text is updated regularly, generally two times per year. 29. Basic, Inc. v. Levinson, op. cit (note 27). 30. See Stephen A. Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Directors, 6th ed. (New York: Aspen Law and Business, 2009). 31. Topping fees, which were very common in the middle to late 1980s, are agreements in which the target agrees to compensate the buyer for potential losses if a new bidder usurps the deal. Because these fees are liabilities of the target, the winning bidder will have to bear their economic burden. This burden has the effect of increasing the cost of, and thus discouraging, other bids. Another arrangement is for the payment of bustup or breakup fees if the transaction is terminated by the target (other than for cause). 32. A no-shop agreement is a provision either in the acquisition contract or in a letter of intent that prohibits the board of directors from soliciting or encouraging other bids. It is always found in private company acquisition agreements and, far more often than not, in the acquisition agreements for public company transactions. 33. If a merger or acquisition involves the issuance of securities to the target’s shareholders, such securities may not be resold freely, but may be restricted. Rule 145 of the Securities Act states that any party to a merger or acquisition transaction receiving securities is deemed to be engaged in a distribution and therefore to be an underwriter. Because of this “underwriter” status, it is necessary to use a Form S-4 registration statement to register securities issued to the target’s shareholders. This form is basically a wraparound of the proxy statement and permits noncontrolling shareholders of the target to sell without restriction. Control persons or “affiliates” must sell, however, either under the registration statement or in accordance with restrictions in Rule 144 under the Securities Act.

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34. For example, the Insider Trading Sanctions Act of 1984 and the International Securities Enforcement Cooperation Act of 1989. 35. In the 111th Congress, as of July 2010 as this edition goes to press, 17 pending bills mention “insider trading,” according to legislation information from the Library of Congress, at http://thomas.loc.gov/ cgi-bin/thomas. 36. United States v. O’Hagan, 117 S. Ct. 2199, 138 L Ed. 2d 724 (1997). Chapter 7

1. Under the U.S. Constitution, “The Congress shall have power to lay and collect taxes, duties, imposts and excises,” U.S. Const., art. I, §8, cl.1. The Sixteenth Amendment, ratified February 4, 1913, granted Congress the right to tax income. 2. Title 26 of the U.S. Code was established following the ratification of the Sixteenth Amendment of the U.S. Constitution (see note 1), empowering Congress to tax “incomes, from whatever source derived.” 3. This chapter is an update and summary of Reed, Lajoux, and Nesvold, op. cit. (Chapter 5, note 13). Special thanks to the Lane and Edson LLP attorneys who provided the original framework for this discussion during the preparation of the first edition of The Art of M&A. 4. This estimate is based on totals derived from two studies. According to one study, between 1986 and 2000, there were 5.400 cumulative changes to the tax code [Source: Daniel J. Mitchell, Ph.D., “Time to Sunset the Tax Code” (Washington, D.C.: The Heritage Foundation, January 28, 2000; http://www.heritage.org/Research/Taxes/EM 645.cfm), and according to another study, from 2001 to the present, there have been 3,125 changes in the tax code (Source: Steve Malanga, “Politicians Love the Tax Code We Hate,” http://www .realclearmarkets.com/articles/2009/04/politicians_love_the_tax_ code.html)]. 5. See Internal Revenue Bulletin 2010-4, January 25, 2010, http://www .irs.gov/irb/2010-04_IRB/ar05.html.

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6. For tax purposes, a transfer of property to a shareholder acting in the capacity of an employee or lender, for example, is not a corporate distribution. This has special implications in employee stock ownership plans (ESOPs) or management buyouts (MBOs). For a discussion of the tax aspects of stock ownership in ESOPs and MBOs, see Reed, Lajoux, and Nesvold, op. cit. (note 3). 7. Source: “Recognition,” Section 740-30-25-7 in 805-30-30-10, “Technical Corrections to Various Topics,” Accounting Standards Update No. 2010-08, February 2010. Regarding the divestiture of a subsidiary, accounting guidance for this was issued as FASB 160, with certain clarifications issued in February 2010. See FASB Accounting Standards Update No. 2010-02, Consolidation—Overall, Topic 810-10, Accounting and Reporting for Decreases in Ownership of a Subsidiary: A Scope Clarification. These standards are available at www.fasb.org. See also “FASB Revises Accounting Requirements for Decreases in Ownership of a Subsidiary,” KPMG LLP, January 2010; http://us.kpmg.com/microsite/DefiningIssues/2010/di-10-2 -fasb-requirements-decreases-ownership-subsidiary.pdf. 8. See “Treasury and IRS Address Interaction of Stapled Stock and Foreign Tax Credit Rules,” July 22, 2003, http://www.treas.gov/ press/releases/js590.htm. 9. See The Consolidated Tax Return (New York: Thomson Reuters, 2010); http://ria.thomsonreuters.com/estore/detail.aspx?ID =WCTR&productInfo=Table%20of%20Contents&SITE=. 10. See “Fin 46 (R) Revised Again: Now It’s All About Who Holds the Power,” Deloitte & Touche, August 2009; http://www.cfo.com/ whitepapers/index.cfm/download/14475141. 11. See: 2010 and 2011 information from the Tax Foundation, “Federal Capital Gains Tax Rates 1988–2011,” http://www.taxfoundation.org/ files/fedcapgainstaxrates-20080527.pdf. 12. Shareholders may not have to pay taxes on their dividends if they hold their stock for a certain period of time.

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13. See Topic 556, “Alternative Minimum Tax,” http://www.irs.gov/ taxtopics/tc556.html. 14. For more on this topic, see James T. Chuda and Harsha Reddy, Stock Purchases Treated as Asset Acquisitions, “Section 338 Election” (Washington, D.C.: BNE, 2010); http://www.irs.gov/taxtopics/tc556.html. For a general background on structuring, see also Alexandra R. Lajoux and H. Peter Nesvold, The Art of M&A Structuring (New York: McGraw-Hill, 2004). 15. Although both forms of merger convey the assets in the same simple manner, in the forward merger, assets end up in another corporate shell. In certain jurisdictions, this may violate lease and other contract restrictions the same way a direct asset transfer does. Similarly, in some jurisdictions, recordation taxes may be due after a forward merger when the buyer seeks to record the deeds in its name to reflect the merger. 16. If the buyer wants a holding company structure—that is, wants the acquired entity to be a subsidiary of a holding company—it forms a holding company with an acquisition corporation subsidiary. After the merger, the holding company will own all the stock of the acquired corporation, and the buyer will own all the stock of the holding company. 17. Under Delaware law, the approval of the surviving corporation’s stockholders is necessary only if its certificate of incorporation will be amended by the merger and if the shares of the survivor issued to the sellers comprise less than 20 percent of the outstanding shares of the survivor. 18. See U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter B, Part IV, Section 172, “Net Operating Loss Deduction,” at thttp://www.law .cornell.edu/uscode/html/uscode26/usc_sec_26_00000172— 000-.html. 19. See “New Law Extends Net Operating Loss Carryback for Small Businesses; IRS to Ensure Refunds Paid Timely,” IR-2000-26, March 16, 2009; http://www.irs.gov/newsroom/article/0,,id= 205329,00.html. For the official IRS revenue procedure, see Rev. Proc. 2009-26 at http://www.irs.gov/pub/irs-drop/rp-09-26.pdf.

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20. “Recognition,” op. cit (Note 8). 21. SFAS 109 is now ASC 740. “In addition to applying FASB ASC 740’s (formerly SFAS No. 109’s) complexities to many common differences between financial accounting and tax compliance, you now must identify uncertain tax positions and apply specific criteria to recognize, measure, and disclose these positions in the financial statements.” See “Accounting for Income Taxes—Applying SFAS No. 109/FIN 48: A Whole New Ballgame!” http://63.236.50.99/ AST/Main/CPA2BIZ_Primary/Accounting/Standards/ StandardsImplementationGuidance/PRDOVR~PC-182791/ PC-182791.jsp. For a chart comparing ASC 740 and SFAS 109, see http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/ Documents/us_tax_FAS109toASC740CrossReferenced_072309.pdf. 22. There are several significant exceptions to this general rule. The most common exception is those situations in which a selling shareholder of the acquired corporation stock is a C corporation: the proceeds from the sale of the acquired corporation stock by a corporate shareholder are likely to be taxed again upon their ultimate distribution to noncorporate shareholders. 23. This section is informed by IRS Publication 537, Installment Sales; http://www.irs.gov/publications/p537/index.html. For a general discussion, see also http://www.irs.gov/taxtopics/tc705.html. 24. As mentioned earlier, the adjusted basis is the initial basis subsequently increased by capital expenditures and decreased by depreciation, amortization, and other charges. 25. Code Section 368 (a) 1 (A) and Reg. Section 1.368-2(b) 1 cited in Martin D. Ginsberg and Jack S. Levin, Mergers, Acquisitions, and Buyouts: A Transactional Analysis of the Governing Tax, Legal, and Accounting Considerations (New York: Aspen Law and Business, 2009), Section 801. 1. Ginsberg and Levin is the main source for our definitions of A, B, C, and D reorganizations. 26. See Linda E. Carlisle, R. David Wheat, and Philip B. Wright, “Interesting Transactions of the Past Year” (undated, but discussing transactions for the year 2003), http://www.tklaw.com/resources/

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documents/Interesting%20Transactions%20of %20the%20Past% 20Year%20(Wheat,%20D.).pdf. 27. Not all states recognize the S corporation. For those that do not, the corporation pays state income taxes as if it were a C corporation. For those states that do recognize S corporations, both resident and nonresident shareholders of the state in which the corporation does business must file returns and pay taxes to that state. In such cases, a shareholder’s state of residence will usually (but not always) provide a credit against its own tax. 28. See Reg-118861-00, “Application of Section 338 to Insurance Companies,” which allows insurance companies to “retroactively apply the regulations to transactions completed prior to the effective date and to stop an election to use a historic loss payment pattern.” Federal Register, April 2, 2009, http://regulations.justia.com/ view/139816/. 29. An acquirer may not be able to amortize Section 197 intangibles acquired in a transaction that did not result in a significant change in ownership or use. Refer to antichurning rules in Publication 535, Business Expenses. See also “Intangibles,” an IRS discussion, at http://www.irs.gov/businesses/small/article/0,,id=110440,00.html. 30. See “Intangibles,” op. cit. (Note 29). 31. In 1969 Congress enacted Section 385 of the tax code, authorizing the Internal Revenue Service (IRS) to issue regulations regarding the debt vs. equity issue. To date, despite some false starts, the IRS has not issued regulations; debt-vs.-equity distinctions are left to the accounting standard-setters. 32. One of the laws limiting the reach of state income taxes was broadened in early 1992 when the U.S. Supreme Court declared a “de minimis” exception to a 1959 law establishing a federal limitation on state income taxes in Wisconsin Department of Revenue v. William Wrigley, Jr., Co. (1992). 33. See: “Business Combinations: Applying the Acquisition Method— Joint Project of the IASB and FASB,” Summary of January 14,

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2008; http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdate Page&cid=900000011074. 34. To maintain a consistent presentation, Topic 805 presents all content as pending content, even though some content applies to business combinations before the effective date of Statement 141(R). See “Codification,” paragraph 805-10-65-1, for the effective date. Accordingly, for business combinations applicable before the effective date in “Codification” paragraph 805-10-65-1, users need to access Statement 141 and any other relevant standards. See FASB Accounting Standards Notification: Notice to Constituents (v. 3.0) about the Codification (Norwalk, CT: Financial Accounting Foundation, 2009), http://asc.fasb.org/imageRoot/32/6737032.pdf. 35. A recent technical correction clarifies that “in situations in which acquiree awards would expire as a consequence of a business combination and the acquirer replaces those awards even though it is not obligated to so, all of the fair-value-based measure of the replacement awards shall be recognized as compensation cost in the post combination financial statements. That is, none of the fair-valuebased measure of those awards shall be considered in measuring the consideration transferred in the business combination.” Source: Paragraph 805-30-30-10, “Technical Corrections to Various Topics,” Accounting Standards Update No. 2010-08, February 2010; http://accountinginfo.com/financial-accounting-standards/asc-800/ 805-business-combinations.htm. Chapter 8

1. See An Antitrust Primer for Federal Law Enforcement Personnel, issued August 2003 and revised April 2005; http://www.justice.gov/ atr/public/guidelines/209114.htm#intro. 2. For an archive of notable cases filed since 1994, see http://www .justice.gov/atr/cases.html. Cases involving mergers typically list two or more companies in the title of the filing. 3. The category of “nonhorizontal” also includes complementary transactions, which achieve growth through diversification. Such transac-

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tions may remove potential competition or discourage competition by others because of the financial or marketing strength of the resulting firm. Antitrust cases against nonhorizontal transactions of this type are less common. 4. Federal Trade Commission press release, “FTC and DOJ Issue Antitrust Guidelines for Collaborations Among Competitors,” April 7, 2000, http://www.ftc.gov/opa/2000/04/collguidelines.shtm. 5. United States of America, et al. v. Ticketmaster Entertainment, Inc., and Live Nation Inc., Proposed Final Judgment, January 25, 2010; http://www.justice.gov/atr/cases/f254500/254558.htm. 6. United States v. Standard Oil Company (New Jersey), 253 F. Supp., 196, 226 (D. N.J. 1966). The DOJ filed an order terminating the final judgment on January 27, 2010. 7. United States of America, Plaintiff, v. Standard Oil Company (New Jersey) and Potash Company of America, Defendants, Order Terminating Final Judgment, January 27, 2010; http://www.justice .gov/atr/cases/standard_oil.htm. 8. Standard Oil Co. v. United States, 221 U.S. 1, 52 (1911). 9. Matsushita Electric Industrial Co. v. Zenith Radio Corp., 106 S. Ct. 1348 (1986). 10. See, for example, this 2010 case involving predatory pricing. Budget Prepay, Inc. v. AT&T Corp., Case No. 09-11099 (C.A. 5, May 3, 2010). http://dockets.justia.com/docket/court-ca5/case_id-O/. 11. David S. Evans, “Untying the Knot: The Case for Overruling Jefferson Parish,” July 2006; http://www.justice.gov/atr/public/ hearings/single_firm/comments/219224_a.htm. 12. Tony Lin, in “Distinguishing Kodak Lock-In and Franchise Contractual Lock-In,” Southern Illinois Law Journal, vol. 23, no. 1 (Fall 1998), notes the following (in abstract). “In Eastman Kodak Co. v. Image Technical Services, Inc., the United States Supreme Court held that Kodak’s replacement parts for its own photocopier equipment could be a relevant market for antitrust purposes. This

