I’m buying a company. How do I know exactly what I’m getting?

Unfortunately, an acquisition is like a box of chocolates: you never know what you’re gonna get. Even if it’s an asset purchase, rather than a merger or stock sale, when you’re buying a company, there’s risk that you’ll be assuming unknown liabilities