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article discusses tying arrangements and compares the Kodak tying arrangement with that of a franchisor and franchisee. The author argues that conducting a preliminary economic analysis does not violate the . . . rule against tying arrangements, and that an economic analysis reveals that franchise tying arrangements are not likely to lead to antitrust concerns. The author then concludes that franchise lock-in and Kodak lock-in are distinguishable under both a legal and economic analysis.” Abstract of. Source: University Law Review Project (lawreview.org). The University Law Review Project is a free service provided by the Coalition of Online Law Journals and FindLaw (http://www.FindLaw.com/) with the support of Stanford University and the Legal Information Institute at Cornell Law School. There are archives of these abstracts at FindLaw LegalMinds (http://www.LegalMinds.org/). The participants encourage redistribution of this material. 13. Michael Cohen, “A New Map?” The Deal, October 30, 2009; http://www.thedeal.com/newsweekly/community/soapbox-1/rules -of-the-road.php. 14. For current trends, see Federal Trade Commission and Department of Justice, Hart-Scott-Rodino Annual Report, at 1 (July 14, 2009), www.ftc.gov/os/2009/07/hsrreport.pdf. 15. John E. Kwoka and Lawrence J. White (eds.), The Antitrust Revolution: Economics, Competition, and Policy (New York/Oxford: Oxford University Press, 2008). 16. In September 2008, the Department of Justice issued a report entitled “Competition and Monopoly: Single-Firm Conduct under Section 2 of the Sherman Act.” In a press release dated September 8, 2008, the Federal Trade Commission stated that it did not support the report (http://www.ftc.gov/opa/2008/09/section2.shtm). And in May 2009, with a new head of antitrust at the helm, the DOJ withdrew the report. See “Justice Department Withdraws Report on Monopoly Law: Antitrust Division to Apply More Rigorous Standard with Focus on the Impact of Exclusionary Conduct on Consumers, http://www.justice.gov/atr/public/press_releases/2009/ 245710.htm.

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Notes for Chapter 8

17. Vivek Ghosal and Joseph Gallo, “The Cyclical Behavior of the Department of Justice’s Antitrust Enforcement Activity,” Working Paper Series, January 2001; http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=256039, accessed January 31, 2010. 18. This definition is based on one offered by Kwoka and White, op. cit. (note 15). 19. These examples come from ibid. 20. For example, according to Ms. Varney, the administration of President George Bush did not file a single complaint alleging violations of Section 2 of the Sherman Act. http://www.justice.gov/atr/ public/speeches/245777.htm. 21. To see all the sections of the Sherman Act, go to http://www4.law .cornell.edu/uscode/html/uscode15/usc_sup_01_15_10_1.html. 22. “Antitrust Issues Involving Minority Shareholding and Interlocking Directorates,” February 19, 2008, citing Eichorn v. AT&T, 248 F.3d 131, 139 (3rd Cir. 2001); and Greenwood Utilities Comm. v. Mississippi Power Co., 751 F.2d 1484, 1497 n.8 (5th Cir. 1985); http://www.ftc.gov/os/sectiontwohearings/docs/section2overview.pdf. 23. Ibid., citing Sonitrol of Fresno v. AT&T, 1986-1 Trade Cas (CCH) ¶ 67,080, at 62,566-57 (D.D.C. 1986). In this case, which featured ownerships in two corporations of 23.9 percent and 32.6 percent, the court found a conspiracy even though the parent company was the largest single shareholder and exercised effective control over the subsidiaries. The court noted that the subsidiaries’ directors still had an independent fiduciary obligation to act in the interests of the subsidiaries’ shareholders. 24. Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR Act), 15 USC, section 18a, as amended, Pub L No. 106-553, 114 Stat 2762 (21 December 2000). See http://www.justice.gov/atr/public/ speeches/200285.pdf. 25. See J. Hart Holden, “2010 Revised (Lower) Hart-Scott-Rodino Act Thresholds.” January 25, 2010. http://www.paulhastings.com/ publicationDetail.aspx?publicationId=1489.

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26. Ibid. 27. Kenneth B. Ewing, “Merger Control,” Antitrust Review of the Americas (London: Law Business Research Limited, 2010); http://www.globalcompetitionreview.com/reviews/20/sections/72/ chapters/790/merger-control/. Mr. Ewing is with the law firm of Steptoe and Johnson. 28. Department of Justice press release, “Smithfield Foods and Premium Standard Famrs Charged with Illegal Premerger Cooridination,” January 21, 2010. 29. In a statement typical of the pro-merger era in which they were written, the guidelines state, “Competition usually spurs firms to achieve efficiencies internally. Nevertheless, mergers have the potential to generate significant efficiencies by permitting a better utilization of existing assets, enabling the combined firm to achieve lower costs in producing a given quantity and quality than either firm could have achieved without the proposed transaction. Indeed, the primary benefit of mergers to the economy is their potential to generate such efficiencies.” See Appendix 8B, part 4. 30. See Christine A. Varney, Assistant Attorney General, Antitrust Division, U.S. Department of Justice, “An Update on the Review of the Horizontal Merger Guidelines: Remarks as Prepared for the Horizontal Merger Guidelines Review Project’s Final Workshop,” Washington, D.C., January 26, 2010. 31. http://www.justice.gov/atr/public/testimony/hhi.htm, accessed January 28, 2010. 32. “2009 Year-End Criminal Antitrust Update,” January 5, 2010, http://gibsondunn.com/Publications/Pages/2009Year-EndCriminal AntitrustUpdate.aspx. 33. For a list and summary of cases in 2009, see ibid. 34. Report of the Defense Science Board Task Force on Antitrust Aspects of Defense Industry Consolidations (Washington, D.C.: Defense Science Board Task Force, 1994).

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35. Annual Industrial Capabilities Report to Congress, from the Office of Under Secretary of Defense Acquisition, Technology & Logistics, Industrial Policy, March 2009; http://www.ndia.org/Advocacy/Policy PublicationsResources/Documents/Report_to_Congress_2009.pdf. 36. This case was resolved November 4, 2008. For a picture of the “time clock” involved, see http://www.fcc.gov/transaction/verizon -alltel.html and http://www.fcc.gov/transaction/verizon-alltel -clockhis.html. 37. See AT&T–Verizon Wireless, WT Docket No. 09-104; http://www .fcc.gov/transaction/att-verizon.html. 38. The facts in this answer are based on a report by Reuters Limited, as reported on the America OnLine news service in December 1999 and confirmed in a number of business periodicals. 39. For a transcript of the hearing, as well as testimony submitted, see http://energycommerce.house.gov/index.php?option=com _content&view=article&id=1873:the-exxonmobil-xto-mergerimpacts-on-us-energy-markets&catid=130:subcommittee-onenergy-and-the-environment&Itemid=71. 40. http://www.globalcompetitionreview.com/reviews/20/sections/ 72/chapters/790/merger-control/. See, for example, the review of antitrust law in more than 30 countries at Concurrences Review of Antitrust Law, http://www.concurrences.com/rubrique.php3?id _rubrique=602&lang=en. 41. The UN Convention on Contracts also covers such legal matters as anticipatory breach, exemptions, and effects of avoidance—items that acquirers can delegate to counsel for mastery. 42. http://www.wto.org/english/thewto_e/minist_e/min09_e/ min09_e.htm. 43. See, for example, “Statements by the United States at the January 19, 2010 DSB Meeting.” United States Mission to the United Nations. http://geneva.usmission.gov/2010/01/19/0119-dsb-meeting/. 44. The guidelines may be supplemented in the future on this point. As stated by Assistant Attorney General Christine Varney,

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There are important considerations that the Agencies routinely employ when assessing unilateral effects but are not mentioned or even alluded to in the Guidelines, and our panelists have likewise identified a number of considerations that are used in their practices and academic work to assess unilateral effects but are not discussed in the Guidelines. Diversion ratios, price-cost margins, win-loss reports, customer switching patterns, and the views of competitors, customers, and industry observers, for instance, are all tools used to analyze mergers of firms selling differentiated products. Yet the Guidelines say rather little about how the Agencies use these types of evidence to assess unilateral effects. Source: Varney, op. cit. (note 20).

Chapter 9

1. Management guru Tom Peters has frequently used the term “age of intangibles” to describe the twenty-first century. See, for example, Project O5, dated Summer 2005, at http://www.tompeters.com/ pdfs/Project05.pdf. See also Bernd Allekotte and Ulrich Blumenröder, “When Patents Become Standard: Litigation for ‘Essential’ Patents,” Intellectual Asset Management Magazine, January 2010. See also Tim Frain, “Patents in Standards and Interoperability,” November 29, 2006; http://www.wipo.int/export/ sites/www/meetings/en/2006/patent_colloquia/11/pdf/frain_paper.pdf. 2. For example, a computer company called DEC (which later, through a series of mergers, became part of Hewlett-Packard) sued Intel for patent infringement on several of its chip patents; Intel responded by searching through its own portfolio to find patents that it could use to sue DEC. Eventually, the dispute was settled when Intel bought a portion of DEC’s manufacturing facilities and worked out a crosslicensing agreement. Source: Julie L. Davis, Principal, Davis & Hosfield Consulting, LLC, Chicago, Illinois, dhllc.com. 3. U.S. Code, Title 17, Chapter 1, Section 10w; http://www4.law .cornell.edu/uscode/17/usc_sec_17_00000102——000-.html. As in all Code citations, check with http://uscode.house.gov/classification/ tables.shtml to see the very latest changes.

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4. U.S. Code, Title 17, Chapters 9 and 13; http://www4.law.cornell.edu/ uscode/17/. 5. See Berne Convention for the Protection of Literary and Artistic Works, http://www.wipo.int/treaties/en/ip/berne/trtdocs_wo001.html. 6. Examples of specialized laws include the Digital Millennium Copyright Act of 1998, which made it illegal to sell, manufacture, or offer for sale any technology designed to circumvent encryption; and the Webcaster Settlement Act of 2009, Pub. L. No. 111-36, 123 Stat. 1926, amending section 114 to authorize a 30-day negotiation period for Webcasters, enacted June 30, 2009. For a detailed history of copyright law in the United States, see Circular 92, Copyright Law of the United States and Related Laws Contained in Tıtle 17 of the United States Code, http://www .copyright.gov/title17/circ92.pdf. 7. For the WTO’s guide to TRIPS, see http://www.wto.org/english/tratop_E/trips_e/trips_e.htm. 8. See Eldred v. Ashcroft (01-618) 537 U.S. 186 (2003) 239 F.3d 372, affirmed; http://www.law.cornell.edu/supct/html/01-618.ZS.html. 9. For a chart showing the various applicable formulas for copyright terms, see http://www.copyright.cornell.edu/resources/public domain.cfm. 10. The items in this checklist and others in this chapter rely heavily on the expertise of Carol Anne Been, Sonnenschein Nath & Rosenthal, Chicago, Illinois, based on her various publications. 11. See http://www.wipo.int/pct/en/texts/articles/atoc.htm. 12. See http://www.uspto.gov/web/offices/opc/documents/ classescombined.pdf. 13. For an example of litigation, see Association for Molecular Pathology, et al. v. United States Patent and Trademark Office, et al., complaint filed May 12, 2009, Case No. 1:2009cv04515, filed U.S. District Court, Southern District of New York. Discussed at http://www.onpointradio.org/2010/01/gene-patenting. The case is

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still pending. See http://dockets.justia.com/docket/court-nysdce/ case_no-1:2009cv04515/case_id-345544/. For media attention, see http://www.onpointradio.org/2010/01/gene-patenting. 14. For example, in August 1998, priceline.com received a patent on reverse auctions, and has successfully challenged alleged infringers. “Expedia Will Pay Priceline.com Royalties for Reverse Auction,” October 1, 2001; see http://www.out-law.com/page-1288. Yet the reverse auction could be considered a basic type of commerce. For a taxonomy of business processes used on the Internet, including reverse auctions, see http://digitalenterprise.org/models/models.html. 15. For details on the 20-year term for patents, see http://www.uspto .gov/web/offices/com/doc/uruguay/20_year_term.html. 16. Source: Carl Davis, “Trademark Infringement and the On-Line World” presented at Spring 2009 CLE Seminar sponsored by the Tennessee Intellectual Property Law Association, Nashville, TN (May 2009) 17. Appeals can be made to the Patents and Trademark Office’s board of appeals, with further or alternative review available from the U.S. Court of Appeals for the Federal Circuit or the U.S. District Court for the District of Columbia. The Court of Appeals for the Federal Circuit (known as the Federal Circuit) has had primary jurisdiction over patents. 18. For this list and the following list, the authors acknowledge guidance from the writings of Carol Anne Been, op. cit. (note 10). 19. See http://www.uspto.gov/teas/eTEASpageC.htm. 20. One source for searching for owners of brands is http://www.fin downersearch.com/. All findings should be reviewed by qualified counsel. 21. Uniform Trade Secrets Act, Section 1ff., 14 U.S.A. 541. 22. Electro Optical Indus., Inc. v. White, 1999 WL 1086467, at *1 (Cal. Ct. App. Nov. 30, 1999. 23. Allekotte and Blumenröder, op. cit. (note 1).

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Notes for Chapter 10

Chapter 10

1. The authors acknowledge the Legal Information Institute at Cornell University as an important source of basic information for this section. 2. Also, “Where the parties do not have a contract, and one party sues another in tort for negligence, there can be no recovery for purely economic loss absent the plaintiff’s physical injury or property damage.” Steven W. Feldman, “The Economic Loss Doctrine: Rescuing Contract from Drowning in a ‘Sea of Tort,” Tennessee Bar Journal, April 2008; http://www.tba.org/journal_new/index.php/component/ content/article/258difficult%20obstacle. 3. This 1972 law was updated in 2008; see http://www.cpsc.gov/ cpsia.pdf. 4. This 1953 law was updated in 2008; see http://www.cpsc.gov/ BUSINFO/ffa.pdf. 5. This 1970 law was updated in 2008; see http://www.cpsc.gov/ BUSINFO/Pppa.pdf. 6. This 1960 law was updated in 2008; see http://www.cpsc.gov/ BUSINFO/fhsa.pdf. 7. See http://www.cpsc.gov/pr/whoweare.html and also Consumer Product Safety Commission, 2011 Performance Budget Request; http://www.cpsc.gov/cpscpub/pubs/reports/2011plan.pdf. 8. See http://www.cpsc.gov/. 9. For the past three decades, in every Congress, members have tried to pass a major product liability reform bill, but so far reformers have not been successful—partly because of opposition from the American Trial Lawyers Association, also known as the plaintiffs bar. The trend, in fact, has gone the other way, with stricter laws for product liability. See notes 3 through 6. 10. “Courts Outside U.S. Wary of Punitive Damages,” New York Times, March 26, 2008; www.nytimes.com/2008/03/26/us/26punitive.html. Authors’ note: Especially in the case of product liability where there


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was no negligence, but where liability is determined on an “absolute basis,” the awarding of punitive damages does indeed seem to be unfair. Absent tort reform, however, this is U.S. law, and it must be factored in as a cost of doing business. 11. Quoted verbatim from UCC Article 2, Section 314, General Obligation and Construction of Contract; Implied Warranty: Merchantability; Usage of Trade; http://www.law.cornell.edu/ ucc/2/2-314.html. 12. The authors (“reporters”) of this text were Michael D. Green, Wake Forest University School of Law, and William C. Powers, Jr., University of Texas. See http://www.ali.org/index.cfm?fuseaction =publications.ppage&node_id=53. 13. See http://www.law.cornell.edu/uniform/vol7.html#concc. 14. See http://docs.house.gov/rules/finserv/111_hr4173_finsrvcr.pdf. 15. The Caux Round Table consists of senior business leaders from Europe, Japan, and the United States. The Round Table was founded in 1986 by Frederick Philips, the former president of Philips Electronics, and Olivier Giscard d’Estaing, vice chairman of INSEAD and brother of the past president of France, Valery Giscardd’Estaing. It has been chaired by U.S. business executives as well, including Winston Wallin, former chairman and CEO of Medtronic, Inc. It has offices in The Hague, Netherlands; Tokyo, Japan; and Washington, D.C.

Chapter 11

1. See http://www.epa.gov/regulations/laws/caa.html. 2. See http://www.epa.gov/regulations/laws/cwahistory.html. 3. Uniform laws include the Uniform Transboundary Pollution Reciprocal Access Act (adopted by Colorado, Connecticut, Michigan, Montana, New Jersey, Oregon, and Wisconsin) and the Uniform Conservation Easement Act (adopted by Alaska, Arizona,

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District of Columbia, Georgia, Idaho, Indiana, Kansas, Kentucky, Maine, Minnesota, Mississippi, Nevada, New Mexico, South Carolina, Texas, Virginia, and Wisconsin). See http://www.thecre .com/fedlaw/legal14/environmental.htm at Uniform Laws. 4. Examples include California, http://www.calepa.ca.gov/; Illinois, http://www.epa.state.il.us/; and Ohio, http://www.epa.state.oh.us/. See http://www.thecre.com/fedlaw/legal14/environmental.htm at Uniform Laws. 5. For the full EPA mission statement, see http://www.epa.gov/ epahome/whatwedo.htm. 6. See, for example, Staff Accounting Bulletin 92 of the Securities and Exchange Commission regarding disclosure of environmental liability exposure and Item 101 of Regulation S-K, 17 C.F.R. Section 229, requiring disclosure of the material effects of compliance with environmental laws, including “any material estimated capital expenditures for environmental control facilities for the remainder of [the Company’s] current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.” 7. See ASTM E1528-06, “Standard Practice for Limited Environmental Due Diligence: Transaction Screen Process”; http://www.astm.org/Standards/E1528.htm. The purpose of this practice is to define good commercial and customary practice in the United States of America for conducting a transaction screen for a parcel of commercial real estate where the user wishes to conduct limited environmental due diligence (that is, less than a Phase I Environmental Site Assessment). If the driving force behind the environmental due diligence is a desire to qualify for one of the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) Landowner Liability Protections (LLPs), this practice should not be applied. Instead, the ASTM Practice E1527, “Environmental Site Assessments: Phase I Environmental Site Assessment Process,” may be used. The ASTM Committee E-50 on Environmental Assessment has produced several useful checklists, including guides for environmental site assessment, sustainable restoration of brownfield properties,


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and evaluations of underground storage tanks. See http://www .astm.org/COMMIT/COMMITTEE/E50.htm. 8. This list is based on past writings of Sean Monoghan, Partner, Drinker Biddle, http://www.drinkerbiddle.com.The estimate on Internet search time is our own. 9. See ASTM E1528-06, http://www.astm.org/Standards/E1528.htm. 10. See ASTM E1527-05, http://www.astm.org/Standards/E1527.htm. 11. See ASTM E1903-97 (2002), http://www.astm.org/Standards/ E1903.htm. 12. See 42 U.S.C. 9601(35)(B), http://www.astm.org/ABOUT/about ASTM.html. 13. The Asset Conservation, Lender Liability, and Deposit Insurance Protection Act, enacted September 30, 1996, amended Superfund by reinstating the EPA Final Rule on Lender Liability Under CERCLA, 1992, which had been struck down by the U.S. Court of Appeals for the District of Columbia in Kelley v. EPA, 15 F. 3d 1100 (CA DC 1994). For a summary of developments since that time, see “CERCLA Lender Liability Exemption: Updated Questions and Answers,” dated July 2007; http://www.epa.gov/compliance/ resources/publications/cleanup/superfund/factsheet/ lender-liab-07-fs.pdf. 14. The lender exception is located at CERCLA Section 101(20). The following section is adapted from material on the EPA Web site at http://www.epa.gov/compliance/resources/publications/cleanup/super fund/factsheet/lender-liab-07-fs.pdf. 15. Source: 42 U.S.C. §9601(20)(F)(i), (iii), and (iv), cited at ibid. 16. Source: 42 U.S.C. §9601(20)(F)(i)-(ii), cited at ibid. 17. Source: 42 U.S.C. §9601(20)(E)(ii), cited at ibid. 18. Source: CERCLA §§101(40) and 107(r)(1), cited at ibid. 19. Regarding “all appropriate inquiries,” a prospective purchaser of contaminated property who wishes to achieve status as a protected


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bona fide prospective purchaser, innocent landowner, or contiguous property owner must perform “all appropriate inquiries” into the previous ownership and uses of the property prior to acquisition of the property. EPA’s final rule was published in the Federal Register (70 FR 66070) on November 1, 2005, and went into effect on November 1, 2006. Generally, the final rule requires that all appropriate inquiries be conducted, or updated, within one year prior to acquiring the property. However, the final rule also requires that certain activities be conducted or updated within 180 days prior to acquiring the property. Source: 42 U.S.C. §9601(40)(B) and 40 CFR 312, cited at ibid. 20. Source: 42 U.S.C. §9601(40), cited at ibid. 21. “Affiliated with” includes direct and indirect familial relationships and many contractual, corporate, and financial relationships, but excludes contractual, corporate, or other relationships created by the instruments by which title to the property is conveyed. An entity cannot be a bona fide prospective purchaser if it is the result of a reorganization of a business entity that was potentially liable. Source: 42 U.S.C. §9601(40)(H), cited at ibid. 22. Source: 42 U.S.C. §9601(40), cited at ibid. Note: In 2003, EPA issued guidance entitled “Interim Guidance Regarding Criteria Landowners Must Meet in Order to Qualify for the Bona Fide Prospective Purchaser, Contiguous Property Owner, or Innocent Landowner Limitations on CERCLA Liability” (Common Elements) to address both pre- and postpurchase requirements. This document is available on EPA’s Web site at http://www.epa.gov/compliance/ resources/policies/cleanup/superfund/ common-elem-guide.pdf. 23. More information on potentially relevant federal cleanup laws may be found at http://www.epa.gov/compliance/cleanup. 24. Ibid. 25. The answers to this question and the rest of the questions in this section are taken verbatim from the EPA’s “Audit Policy Interpretive Guidance,” published January 1997 and still current as of June 1, 2010.


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Chapter 12

1. In addition, there is the Civil Rights Act of 1991, which amends previous law from the post–Civil War era (1866) to ensure to all persons equal rights under the law, and outlines the damages available to complainants in actions brought under the Civil Rights Act of 1964, the American with Disabilities Act of 1990, and the Rehabilitation Act of 1973. 2. The Equal Opportunity Employment Commission interprets and enforces the Civil Rights Act of 1964, the Equal Payment Act of 1963, the Age Discrimination in Employment Act of 1967 Title VII, the Americans with Disabilities Act, and sections of the Rehabilitation Act of 1973 (all described later in the chapter). 3. See http://www.supremecourtus.gov/opinions/08pdf/08-441.pdf. 4. H.R. 3721, S. 1756; http://www.opencongress.org/bill/ 111-h3721/show. 5. Burch v. Coca-Cola Co., 119 F.3d 305 (5th Cir.1997); and Zenor v. El Paso Healthcare Systems, Ltd., 176 F.3d 847, 859 (5th Cir. 1999). 6. The Department of Labor enforces Section 793 of the law, which refers to employment under federal contracts. The Department of Justice enforces Section 794 of the law, which refers to organizations receiving federal assistance. Source: Legal Information Institute, Cornell University. 7. A qualified “special” disabled veteran is a veteran who is entitled to compensation under the laws administered by the U.S. Department of Veterans Affairs for a disability rating of 30 percent or more, or a veteran entitled to compensation for a disability rated at 10 to 20 percent if it has been determined that the individual has a serious employment disability; or a veteran who was discharged or released from active duty because of a service-connected disability. Employers with federal contracts or subcontracts of $25,000 or more that were entered into before December 1, 2003, are required to complete an annual report showing the numbers of qualified special disabled veterans, veterans of the Vietnam era, and any other protected veterans hired or employed during the reporting period. See


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Vietnam Era Veterans’ Readjustment Act of 1972 (“VEVRAA” or “Section 4212”), 38 U.S.C. 4212, http://usmilitary.about.com/ od/jobopportunities/a/disabledvet_2.htm. 8. Adam Liptak, “Court Expands Ability to Sue in Sexual Harassment Investigations,” New York Times, January 27, 2009; http://www .nytimes.com/2009/01/27/washington/27scotus.html. 9. Faragher v. City of Boca Raton, 524 U.S. 775 (1998); also see http://www.law.cornell.edu/supct/html/97-569.ZS.html. 10. “The most heralded legacy of the 1998 U.S. Supreme Court decision in Faragher v. City of Boca Raton, 524 U.S. 775 (1998)—a plaintiff’s victory allowing vicarious liability for hostile-environment discrimination—is, ironically, the ‘Faragher defense.’” William R. Amlong, “Faragher v. City of Boca Raton: A Seven-Year Retrospective,” Florida Bar Journal, January 1, 2006; http://goliath.ecnext.com/ coms2/gi_0199-5155959/Faragher-v-City-of-Boca.html. 11. Faragher v. City of Boca Raton, 118 S. Ct. 2275, 141 L. Ed. 2d 662 (1998). Our summary owes a debt to the late Kermit L. Hall, who generously shared his expertise on an online encyclopedia (answers.com). See http://www.answers.com/topic/burlington-industries-inc-v-ellerth. 12. Examples include Reedy v. Quebecor Printing Eagle, Inc., 333 F.3d 906, 909-910 (8th Cir. 2003); Cerros v. Steel Techs., Inc., 398 F.3d 944, 952-955 (7th Cir. 2005); and Fairbrother v. Morrison, Case No. 03-9242-cv, Slip Op., 2005 U.S. App. LEXIS 11148, *36 (2d Cir. June 14, 2005. 13. Amlong, op. cit. (note 10). 14. The case is Lewis v. City of Chicago (7th Cir 06/04/2008). The Court announced that it would hear the case (granting certiorari) on September 30, 2009. The first oral arguments were heard on February 22, 2010; http://www.lawmemo.com/supreme/case/Lewis/. 15. This law amended Title VII of the Civil Rights Act of 1964 and the Age Discrimination in Employment Act of 1967, and modified the operation of the Americans with Disabilities Act of 1990 and the


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Rehabilitation Act of 1973, regarding the statute of limitations. See http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111 _cong_bills&docid=f:s181enr.txt.pdf. 16. “Companies May Hit New Anti-Discrimination Law When Asking Workers about Health Issues,” Kaiser Health News, Febuary 1, 2010. 17. The Legal Information Institute at Cornell University cites California as an example of a state that has passed, with federal permission, its own set of health and safety laws. The California laws are generally considered even tougher than the federal laws. 18. See Home-Based Worksites, Directive No. CPL 2-0.125, effective February 25, 2000. This was still posted as current as of February 25, 2010. 19. 29 CFR 1900.1, Docket No. S&H-0027. See http://www.osha.gov/ dsg/topics/safetyhealth/nshp.html. 20. See http://www.osha.gov/SLTC/ergonomics/faqs.html#differ. 21. Jonathan Adams and Kathleen E. McLaughlin, “Special Report: Silicon Sweatshops”; http://www.globalpost.com/dispatch/china -taiwan/091103/silicon-sweatshops-globalpost-investigation. This article claims that “despite strict ‘codes of conduct,’ labor rights violations are the norm at factories making the world’s favorite hightech gadgets.” 22. See http://www.globalpost.com/dispatch/china-taiwan/091103/ silicon-sweatshops-promising-model. 23. For more details, see the Department of Labor’s FAQ on the minimum wage at http://webapps.dol.gov/dolfaq/go-dol-faq.asp?faqid=218. 24. For more details, see the Department of Labor’s FAQ on overtime at http://webapps.dol.gov/dolfaq/go-dol-faq.asp?faqid=320. 25. The U.S. Code has 50 titles (and within these, chapters, subchapters, subtitles, parts, and sections). See Chapter 4 for more details. 26. Tax Code (Title 26 A, 1, D, I, B, Sections 430 and 431). This is administered and enforced by the Internal Revenue Service (IRS), in


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the Department of the Treasury. Under Title 26 rules for taxation of deferred compensation, there is a section on minimum funding standards. The section is found in Title 26, Subtitle A, Chapter 1, Subchapter D, Part 1, Subpart B, Sections 430 and 431. The long form of this citation is Title 26, Internal Revenue Code, Subtitle A, Income Taxes, Chapter 1, Normal Taxes, Subpart D, Deferred Compensation, Part I, Pension Plans, Subpart B, Special Rules, Sections 430 and 431, Minimum Funding Standards. The link to these standards is http://www.law.cornell.edu/uscode/uscode26/ usc_sec_26_00000430——000-.html. See http://www.law.cornell.edu/ uscode/uscode26/usc_sec_26_00000431—000-.html. 27. Labor Code (Title 29, . . . , Section 1082). This is administered and enforced by the Department of Labor (DOL). The Employee Retirement Income Security Act of 1974 (ERISA) is duly entered into Chapter 18 of the Labor Code of the United States (Title 29 of the U.S. Code). The part concerning funding is found within Chapter 18 at Subchapter 1, Subtitle B, Part 3, Section 1082. The long form of this citation is Title 29, Labor Code, Chapter 18, Employee Retirement Income Security Program, Subchapter 1, Protection of Employee Benefit Rights, Subtitle B, Regulatory Provisions, Part 3, Funding, Section 1082, Minimum Funding Standards. Section 1082 grants a waiver under certain conditions; see http://www.law.cornell.edu/uscode/uscode26/usc_sec_26_00000412 —000-.html. Note that ERISA is not the only law that pertains to pension funding. There have been others, most recently the Pension Protection Act of 2006 (P.L. 109-280), which is also part of Title 29, Chapter 18. 28. In citing the source of a regulation, one can cite either the law or the Code section. For reasons of consistency, this chapter cites Code sections. 29. See http://www.dol.gov/ebsa/pdf/fab2009-1.pdf. 30. Note: There is also an alternative minimum funding standard at U.S. Code Title 29 . . . , Section 1082, “Minimum Funding Standards.” 31. See Wayne Miller, “What’s Fiduciary to Do?” Directors & Boards; http://www.nacdonline.org/conference08/pdf/handouts/ErisaReprint.pdf.


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32. “Insider Trades During Pension Fund Blackout Periods,” Securities and Exchange Commission Release No. 34-47225, effective January 26, 2003. http://www.sec.gov/rules/rinal/34-47225.htm. 33. See http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname= 110_cong_bills&docid=f:h1424enr.txt.pdf. 34. See Title VII of Division B of the 2009 Recovery Act, http://www .house.gov/billtext/hr1_cr_jesb.pdf. 35. See Stanley Foster Reed, Alexandra Reed Lajoux, and H. Peter Nesvold, The Art of M&A: A Merger/Acquisition/Buyout Guide, 4th ed. (New York: McGraw-Hill, 2007). 36. Plans may be combined in an assets acquisition only if the buyer assumes the acquired company’s plan or if the plan assets are spun off to the buyer’s plan. 37. http://courts.delaware.gov/opinions/(ymaqvrn5bplq3n45izvbwx55) /download.aspx?ID=64510, upheld at http://courts.delaware.gov/ opinions/(y501l1453qrhjvvfdzlhnv55)/download.aspx?ID=77400. 38. Michael P. Barry, Plan Advisory Services Group, Chicago, IL. This answer is verbatim text from correspondence of May 18, 2010. 39. A bill now pending in the U.S. Senate (as of February 22, 2010) requires large employers (i.e., those with more than 50 workers) to provide insurance coverage. “The assessment on the employer is $3,000 per full-time worker obtaining tax credits in the exchange if that employer’s coverage is unaffordable, or $750 per full-time worker if the employer has a worker obtaining tax credits in the exchange but doesn’t offer coverage in the first place. The House bill requires a payroll tax for insurers that do not offer health insurance that meets minimum standards. The tax is 8% generally and phases in for employers with annual payrolls from $500,000 to $750,000; according to the Congressional Budget Office (CBO), the assessment for a firm with average wages of $40,000 would be $3,200 per worker. Under the President’s Proposal, small businesses will receive $40 billion in tax credits to support coverage for their workers beginning this year. Consistent with the Senate bill, small businesses with fewer than 50 workers would be exempt from any

520


employer responsibility policies.” Source: http://www.whitehouse .gov/sites/default/files/summary-presidents-proposal.pdf. 40. A recent disabilities case involved Balance Staffing, a nationwide staffing company. A U.S. District judge entered a consent decree on June 14, 2010, requiring the company to pay $100,000 to a blind woman whom it had hired and then immediately fired (by revoking the job offer) when learning she was blind. (Note: If a job does not require a particular ability, such as sightedness, to perform its core functions, a complaint of discrimination can find redress in the Americans with Disabilities Act.) 41. The laws governing reduction in force (RIF) apply only to the federal government. The government, by its very economic nature— being financed by taxes rather than by competitive market forces—has traditionally been able to employ large numbers of people for long periods of time. This began to change in the 1980s, however, when the government made its first attempt at downsizing. 42. This applies, in ADEA language, to a waiver requested in connection with “an exit incentive or other employment termination program offered to a group or class of employees.” 43 For example, the National Labor Relations Act usually has precedence over bankruptcy law. 44. The law governs such activities as legal injunctions (court-ordered actions), lockouts (employer action to prevent workers from entering workplace), pickets (demonstrations by employees), and strikes (employee refusal to report to work). The right to strike is supported by the NLRA. This is in part because of the Norris-LaGuardia Act of 1932, which limited the power of federal courts to issue injunctions prohibiting unions from engaging in strikes and other coercive activities. The President of the United States may prohibit a strike on behalf of public safety, as President Ronald Reagan did when he prohibited a strike by the National Air Traffic Controllers union. 45. For more on this and other laws overseen by the Department of Labor, see http://www.dol.gov/opa/aboutdol/lawsprog.htm.

Notes for Cases

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Cases

1. For a full discussion of the cases by Morris James attorneys, see http://www.delawarebusinesslitigation.com. 2. This summary is based on the writings of Professor Paul L. Caron, University of Cincinnati College of Law; see rersei http://taxprof .typepad.com/taxprof_blog/2008/03/7th-circuit-kpm.html. 3. For recent commentary on this case, see the 2009 case Cassens Transport Company et al. v. Paul Brown et al., On Petition for a Writ of Certiorari to the United States Court of Appeals for the Sixth Circuit. Respondents’ brief in opposition can be found at http://www.citizen.org/documents/cassensBIO_1.pdf. 4. See Stoeklin v. United States, 858 F. Supp. 167, 168 (M.D. Fla. 1994) (government is not bound by the identical extinguishment provision of Florida’s Transfer Act because of the rule of Summerlin): “Apparently the extinguishment provision was designed in part to bar actions asserted by the government under the Summerlin rule: The section rejects the rule applied in the United States v. Gleneagles Inv. Co., 565 F. Supp. 556, 583 (M.D.Pa.1983) (state statute of limitations held not to apply to action by United States based on Uniform Fraudulent Conveyance Act).” Unif. Fraudulent Transfer Act S 9, comment (1), 7A U.L.A. 665-66 (1984) (quoted in Vellalos, 780 F. Supp. at 707). “In this regard, the provision appears to be a dressed-up statute of limitations, crafted to circumvent the rule of Summerlin.” USA v. Bacon (1996). http://caselaw.lp.findlaw .com/cgi-bin/getcase.pl?court=9th&navby=case&no=9436249#f2. 5. See http://www.delawarebusinesslitigation.com/uploads/file/ Collins.pdf. 6. Edgar v. MITE Corp., 457 U.S. 624 (1982). This case, now superseded by CTS Corp. v. Dynamics Corp. of America, struck down state antitakeover laws. 7. The Internal Revenue Service recently referred to this classic case, in a memo on “Supervisory Goodwill—Revised 5-11-2010,” (Internal Revenue Service, LMSB4-1109-042, Revision Date May 11, 2010), stating as follows:

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Notes for Cases

[S]ome taxpayers are claiming depreciation or amortization deductions under I.R.C. § 167 for supervisory goodwill. Relying on Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993), these taxpayers claim that supervisory goodwill has an ascertainable value and a limited useful life which could be determined with reasonable accuracy. . . . Taxpayers cannot establish a tax basis in supervisory goodwill and, therefore, they are not entitled to deductions . . . for depreciation or amortization with respect to supervisory goodwill. Even if a taxpayer could establish a tax basis in supervisory goodwill, that taxpayer must affirmatively establish that it satisfied Newark Morning Ledger’s requirements before it would be entitled to such deductions. http://www.irs.gov/businesses/article/0,,id=223604.00.html#1.

8. This summary is based in part of coverage by Robert Willens, “Wells Fargo Is Chastised for SILO Deals,” January 25, 2010; http://www.cfo.com/article.cfm/14470315. The authors also acknowledge helpful dialogue with financier Cheryl C. Moss of Friend Skoler & Co., Inc., Saddle Brook, NJ. 9. This case summary is reprinted verbatim from the American Bar Association Web site for public education, http://www.abanet.org/ publiced/preview/summary/home.html. 10. Per se is from the Latin for “for itself.” Per se liability means liability if no other factors are considered.

INDEX

A reorganization, 214 Abraham v. Emerson Radio Corp., 414 Abstract for review of minute books, 18 Abry Partners V.L.P., et al. v. F & W Acquisitions LLC, et al., 414 Accardi v. Control Data, 452–454 Accounting guidance: AICPA, 48, 54–57 ASC, 192 FASB, 104, 209, 227–228, 388, 470n4, 471n5–471n6 GAAP, xvi, 388 IASB, 192, 209, 227, 375 IFRS, xv–xvi, 388 international standards, xv–xvi principal pronouncements, 227–228 (See also Tax law and accounting regulations) Accumulated funding deficiency, pensions, 367–368 Acquisition agreements (See M&A agreements/related contracts) Acquisition method, business combinations, 227 Active compliance program, D&O, 114–115 Adcock v. Firestone Tire & Rubber Co., 375 Adjusted basis, transaction structure, 204 Administrative regulatory law, 98–99 Administrative-services only (ASO) health plan, 377

Affiliated corporation, 196–197 “Affiliated with, “ prospective purchaser, 514n21 Against the Gods (Bernstein), 385 Age discrimination, employment, 354, 378–379 Age Discrimination in Employment Act of 1967 (ADEA), 354, 378, 515n2, 520n42 “Age of intangibles,” 507n1 Agreements (See Contracts and agreements) Aldersman, William F., 465n16 “All appropriate inquiries,” property, 513–514n19 Allen, William T., 116 Alternative dispute resolution (ADR), 107 Alternative minimum tax (AMT), 200 American Bar Association (ABA), 101–102, 166 American Institute of Certified Public Accountants (AICPA), 46–48, 54–57, 468n31 American Law Institute, 102, 319 American Recovery and Reinvestment Act of 2009 (ARRA), 373 American Society for Testing and Materials (ASTM), 331–332, 512–513n7–12 Americans with Disabilities Act of 1990 (ADA), 354–356, 515n2, 516–517n15 523

524

Amortization, intangible assets, 223–224 Andaloro v. PFPC Worldwide, Inc., 414–415 Annual reports, (10K), 9, 11, 35, 36, 61 Antar, Eddie, 69 Antitrust Revolution (Kwoka and White), 236 Antitrust and trade law, 231–289 application to M&A, 243–246 Clayton Act, 235, 238–240 fundamentals, 232–237 Hart-Scott-Rodino Act, 238–243, 503n14, 504n24 horizontal mergers, 233–236, 243–246, 258–278 industry issues, 247–250 international economic laws, 250–253 landmark court cases, 439–441 monopolies, 237–238 oligopolies, 238 Sherman Antitrust Act, 238–239, 503n16, 504n20–21 U.S. law/regulation framework, 254–257 vertical mergers, 233–235, 246, 279–287, 501–502n3 Appriva Shareholder Litigation Co. v. ev3, Inc., 422 Arbitration in collective bargaining, 381 The Art of M&A (Reed, Lajoux and Nesvold), 488–489n13, 490n3 Arthur Anderson, xiv Articles of incorporation, 65 “As is” acquisitions, 132 Ashkenas, Ron, 81 Asset(s): analysis of testing company, 90–91 identifying key, operations/management, 76–80 intangible, 223–224, 389, 500n29, 507n1 interview revelation of, 69–70 misappropriation, financial statements, 46–47 tangible (See Tangible assets) Asset Conservation, Lender Liability, and Deposit Insurance Protection Act (1996), 513n13 Asset transactions: carryover-basis, 206 extent of due diligence, 9, 136–137 vs. other transactions, 204–205 vs. stock transactions, 136–137

Index

tax issues in, 200–202, 204–206, 210–211 Asset turnover ratio, 41, 45 Assignments, intellectual property, 303–305 Association of Certified Fraud Examiners (ACFE), 46 Association of Corporate Counsel (ACC), 101 Association for Molecular Pathology, et al. v. United States Patent and Trademark Office, et al., 508–509n13 ATS, Inc. v. Bachmann, 422 AT&T, 248 Auction–rate securities (ARS), 470n4 Audit committee, role of, 52–53 Audit Policy, EPA, 341–342, 348–350 Authorization limit (AL) materiality, 106, 482–483n22 B reorganization, 214 Balance sheet, 36–39, 469–470n2 Balance sheet analysis: for bank acquisition, 43–44 for financial services acquisition, 43–45 for high-technology companies, 45–46 for insurance company acquisition, 44–45 Balance sheet ratio, 40–41 Bank acquisition, balance sheet analysis, 43–44 Bank fraud, 478n20 Bargain price, 228 Basic, Inc. v. Levinson, 172, 178–179, 428–429, 495n27 B.E. Tilley v. Mead Corp., 455–456 Bear Stearns, 471–472n8 Beneficial owners, 175–176 Berg & Berg Enterprises, LLC v. Boyle, 490n4 Bernstein, Peter L., 385 “Best of knowledge” representations, 141, 144–145 “Big 10” federal agencies, 99 Black Lung Act (1969), 360 The Black Swan (Taleb), xii Blackout periods, pension funds, 372 Black’s Legal Dictionary, 4 Blau v. Del Monte Corp., 454 Blessit v. Retirement Plan for Employees of Dixie Engine Co., 454–455

Index

Block, controlling, 185–186 BMC, 85 Board of directors [See Director and officer (D&O) issues] Boeing, 248 Books, board of directors, 18 Boyle v. United States, 171, 493n20 Brand, as key asset, 77 Breach, representation/warranty, 154 Breach of contract, and deposit, 129 Bright line test, 179, 292 Bringdown due diligence, 20–21, 150–152 Brokers, contractual due diligence, 8 Brownfields, 334, 339 Bulk sales law, 137, 488n10 Burch v. Coca-Cola Co., 355, 515n5 Burlington Industries Inc. v. Ellerth, 357–358 “Burn or return” provision, 14 Business due diligence, 59–60 (See also Operations and management review) Business judgment rule, 180–181 Business objectives, internal controls, 50–53, 59 Bust-up fees, 182 Buyer bias, correcting, 128–133 Bylaws, due diligence checklist, 387 C corporations, 217–219, 224 C reorganization, 214 Calpine Corporation v. The Bank of New York, 415 Canadian Institute of Certified Accountants (CICA), 46 Capital confirmation, due diligence checklist, 398 Capital gains tax rate, 198–199 Capital resources, MD&A checklist, 63 Caron, Paul L., 521n2 Carry forward, 208 Carrybacks, 208 Carryover basis, 205–208, 210, 222 Carve out, MAC, 127–128 Cascade International, Inc., 69 Case law, xiii, 4, 96–97, 101–102, 299 Cash, as key asset, 77 Cash flow statements, 39–40 Caux Round Table, 322, 342, 511n15 CERES Principles, 344–347 Certainteed Corp. v. Celotex Corp., et al., 406–407

525

Certificate of Incorporation (CI), 387 Chancery courts, 96, 115, 435, 458, 481n5 Chandler, William B., 375 Checklists: consultants and experts, 398–400 due diligence, 16–17, 387–395, 398–400, 477–478n15 interviews, 68–69 MD&A, 62–65 Circuit Courts, Federal, 461–462 Civil law, as statutory, 98 Civil Rights Act (1964), 353, 357, 515n2, 516–517n15 Civil Rights Act (1991), 353–354, 515n1 Claims-incurred insurance policy, 113 Claims-made insurance policy, 113 Clayton Act (1914), 235, 238–240 Clean Air Act of 1970 (CAA), 326 Closing, 150–158 closing day, 155–156 conditions to, 133, 150–154 litigation analysis at, 105 logistical problems, 156–157 MAC condition, 127–128, 487n6 postclosing activities, 157–158 preclosing, 154–155 risk transfer, 130–132 Closing memorandum, 18 Code of Federal Regulations (CFR), 101–102, 120–122, 482n16 (See also U.S. Code) Collective bargaining, 380–382 Collins & Aikins Corp. v. Stockman, 415–416 Collusion, as red flag, 233–235 Committee of Sponsoring Organizations of the Treadway Commission (COSO), 1, 51–52, 59 Common law, xv, 4, 96–97, 101–102, 299 Communication: consent decree, 248–249 internal control, 52 as key to positive diligence relationship, 12–14 Company entity type, 8, 177–178, 194, 217–224 Company information, risk assessment, 62 Compensation: deferred, 394 discrimination in, 359 insurance for, 376–377 wage and hours laws, 363–364

526

Competition, foreign, and antitrust, 246 Competitor-initiated litigation, 118 Compliance review (See Legal compliance review) Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), 326, 331–332, 336–340, 513n13–14 Comshare Inc. Sec. Litig., 469n38 Concentrated industry, 243–245 Concentration of industry, mergers, 243–244 Conditions to closing section, in M&A agreement, 133, 150–154 Confidentiality agreement, 14, 18, 73–74 Conflict of interests, defined, 22–23 Conflict management due diligence in, 80–84 “Consideration of Fraud in a Financial Statement Audit” (AU 316, AICPA), 48, 54–57 Consolidated income tax return, 197, 220 Constitution, U.S., 98, 290, 294, 480–481n3, 496n1–2 Consultants and experts: to conduct due diligence, 21–22 consulting agreements, 391 credentials, 74–75 due diligence checklist, 398–400 engagement letter, 18 environmental, 330 expert witnesses, 75, 487n40 vs. nonexperts and material misrepresentation/omission, 25 operations/management review, 74–76 Consumer credit law, 321–322 Consumer Product Safety Commission (CPSC), 100, 317 Consumer Product Safety Improvement Act (1972), 316 Consumer Protection Act (2009), 322 Consumer protection laws, 313–323 consumer credit, 321–322 food and drug, 320–321 landmark court cases, 446–450 product liability, 314–320 Continuity of interest requirement, taxfree transaction, 217 Contracts and agreements: in common law, 96 due diligence checklist, 391–393 labor, 111, 380–382

Index

protections against postacquisition losses, 32 severance, 374–375, 378 warranty, 318–319, 393 (See also M&A agreements/related contracts) Contribution margin per unit, 41 Contribution margin ratio, 41 Control block, 185–186 Controls: defined, 1 internal, 10, 50–53, 59, 61 (See also Committee of Sponsoring Organizations of the Treadway Commission) Cooperation, due diligence process, 14–15 Copying documents, 15–16 Copyright, 290–294, 389 Copyright Act (1976), 291–292 Copyright Office, Library of Congress, 293 Copyright Term Extension Act (1998), 292 Corporate formation, operations/management review, 65–66 Corporate vs. individual tax rates, 199 Corporate securities, 162–163 Correspondence, due diligence checklist, 393 Corruption, 46–47, 473n15 Cost: basis for, transaction structure, 205–211, 222 cost-benefit of due diligence, 64–65 environmental liability, 330–333 of litigation, options and alternatives, 106–108 Cost of goods sold (COGS), 473n19 Courts: case review, litigation analysis, 109 (See also Landmark court cases) Delaware Chancery Court, 96, 115, 435, 458, 481n5 (See also Delaware Supreme Court) Federal Circuit, 461–462 U.S., 100–101 Covenants, M&A agreements, 134, 147–148 Crawford v. Metropolitan Government of Nashville and Davidson County, Tenn., 357 Crazy Eddie Stores, 69–70 Credit Managers Ass’n of Southern Cal. v. Federal Co., 409–410

Index

Credit rating agencies, risk assessment, 61 Creditor check, due diligence checklist, 400 Crescent/Mach I Partnership, L.P. v. Turner, 416 Criminal law, as statutory, 98 Critical status, pension plans, 369 Cross-checking representations, 30–31 CTS Corp. v. Dynamic Corp. of America, 429–430 Cultural due diligence, 60–61, 81–83, 92–94, 475n2 Culture, as key asset, 77, 82–83 Current ratio, 41 Customer-initiated litigation, 116 D reorganization, 214 Data rooms, electronic: do-it-yourself due diligence, 15–16 increasing use of, xv interview record keeping, 75 security precautions, 19, 85–89 virtual data room, 18–19, 148–150 Daubert v. Merrell Dow Pharmaceuticals (1993), 75, 468n36, 479n24, 487n40 Debt: acquirer’s potential liability, 106–107, 136–137 vs. equity, tax view of, 225 litigation analysis, 110–111 Debt ratio, 41–42 Debt securities, corporate, 162 Debt to equity ratio, 41, 471–472n8 Debt to sales ratio, 42, 46, 472n12 Deceptive business practice, 299–300 De facto merger doctrine, 137 Defects, in products, 315 Defense industry, 247–248 Deferred compensation plans, due diligence checklist, 394 Defined benefit plan (DBP), 364– 365, 370 Defined contribution plan (DCP), 364–365, 370, 374 Delaney Clause, Food Additives Act (1952), 320 Delaware Chancery Court, 96, 115, 435, 458, 481n5 Delaware corporate law, 165, 173 Delaware County Redevelopment Authority v. McLaren/Hart, 450

527

Delaware Open MRI Radiology Associates, P.A. v. Kessler, 407 Delaware Supreme Court: board of director duties, 459 “due diligence” as term, 6 fraud or negligence, 406, 409, 416 legal compliance profile of seller, 115 M&A agreements/related contracts, 420, 426 securities law violations, 433, 435 severance agreements, 375 Deposit to capital ratio, 44 Deposits in acquisition agreement, 129 Derivatives of works, copyright, 292 Design defects, 315, 318–319 Design patents, 295 Digital Millennium Copyright Act (1998), 508n6 Diligence in patent application filing, 309–311 Director and officer (D&O) issues: cases, 458 duty of due care, 181 duty of good faith, 115–116, 459–460 duty of loyalty, 181–182, 186 insurance, 32, 111–114, 469n41 interviews with, 67–76 legal compliance review, 111–118 litigation trends against, 116–118 minutes and books, 18, 65–66, 387–388 securities laws, 180–182 shareholder lawsuits, 162 special committees, 182–185 Disabilities, discrimination, 354–356, 520n40 Disclose or abstain rule, 188 Disclosure: D&O litigation inadequate, 162 environmental, 329, 336, 341–342 “line of business” reports, 477n11 in merger negotiations, 179–180 schedule, representation/warranties, 138–139 securities laws, 178–180 Discovery in environmental law, 341–342 Discrimination in employment, 352–357, 378–379 Distributions to shareholders, 196 Divestiture, tax issues in, 193–195 Dividend payout ratio, 42 Document request lists, 18

528

Documentation and transactional due diligence: acquisition agreement components, 133–135 acquisition agreement key points, 126–133 checklist, 387–395 closing, 150–154 copyright issues, 293–294 covenants, 134–135, 147–148 document flow, especially electronic, 148–150 extent of due diligence, 8–9 intellectual property, 304–305 introductory matter, 135–136 license and license agreements, 302–303 M&A due diligence, 8 on-site/do-it-yourself due diligence, 15–16 operations/management review, 65–67 patent issues, 297 price/mechanics of transfer, 135–136 representations and warranties, 137–147 trade secrets, 300–302 trademarks, 300–301 Dodd-Frank Act (2010), 322 Do-it-yourself due diligence, 15–16 Double taxation, corporate, 199–200, 211 Drug and food law, consumer protection, 320–321 Due care, duty of, 181 Due diligence: changing landscape for, xi–xvii checklist for, 387–395 conducting, overview, 3–33 current event impact on, xi–xii, xiv–xvi defined, 4–5 do-it-yourself, 15–16 duration of, 19–21 end of, 21 financial statement review, 35–57 hierarchy of diligence, 4–5 key participants, 21–23 legal compliance review, 95–122 legal requirements for, 23–28 M&A due diligence, 6–7 need for, 385–386 nontraditional, 60–61 operation and management review, 59–94

Index

predictions, xvii public company (See Public company due diligence) scope and extension of, 7–19 Securities Act (1933), xiv, 24–28, 163, 166, 171, 495n33 Securities Exchange Act (1934), 28–29, 51 as term, in landmark legal cases, 6 transactional (See Transactional due diligence) value of, xii–xiii verification and risk prevention, 30–32 when to start, 19–20 Duration: of copyright, 293 of due diligence, 19–21 of patents, 296 of trademarks, 298 Duty of due care, 181 Duty of good faith, 115–116, 459–460 Duty of loyalty, 181–182, 186 Earning assets to total assets ratio, 44 Earnings: defined, 195 double taxation on corporate, 199–200, 211 per employee ratio, 43 per share (EPS) ratio, 42 Earnings statement, public companies, 469–470n2 Eastman Kodak Co. v. Image Technical Services, Inc., 502–503n12 Economic downturn, M&A agreement, 153–154 Economic losses, product liability, 315–316 Economic models, for due diligence, 31 Economic Recovery Act (2008), 11 Edelman v. Fruehauf Corp., 430 E. H. I. of Florida, Inc. d/b/a Horizon Hospital, Appellant, v. Insurance Company of North America, 492n15 E-Know, Inc., 467n27 Electro Optical Industries v. White, 301, 441–442 Electronic document data flow, 148–150 (See also Data rooms, electronic) Embedded leverage, 472n9

Index

Emergency Economic Stabilization Act of 2008 (EESA), xv, 11, 147, 372–373, 489n15 Emerging Issues Task Force (EITF), 471n5 Employee-initiated litigation, 116–117, 351–352 Employee Retirement and Income Security Act of 1974 (ERISA), 365–367, 371, 518n27 Employment agreements, due diligence checklist, 391 Employment laws, 351–383 areas covered, 352 collective bargaining, 380–382 common lawsuits, 351–352 compensation insurance, 376–377 equal opportunity, 352–360 health insurance, 377 health and safety, 360–363 immigration, 382–383 landmark court cases, 452–458 pensions, 364–376 wage and hours, 363–364 workforce reduction, 377–380 Endangered status, pension plans, 369 Energy Policy Act (2005), xvi Engagement letter for consultant, 18 Engineering reports, due diligence checklist, 388 Enron, xiv Entity type, company, 8, 177–178, 194, 217–224 Environmental law, 325–350 agencies and EPA, 327–329 CERCLA, 326, 331–332, 336–340, 513n13–14 CERES Principles, 344–347 compliance checks, 329–336 EPA’s Audit Policy, 341, 348–350 federal and state, 325–327, 340–341, 511n3 landmark court cases, 450–452 lender liability, 336–341 new regulations, xvi U.S. Code, 325–326 violations, voluntary discovery, and disclosure of, 341–342 Environmental Protection Agency (EPA): Audit policy, 341–342, 348–350 as federal agency, 100 prospective purchaser rules, 513–514n19–22

529

purpose of, 327–328 and U.S. Code, 326 Equal Employment Opportunity Commission (EEOC), 100, 353, 515n2 Equal opportunity laws, 352–360 Equal Pay Act (1963), 356, 515n2 Equitable action, in common law, 96 Equity capital to total assets ratio, 44 Equity law, xiii Equity securities, 161–162 Ergonomics regulation, 361–362 Ernst & Ernst v. Hochfelder, 402–403, 468n34 Escott v. BarChris Construction Corp., 6, 24, 30–31, 139, 403–404 Exam control environment, Kroll’s analysis, 91 Excess pension plans, due diligence checklist, 394 Exchange Act [See Securities Exchange Act (1934)] Exclusion, as red flag, 233–235 Executive branch, federal government, 97–100 Executive orders, 98 Exhibits representations/warranties, 138–140 Expert witnesses, 75, 487n40 (See also Consultants and experts) Export controls, international antitrust, 252–253 ExxonMobil, 235, 249–250 Facchina v. Malley, 422–423 Fair Labor Standards Act of 1938 (FLSA), 356, 363 “Fair use” and copyright, 292 Fair-value-based measure, 501n35 Fairness opinion, 30, 183–185 Fall River Dyeing and Finish Corp. v. NLRB, 455 Family and Medical Leave Act of 1993 (FMLA), 364 Faragher v. City of Boca Raton, 358–359, 516n9–11 The FASB Accounting Standards Codification, 388 Federal agencies, 99–100 Federal Arbitration Act (1925), 381 Federal Clean Water Act of 1972 (FCWA), 327

530

Federal Hazardous Substances Act (1960), 316 Federal income tax rate structure, defined, 198 Federal laws: Circuit Courts, 461–462 due diligence checklist, 397–398 due diligence required by, 23–29 environmental, 325–327 regulatory, 98–99 securities, 163–178 statutory, 97–98 structure of, 97–100 Federal Register, 101–102 Federal Sentencing Guidelines (1987), 114–115 Federal Trade Commission (FTC), 100, 233, 238, 249–250, 258–278, 300 Fees for patent maintenance, 290, 296 Feit v. Leasco Data Processing Corp., 404–405 Feldman, Steven W., 510n2 Feltner v. Columbia Pictures Television, Inc., 442–443 Fiduciary decision, pension plan, 370 Financial Accounting Standards Board (FASB), 104, 209, 227–228, 388, 470n4, 471n5 Financial Industry Regulatory Authority (FINRA) questionnaire, 67 Financial information, due diligence checklist, 395 Financial misstatements, as fraud, 473n16 Financial projection, environmental liability, 330–333 Financial services acquisition, balance sheet analysis, 43–45 Financial statements, 36–43 balance sheet, 36–39 cash flow statements, 39–40 income statements, 36, 39 key ratios, 40–43 Financial statements review, 35–57 audit committee role, 52–53 classic, 36 “Consideration of Fraud in a Financial Statement Audit” (AU 316), 48, 54–57 due diligence checklist, 388 industry considerations, 43–46 internal controls assessment, 50–53, 59, 61

Index

key ratios, 40–43 M&A due diligence, 7 for public companies, 469–470n2 red flags, 31–32, 46–50 representations/warranties regarding, 146–147 Financing: closing, and third-party, 156 litigation analysis during, 105 material numerical benchmarks, 10–11 sources and the extent of due diligence, 9 tax law considerations, 194, 224–225 Finkelstein v. Liberty Digital, Inc., 407 Fizzano Brothers Concrete v. XLN, Inc., 484–485n28 Flammable Fabrics Act (1953), 316 Fletcher, John C., 472n10 Flight Options Int’l, Inc. v. Flight Options, LLC, 423 Flowserve Corp. v. Burns Int’l Servs. Corp., 452 Food Additives Amendment (1957), 320 Food and Drug Administration (FDA), 317, 320–321 Food, Drug and Cosmetic Act (1938), 320 Food and drug law, consumer, 320–321 Foreclosure, environmental exposure, 338–339 Foreign Corrupt Practices Act of 1977 (FCPA), xvi, 47–48, 51 Forms, for due diligence review, 16–18, 64–65 (See also Checklists; Documentation and transactional due diligence; M&A agreements/related contracts) Forward merger, 203, 214, 498n15 401(k) plan, 364–365, 370, 374 Franchise agreements, due diligence checklist, 391 Fraud: acquirer’s potential liability, 110–111 bank, 478n20 “Consideration of Fraud in a Financial Statement Audit” (AU 316), 48, 54–57 corruption, 473n15 financial misstatements, 473n16 in financial statements, 46–50 insider trading, 186–190

Index

landmark court cases, 409–419 management override of existing controls, 475n30 misappropriation, 472–473n14 response to, by industry sector, 70–72 Fraudulent conveyance, 12 Frontier Oil Corporation v. Holly Corporation, 128, 423 Full-funding limitation, pensions, 368 Funded health plans, 377 Funding shortfalls, pensions, 368 Funding target, pensions, 368 Gantler v. Stephens, 6, 416–417 Geier v. American Honda Motor Company, Inc., 446–447 Gender, discrimination based on, 356–357, 359 General Agreement on Tariffs and Trade (GATT), 252, 293 General counsel, 101 General Electric Company, et al., Petitioners (1997), 479n25 General partnerships, 218–219 Genetic Information Nondiscrimination Act of 2008 (GINA), 360 Gesoff v. IIC Indus. Inc., 417 Gilliland v. Motorola Inc., 417 Giuliani, Rudolph, 171 Glassman v. Computervision Corp., 24, 468n34 Golden parachutes, 372–375 Goldman Sachs, 471–472n8 Gollust v. Mendell, 431 Goodwill, 228, 303 Google search engine, 475n2, 477n10 Governance information, due diligence checklist, 395 Government obligations, due diligence, 118–119 Grand Street Artists v. General Electric Co., 450–451 Great American Opportunities Inc. v. Cherrydale Fundraising LLC., 423–424 Gross margin ratio, 41, 46 Gross v. FBL Financial Services, 354 Group, security law definition of, 177 Hall, Kermit L., 358 Halliburton Co. Benefits Committee v. Graves, 456–457

531

Hanson Trust PLC v. SMC Corp., 181, 405 Harris v. Forklift Systems, Inc., 357 Harrison, Edward, 481n7 Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR), 238–243, 503n14, 504n24 Hay Management Consultants, 81, 92–94 Hazard Ranking System (HRS), 332–333 Health plans and insurance, 377, 519–520n39 Health and safety laws, 360–363 Henderson, James A., Jr., 310 Herfindahl-Hirschmann Index (HHI), 243–244 Hewlett-Packard (HP), 363 Hierarchy of diligence, and risk, 4–5 High-technology companies, balance sheet analysis, 45–46 High technology industry key ratios, 45–46 Holding company structure, 498n16 Holmes v. Securities Corp., 171 Homan v. Turoczy, 417 Honda Motor Company Co., Ltd., et al. v. Oberg, 318, 447–448 Horizon Personal Communications, Inc. v. Sprint Corp., 424 Horizontal Merger Guidelines, 258–278 Horizontal mergers, 233–236, 243–246, 258–278 Hostile takeover, 174 Hostile work environment, 357–358 Humana v. Forsyth, 411–412 Hybrid ratios in financial statement, 41–42 Immigration Act (1990), 382–383 Immigration and Nationality Act of 1952 (INA), 382 Immigration Reform and Control Act of 1986 (IRCA), 382–383 Inadequate instructions, as defect, 315 Incendy, Victor G., 69 Income statement ratio, 41 Income statements, 36, 39 Income tax rates, 198–199 Indemnification section, M&A agreement, 133–134 Index of documents, 18 Individual tax rates, 199 Indopco, Inc. v. C.I.R., 437–438

532

Industry issues: antitrust law, 247–250 concentrated industries, 243–245 environmental exposure, 334–335 financial statement review, 43–46 fraud, response to, 70–72 Information: and communication, internal control, 52 financial, due diligence checklist, 395 Internet, as source, 61–62, 101 research services, 61–62 (See also specific topics) Information technology (IT) due diligence, 60 In-house data document management, 149 Initial basis, transaction structure, 204 Innocent purchaser, environmental, 331 In re Caremark, 115, 458–460 In re Emerging Communications, Inc, 418 In re Healthco International, Inc., Securities Litigation, 410–411 In re IBP Inc,. Shareholders Litigation, 128, 425 In re J.P. Morgan Chase & Co. S’holder Litig., 408 In re LNR Property Corp. Shareholders Litigation, 418 In re McKesson HBOC, Inc., Securities Litigation, xiv In re PNB Holding Co. Shareholders Litigation, 426 In re Software Toolworks Inc. Sec. Litig., 30, 468n34 In re The Walt Disney Company Derivative Litigation, 375 In re Toys “R” Us Shareholder Litigation, 425 In re Transkaryotic Therapies, Inc., 436–437 Insider trading, 186–190 Insolvency, fiduciary duty of directors, 490n4 Installment performance ratio, 45 Installment sale, 212 Institute of Internal Auditors (IIA), 46 Insurance: for compensation, 376–377 director and officer (D&O), 32, 111–114, 469n41 health insurance, 377 policies, due diligence checklist, 394–395

Index

Insurance company acquisition, balance sheet analysis, 44–45 Insurance Services Office (ISO), 485n33 Insured, as term, ISO definition, 485n32 Intangible assets, 223–224, 389, 500n29, 507n1 (See also Intellectual property law) Integrity in representations/warranties, 146 Intellectual property law: assignment and transfer of, 303–305 copyright, 291–294, 389 critical considerations, 289–290 described, 290 intellectual property pyramid, 307–308 as key asset, 77 landmark court cases, 441–446 licenses and license agreements, 302–303 patents, 294–297, 309–311 scope and definitions, 290 service marks, 290, 297–301 trade secrets, 301–302 trademarks, 290, 297–301, 389 Intent, determination of, 474n28 Intentional torts, product liability, 315–316 Interest-bearing debt, financial statements, 41 Interest coverage ratio, 41 Interest on loans, deductibility, 225–226 Internal controls, 10, 50–53, 59, 61 Internal Revenue Code, 214–218, 517–518n26 Internal Revenue Service (IRS), 193, 374, 377, 500n29, 517–518n26, 521–522n7 International accounting standards, xv–xvi International Accounting Standards Board (IASB), 192, 209, 227, 375 International economic laws, antitrust, 250–253 International Financial Reporting Standards (IFRS), xv–xvi, 388 Internet, as information source, 61–62, 101 Interviews, operation/management review, 67–76 Intracompany transactions, as red flag, 473n18 Introductory matter, M&A agreement, 135–136 Inventions and patent protections, 294–296

Index

Investigation covenant, M&A agreement, 14 Investigative due diligence, operation/management review, 75 Investment Adviser Act (1940), 164 Investment Company Act (1940), 164 IP (See Intellectual property law) Jackvony v. IHT Financial Corporation, 178–179, 495n28 Jefferson Parish Hospital v. Hyde, 235 Jeffries, Jim, 83 Joiner General Electric Company, et al. v. Robert K. Joiner, 75 Judiciary branch, federal government, 98, 100–102 Kanberg, John, 465–566n16 Kefauver-Harris Drug Amendments (1962), 320 Kennedy, Anthony M., 358 Klasfeld, Jerry, 82 Know-how, as intellectual property, 303 Knowledge of liabilities, representations/warranties, 144–146 Koppers Co., Inc. v. American Express Co., 429 Kosseff v. Ciocia, 418–419 Kroll Associates, 78, 90–91 Kumho Tire Company, Ltd., et al., Petitioners v. Patrick Carmichael, etc., et al, 75, 479n26 Kupetz v. Wolf, 412–413 Kwoka, John E., Jr., 236 Labor agreements, due diligence checklist, 392 Labor Code, 518n27 Labor laws (See Employment laws) Labor Management Relations Act (TaftHartley, 1947), 380 Labor Management Reporting and Disclosure Act (Landrum-Griffin, 1959), 380 Labor unions, 111, 137, 380–382, 392 Lajoux, Alexandra, 488–489n13 Landmark court cases: antitrust and trade laws, 439–441 consumer protection laws, 446–450 due diligence, as term in, 6 employment laws, 452–458 environmental law, 450–452

533

fraud, in sale of a business, 409–419 health, safety, and labor laws, 452–458 intellectual property law, 441–446 M&A agreements/related contracts, 419–428 negligence, 402–419 securities law, 428–438 tax laws and accounting regulations, 437–439 Lanham Act (1946), 298 Laven v. Flanagan, 405–406 Lawyers, litigation analysis, 104–109, 114 Layoffs, 377–380 Lease agreements, due diligence checklist, 391 Legal compliance review, 95–122 antitrust law, 231–289 CFR title list, 120–122 compliance review method, 114–119 consumer protection laws, 313–323 D&O liability and insurance, 111–114 employment law, 351–383 environmental laws, 325–350 intellectual property law, 289–311 internal controls, 50–53, 59, 61 litigation analysis, 104–111, 395–398 litigation sources, 102–104, 161–162 M&A due diligence, 8 note taking and discovery, 73–74 pending litigation considerations, 105 private company operations/management, 65–67 representations/warranties, 146–147 thorough due diligence by buyer/seller, 8–13 U.S. legal system overview, 96–102 Legal foundations for due diligence, 3–7 Legal Information Institute, Cornell University, 102 Legislative branch, federal government, 98 (See also specific legislative acts) Lehman Brothers, 471–472n8 Lender liability, environmental law, 336–341 Lender-required representations/warranties, 138 Letter of intent, 12–13, 126 Leverage, and double taxation effects, 200 Lewis v. City of Chicago, 359, 516n14 Liability: financial (See Debt) legal, 68, 102–104, 161–162 (See also Legal compliance review)

534

Librarian, data room interviews, 75 Library of Congress, Copyright Office, 293 Licenses and license agreements, 302–303, 389, 391 Lien search, due diligence checklist, 398–400 Lilly Ledbetter Fair Pay Act (2009), 359 Limited liability companies (LLCs), 217–218, 220 Limited partnerships, 172–184, 218–219 Lin, Tony, 502–503n12 “Line of business” reports, 477n11 Liquidated damages clause, 129–130 Liquidating distribution, 195–196 Liquidity, MD&S checklists, 63 Litigation: analysis of, 104–111 (See also Legal compliance review) due diligence checklist, 395–398 employee-initiated, 116–117, 351–352 as nonroutine business threat, 80 Litigation review, 105–107 Litton Industries, Inc. v. Lehman Brothers Kuhn Loeb Inc., 431–432 Loan agreements, due diligence checklist, 392 Loan portfolio, random sampling model, 477n14 Loans to deposits ratio, 44 Lockheed Martin, 248 Lockup, stock, 493–494n22 Loss carryover, 209 Loyalty, duty of, 181–182, 186 Lyondell Chemical Co. v. Ryan, 426 M&A agreements/related contracts: buyer bias correction, 128–133 buyer/seller concerns, 130–132, 139–140, 142–143, 150–151 components, 133–135 covenants, 134–135, 147–148 crucial communication in transaction, 12–14 do-it-yourself due diligence, 16–17 due diligence checklist, 393 introductory matter, 135–136 key points, 126–128 landmark court cases, 419–428 license agreements, 302–303 mechanics of transfer, 135–136

Index

post-closing legal defects and loss risk, 132–133 purpose of, 126 representations/warranties, 134–135, 137–147 source of forms, 467n25 Magazines, risk assessment, 62 Maintenance fees for parents, 290, 296 Management: defined, 59 due diligence checklist, 395–398 environmental exposure, 337–339 fraud, from overriding existing controls, 475n30 (See also Operations and management review) Management agreements, due diligence checklist, 392 Management decision, pension plan, 370 Management Discussion and Analysis of Financial Condition and Results of Operations (MD&A), 62–65 Manual of Patent Examination Procedures (MPEP), 296–297, 309–311 Manufacturing, sweatshop, 362–363 Manufacturing defects, 315, 318–319 March v. New Jersey Department of Environmental Protection, 451–452 Marginal income tax rates, 198 Market cap to sales ratio, 42, 46 Market-driven ratio, 42 Market position, as key asset, 77 Market studies, due diligence checklist, 389, 398 Marketing due diligence, 60 Marks, Mitchell, 81 Martin Marietta Corp. v. Bendix Corp., 432 Mass layoffs, WARN, 379 Material, defined, 140 Material adverse change (MAC) clause, 127–128, 487n6 Material weakness, 10 Materiality: disclose or abstain rule, 188 extent of due diligence, 9–10 limits, 17, 106, 482–483n22 litigation review, 105–107 misrepresentation, 24–25 numerical benchmarks for, 10–11, 466n20 in representations/warranties, 140–141

Index

Materiality threshold (MT), 106, 482–483n22 Matsushita Electric Industrial Co. v. Zenith Radio Corp., 235, 502n9 Maxwell v. KPMG, 408 McLaughlin, Joseph, 468n35 Meat Inspection Act (1906), 320 Mechanics of transfer, M&A agreements, 135–136 Medical leave, 364 Mehiel v. Solo Cup Co., 426–427 Merck & Co. Inc., et al. v. Richard Reynolds, et al., 436 Merger, defined, 203 Merger agreements (See M&A agreements/related contracts) Meritor Savings Bank v. Vinson, 357 Millett v. Truelink, Inc., 449 Millsap v. McDonnell Douglas, 371 Minimum wage, 363 MiniScribe Corp., 70 Minnesota Invco of RSA #7, Inc. v. Midwest Wireless Holdings LLC, 419 Minutes, board of directors, 18, 65–66, 387–388 Misappropriation, as fraud, 472–473n14 Misappropriation theory of liability, 188 Model Business Corporation Act (1946), 97, 165–166 Model State Trademark Bill (1964), 299 Model Uniform Products Liability Act (MUPLA), 317 Monitoring, internal control, 52 Monopolies, 237–238 Monopsony, 237 Mortgages, due diligence checklist, 390 Motivation to narrow scope, representations/warranties, 142–143 Multiemployer plans, due diligence checklist, 394 Myers-Briggs Personality Inventory, 82, 479–480n32 Nacchio v. United States of America, 10 National Association of Corporate Directors (NACD), 48–50 National Commission on Consumer Finance, 322 National Labor Relations Act of 1935 (NLRA), 380–381, 520n44 National Labor Relations Board (NLRB), 100, 380–381

535

National Priorities List (NPL), 33 Nationally Recognized Statistical Rating Organization (NRSRO), 476n9 Negligence: acquirer avoidance of change of, 103 landmark court cases, 402–419 Negligent torts, product liability, 315–316 Negotiation, 105, 179–180 Nesvold, H. Peter, 488–489n13 Net operating loss (NOL), 208–209 Net working capital ratio, 41 Newark Morning Ledger Co. v. United States, 438 Newspapers, risk assessment, 62 Niton Corp. v. Radiation Monitoring Devices, Inc., 443 “No comment,” on negotiations, 179 Nonhorizontal mergers, 233–235, 246, 279–287, 501–502n3 Nonliquidating distribution, defined, 196 Nonqualified pension plan, 365 Nonroutine business threats, 79–80 Norris-LaGuardia Act (1932), 520n44 Northrup-Grumman, 248 No-shop agreement, 495n32 No-shop clauses, 182 Notice to employees/communities, WARN, 379 Nuclear Waste Policy Act (1982), 327 Nutrition Labeling and Education Act (1990), 320 Occupational Safety and Health Administration (OSHA), 100, 328, 360–361 Occupational Safety and Health Review Commission, 361 Off-balance sheet financing disclosure, 477n12 Off-site interviews, 73 “Off-the-hook” clause, M&A agreement, 14 Office of Federal Contract Compliance Programs (OFCCP), 356 “Officer’s certificate,” 152–153 Older Workers Benefit Protection Act (1990), 354 Oligopolies, 238 Olin Corporation v. Federal Trade Commission, 439–440 Oliver v. Boston University, 419

536

Omnibus Budget Reconciliation Act of 1987 (OBRA), 371 Omnibus Trade and Competitiveness Act (1988), 379 Omnicare. Inc. v. NCS Healthcare, Inc., 408–409 Oncale v. Sundowner Offshore Services, Inc., 357 One-step acquisition, 173 Online information and services, 61–62, 101 On-site due diligence, 15–16 Operating margin ratio, 41, 46 Operational results, MD&A checklists, 63–64 Operations, 59, 77 Operations and management review, 59–94 analysis of testing company, 90–91 assets and threats to, 76–84 cultural due diligence, 60–61, 81–82, 92–94, 475n2 data site security precautions, 85–89 defined, 59–60 evaluation, 60–62 financial flaws in takeover target, finding, 78–79 fraud, response to, by industry sector, 70–72 fraud risk factors, financial statement, 47–50 interview conduction, 67–76 M&A due diligence, 7 MD&A as checklist, 62–65 private company due diligence, 65–67 red flags, 32 “soft” area due diligence, 80–84 Options Clearing Corporation (OCC), 494n26 Order of Confidential Treatment, SEC, 178 “Ordinary course of business” representations/warranties, 143–144 OSI Systems, Inc. v. Instrumentarium Corp., 427 Outside professional/sources, due diligence checklist, 398–400 (See also Consultants and experts) Overtime pay, 363 Ownership information, due diligence checklist, 395

Index

Paramount Communications Inc. v. QVC Network Inc., 433–434 Participates in management, environmental exposure, 337–339 Partnerships, 218–219, 221, 224 Pass-through entities, 199, 218–219, 224 Patent Cooperation Treaty (1970), 295 Patents, 290, 294–297, 309–311, 389, 509n14–15 Payout ratio, 45 Pension Benefit Guaranty Corporation, 367 Pension plans, 364–376, 393–394 Pension Protection Act of 2006 (PPA), xvi, 366, 369 People, as key asset, 77 Per se liability, 522n10 Personnel, interviews with key, 67–76 Peters, Tom, 507n1 Pfaff v. Wells Electronics, Inc., 444 Philips, Frederick, 511n15 Phillips, Jerry, 484n27 Picard Chemical Inc. Profit Sharing Plan v. Perrigo Co. (1998), 68, 478n18 Pitofsky, Robert, 249 Planning for M&A, litigation analysis, 105 Plant closings, WARN, 379 Plant patents, 295 Poison Prevention Packaging Act (1970), 316 Post-closing issues: activities and cleanup, 157–158 avoidance of postacquisition lawsuits, 102–103 lawsuit and “conditions to closing,” 151–152 legal defects and loss risk, 132–133 protections against postacquisition losses, 32 Practice of transaction, antitrust, 233 Practicing Law Institute, 102 Preclosing process, 154–155 Pregnancy Discrimination Act (1978), 356 Premerger notification form, HSR Act, 240–242 Premium level ratio, 45 Premium sales growth ratio, 45 Premium Standard Farms LLC, 242 Price, transaction: fairness opinion of transaction price, 183–185

Index

in M&A agreement, 135–136 tax allocation considerations, 222–223 undisclosed legal defects accountability, 132–133 Price/earnings ratio, 42 Principles for Business (Caux Round Table), 322–323, 342 Private company due diligence, 11–12, 65–67, 172 Private investigators, and red flags, 32 Private ordering, federal securities law, 165 Private right of action, federal securities law, 165 Product, defined, 315 Product liability laws, 314–320, 389, 393, 398, 510n9 Profit margin ratio, 41 Profit per employee ratio, 46 Profit-sharing plans, due diligence checklist, 393–394 Profits, defined, 195 Prospective purchaser, environmental liability exemption, 339–340 Protecting Older Workers Against Discrimination Act (pending passage, 2010), 354 Proxy statement, 11–12, 173–174, 491n8 “Prudent man” theory, Securities Act (1933), 25 Public Company Accounting Oversight Board (PCAOB), xv Public company due diligence: acquisition forms, 173–174 extent of due diligence, 9–12 representations/warranty exhibits, 141 securities laws, 166–178 (See also Materiality) Public Utility Holding Company Act (1935), 164–165 Publications International, Ltd. v. Landoll, Inc., 443–444 Pyramid, intellectual property, 307–308 Qualified pension plan, 365 Qualitex Co. v. Jacobson Co., Inc., 444–445 Quick ratio, 41 Quid pro quo, sexual harassment, 357–358

537

Rabbi trust, 365 Racketeer Influenced and Corrupt Organizations Act of 1970 (RICO), 171 Railway Labor Act (1926), 380 Raytheon, 248 Real property, 66, 390–391 (See also Environmental law) Reasonable assurance, 61 “Reasonableness” standard, 26–28 Recordkeeping, of interviews, 73–74 (See also Documentation and transactional due diligence; Financial statements review) Red flags, financial statements review, 31–32, 46–50 Reduction in force (RIF), 377–379, 520n41 Reed, Stanley Foster, 488–489n13 Regulation M-A, SEC, 168–170, 491–492n13, 492n14 Regulation S-K, SEC, 167, 484n26, 512n6 Regulation S-X, SEC, 167 Regulator-initiated litigation, 118 Regulatory law, 98–101 (See also Legal compliance review) Rehabilitation Act (1973), 355–356, 515n2 Renewal rate ratio, 45 Reorganization, tax-free, 212–215 “Reorganization not solely for voting stock,” 214 Report to the Nation on Occupational Fraud and Abuse, issued by ACFE, 46 Representations and warranties: in M&A agreement, 134–135, 137–147 “officer’s certificate,” 152–153 operations/management review, 78 private company due diligence, 12 scope of, 134–135, 141–142 verification, 30–32 Research sources, operations/management, 61–62 (See also Information) “Reservation of rights,” D&O liability, 113 Resource Conservation and Recovery Act of 1976 (RCRA), 327 Restatement Third, Torts: Liability for Physical and Emotional Harm (American Law Institute), 319–320 Retirement (pension) plans, 364–376, 393–394

538

Return on assets ratio, 42 Return on equity ratio, 42 Revenue per employee ratio, 46 Reverse auctions, 509n14 Reverse merger, 203 Revlon Inc. v. McAndrews & Forbes Holdings, Inc., 172, 419–421 Right-to-know filings, environmental, 331 Risk and risk assessment: analysis of testing company, 90–91 cultural due diligence checklist, 92–94 data site security precautions, 85–89 environmental, 329–336 evaluation overview, 60–62 financial statements, 47–50 hierarchy of diligence, 4–5 internal control, 52 interviews, conducting, 67–76 key assets, operations/management, 76–80 MD&A as checklist, 62–65 operation/management review, 61–62, 76–84 pension plans, 368–369 private company due diligence, 65–67 red flags, 31–32 representation verification, 30–32 risk transfer, from buyer to seller, 129–130 “soft” areas of human feelings/values, 80–84 transaction dates, 129 undisclosed legal defects, 132–133 Robert H. Schaffer & Associates, 81 Roman Law, early due diligence, 4–5 Routine business threats, 79–80 Rule 10, SEC, 28–29, 167, 187, 189–190 Rule 13, SEC, 167, 175–177 Rule 14, SEC, 167, 187, 190 Rule 15, SEC, 488n12 Rule 16, SEC, 167, 176–177, 187–188 Rule 144, SEC, 167, 495n33 Rule 145, SEC, 167, 186, 495n33 Rule 176, SEC, 26–28 S corporations, 217–219, 221, 224, 500n27 Sales agreements, due diligence checklist, 391, 393 Sales per employee ratio, 43 Saratoga Fishing Co. v. J.M. Martinac & Co., et al., 314, 448–449

Index

Sarbanes-Oxley Act of 2002 (SOX): auditing work not allowed, 468n32 bonus and profit forfeiture, 489n14 conflict of interests, 22–23 extent of due diligence, 10 internal control assessment, 51 interview record confidentiality, 73–74 off-balance sheet financing disclosure, 477n12 passage of, xv pension plans, 371–372 public company due diligence, 11 representations/warranties, 147, 149 Scale, as key asset, 78 Schedule TO for tender offers, 168–169 Schonberger, Mark, 467n26, 467– 468n30 Scienter requirement, 29, 189 Scope: of due diligence review, 7–8 intellectual property law, 290 representations/warranties, 134–135, 141–142 Section 11, Securities Act (1933), 24–25 Securities Act (1933), xiv, 24–28, 163, 166, 171, 495n33 Securities and Exchange Commission (SEC): auditor independence, 25 D&O interviews, 67 extent of due diligence, 10 as federal agency, 100 federal security law enforcement, 163 financial statements, recommended, 469–470n2 insider trading, 186–190 international accounting standards, xv–xvi materiality, 140–141 NRSRO, 476n9 Order of Confidential Treatment, 178 recordkeeping requirements, 473–474n21 Sarbanes-Oxley Act impact on, xv Securities Act, xvi, 24–28, 163, 166, 171, 495n33 (See also under Regulation; Rule) Securities Deskbook (University of Cincinnati Law School), 491n10 Securities Exchange Act (1934), 28–29, 51, 164, 166–168, 175–177, 187–188

Index

Securities laws, 161–190 control block, sale of, 185–186 corporate securities, 162–163 director duties, 180–182 due diligence requirements, 23–29 federal, 163–178 insider trading, 186–190 landmark court cases, 428–438 merger disclosure issues, 178–180 public companies, 166–178 special committees, 182–185 state, 165–166, 180–182 Security agreements, due diligence checklist, 393 Security precautions, data site, 19, 85–89 Seller, defined, 465n13 September 11, 2001 terrorist attacks, xiv Service marks, 290, 297–301 Severance agreements, 374–375, 378 Sexual harassment, 357–358 Shadewell Grove IP, LLC v. Mrs. Fields Franchising, LLC, 445–446 Shamrock Holdings v. Arenson, 427–428 Shareholder agreements, due diligence checklist, 392 Shareholder-initiated litigation, 117, 161–162 Shareholder/investor claims, 490n1 Shares, defined, 161 (See also under Stock) Shell Oil Co. v. Dagher et al., 440–441 Sherman Antitrust Act (1890), 238–239, 503n16, 504n20–21 Short-swing profit rule, 187 Short tendering, 178 Shortfall amortization, pension plans, 369 Significance, litigation review, 105–107 Significant deficiency, internal controls, 10 Site examination, 13–14 Small Business Liability Relief and Brownfields Revitalization Act (2002), 339 Smith v. Van Gorkom, 103, 181, 406 Smithfield Foods, 242 Social Security Act (1935), 376 Society of Corporate Secretaries and Governance Professionals, 102 “Soft” areas of human feeling, 80–84 Software Toolworks Sec. Lit., 406 Sonitrol of Fresno v. AT&T, 504n23

539

Special committees, securities laws, 182–185 Sponsorship agreements, due diligence checklist, 392 Staff Accounting Memorandum 99 (SAM 99), 10, 140 Stakeholder principles, Caux Round Table, 322–323 “Stalking horse,” 172 State ex rel. Brady v. Pettinaro Enterprises, 449–450 State laws: collective bargaining, 380 common law, 96 consumer protections, 316 copyright, 291 environmental, 325–327, 340–341, 511–512n3 government structure, 97 health and safety, 517n17 income taxes, 500n32 securities, 165–166, 180–182 statutory law, 97–98, 102 staying current, 102 taxation, 226–227 torts, 96, 110–111, 315–316, 318 trademarks, 299 Uniform Trade Secret Act, 301 State Street Bank & Trust Co. v. Signature Financial Group, Inc., 443 Statute of limitations, discrimination, 359–360 Statutory law, 100–102 Statutory merger transaction structure, 201, 204 Step-up transaction, 201, 207–210, 488n9 Stock, restricted, 495n33 Stock exchanges, new rules for, xv Stock lockup, 493–494n22 Stock option plans, due diligence checklist, 394 Stock transactions: carryover-basis, 205–206 extent of due diligence, 9, 136–137 insider trading, 186–190 vs. other transactions, 204–205 share price, in M&A agreement, 136 tax issues, 202, 204–206, 211 and tender offer, 175 (See also Asset transactions) Stoeklin v. United States, 521n4 Stone v. Ritter, 115, 459

540

Straight debt financing, 224–225 Strict liability wrongs, product liability, 315–316 Structure of transaction (See Transaction structure) Subsidiary merger, 203 Successor liability, environmental, 330–331 Successor plan rule, pensions, 374 Superfund Amendments and Reauthorization Act of 1986 (SARA), 326, 331 Superfund/Superfund sites, 326, 331, 334–336 Supplemental pension plans, due diligence checklist, 394 Supplier-initiated litigation, 118 Supply agreements, due diligence checklist, 391 Supreme Court, Delaware (See Delaware Supreme Court) Supreme Court, U.S., 101 (See also Landmark court cases) Survivorship, 498n17 Sweatshops, 362–363 “Tail” insurance policy, 113 Takeover bid, 180 Taleb, Nicholas, xii Tangible assets, 66, 390–391 Target, finding acquisition, litigation analysis, 105 Tax basis, in asset sale, 201 Tax-free forward merger, 203 Tax-free reorganization, 212–215 Tax law and accounting regulations, 191–228 basics, 193–195 corporate distribution, 497n6 definitions of terms in M&A, 194–200 due diligence checklist, 396–397 entity type, choice of, 217–224 financing arrangements, 224–226 Internal Revenue Code, 214–218, 517n26 IRS, 193, 374, 377, 500n29, 517n26, 521n7 landmark court cases, 437–439 pension minimum contributions, 366–368 principal accounting pronouncements, 227–228

Index

representations/warranties regarding, 146–147 state and local taxes, 226–227 transaction structure, 193–194, 200–224, 226–227 Tax rates, defined, 198–199 Tax year, defined, 198 TDF International, 82–83 Telecommunications Act (1996), 248 Telecommunications industry antitrust, 248–249 10-K, SEC, 9, 11, 35, 61, 389, 476n8 10-Q, SEC, 9, 11, 35, 476n8 Tender offer premium, 492n19 Tender offers, 168–170, 174–176, 178, 492n18 Teppco Partners, L.P., 483–484n25 Texaco Inc. v. Dagher et al., 440–441 Texaco, Inc. v. Pennzoil Co., 421–422 Texas Gulf Sulfur case, 188 Third-party vendor document management, 149 Threats, identification and asset analysis, 76–84 Tillinghast survey, D&O liability, 95, 116, 480n1–2, 486n38 Time for due diligence, 64–65 Time Incorporated v. Paramount Communications, Inc., 181, 435–436 Tippee/tipper/tipping, insider trading, 189–190 Title documents (real estate and personal property), due diligence checklist, 390 Title VII, Civil Rights Act (1964), 356–357, 515n2, 516–517n15 Topping fees, 182, 495n31 Torts and tort law, 96, 110–111, 315–316, 318 Tousa Inc. v. Citicorp (2009), 466n23 Tower Watson’s Tillinghast survey, 95, 116, 480n1–2, 486n38 Toxic Substances Control Act of 1976 (TSCA), 327 Trachtman, Joel P., 251 Trade law (See Antitrust and trade law) Trade names, 389 Trade-Related Aspects of Intellectual Property Rights, Agreement on (TRIPS), 292–293, 296 Trade secrets, 301–302 Trademarks, 290, 297–301, 389

Index

Transaction structure: antitrust, 233 disclosure of change in, 177–178 litigation analysis during, 105 and taxes, 193–194, 200–224, 226–227 Transaction timetable, 18 Transactional due diligence: document/transaction review, 123, 126–159 documentaion and (See Documentation and transactional due diligence) red flags, 32 securities laws, 161–190 tax laws and accounting regulations, 191–228 (See also Asset transactions; Stock transactions) Transfers, intellectual property, 303–305 Treadway Companies, Inc. v. Care Corp., 435 Trend in gross margin ratio, 46 Troubled Asset Relief Program of 2009 (TARP), xv, 11, 373 Trust Indenture Act (1939), 164, 491n5 Twerski, Aaron D., 310 2010 Report on Foreign Policy-Based Export Controls, 253 Two-step acquisition, 173, 204 UbiquiTel v. Sprint Corporation, 409 Underfunded plan, pensions, 368 Undisclosed liabilities, representations/warranties, 145–146 Unemployment compensation insurance, 376–377 Unemployment Trust Fund, 376 Unfair competition, law of, 299 Unfair trade practices, 299–300 Unfunded health plans, 377 Uniform Arbitration Act (1955), 381 Uniform Commercial Code (UCC), 4, 97, 102, 137, 156, 318–319, 490n19 Uniform Consumer Credit Code, 321–322 Uniform Deceptive Trade Practices Act (1964), 299–300 Uniform Fraudulent Transfer Act (1984), 110 Uniform laws, 511n3 Uniform Partnership Act (1997), 97 Uniform Rules of Evidence, 75 Uniform Securities Act of 1956 (USA), 165, 491n7

541

Uniform Trade Secret Act, 301 Unions, labor, 111, 137, 380–382, 392 United Nations (UN) Convention on Contracts, 251–252, 506n41 United States of America, et al. v. Ticketmaster Entertainment, Inc. and Live Nation, Inc., 233–234, 502n5 U.S. v. Gleneagles Inv. Co., 413–414 United States v. O’Hagan, 188, 496n36 United States v. Philadelphia National Bank et al., 440 United States v. Scheffer, 75 United States v. Standard Oil Company (New Jersey), 234–235, 502n6–8 U.S. Code: CFR, 101–102, 120–122, 482n16 copyright, 291 environmental law, 325–326 immigration, 382 Internal Revenue Code, 214–218 patents, 295 pension funding, 366, 369 staying current, 102 trademarks, 298 workforce reduction, 378 U.S. Constitution, 98, 290, 294, 480–481n3, 496n1–2 U.S. Customs Service, 294, 300 U.S. Department of Commerce, 100, 251, 253, 317 U.S. Department of Defense, 247–248 U.S. Department of Energy, 328 U.S. Department of Health and Human Services (HHS), 320, 486n35 U.S. Department of the Interior, 328 U.S. Department of Justice (DOJ): antitrust framework, 238, 254–257 as federal agency, 100 horizontal merger guideline revision, 258–278 organizational federal assistance, 515n6 vertical merger guidelines, 279–287 (See also Antitrust and trade law) U.S. Department of Labor (DOL): disability-based discrimination, 356 environmental law, 328 as federal agency, 100 federal contracts, 515n6 health and safety, 360–361 Labor Code, 518n27 pensions, 365–366

542

U.S. Department of Transportation (DOT), 317 U.S. Department of the Treasury, 100, 193, 317 (See also Tax law and accounting regulations) U.S. Patent and Trademark Office (USPTO), 295–299, 309–311, 389, 509n17 “Unorthodox” transactions, 494n25 Utility patents, 295 Valuation, litigation analysis, 105 Varney, Christine, 238, 506–507n44 Verification of representations, 30–32 Verizon Wireless, 249–250 Vertical mergers, 233–235, 246, 279–287, 501–502n3 Veterans, disabled, 515–516n7 Vietnam Era Veterans’ Readjustment Assistance Act of 1972 (VEVRAA), 356, 515–516n7 Virginia Bankshares, Inc. v. Sandberg, 434–435 Virtual data room (VDR), 18–19, 148–150 Wage and hours laws, 363–364 Wall Street Reform and Consumer Protection Act of 2010 (DoddFrank), 322 Warnings defects, 315

Index

Warranty agreements, 318–319, 393 (See also Representations and warranties) Waste handling, 327, 333–336, 340 Weinberger v. Jackson, 67, 478n16 Weisgram v. Marley Co., 75 Welfare benefit plans, due diligence checklist, 394 Wells Fargo & Company and Subsidiaries v. United States, 438–439 Westlaw.com, 101 White, Lawrence J., 236 Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 500n32 W.L. Gore & Associates, Inc. v. Wu, 428 Worker Adjustment and Retraining Notification Act of 1988 (WARN), 379 Workers’ compensation laws, 376–377 Workforce reduction laws, 377–380 World Intellectual Property Organization (WIPO), 292, 295 World Trade Organization (WTO), 252 WorldCom, xiv–xv Writings and copyright protection, 291 Wrongful business/trade practice, 299–300 Yolton et al. v. El Paso Tennessee Pipeline Co. and Case Corporation, 457–458 Zenor v. El Paso Healthcare Systems, Ltd., 355, 515n5

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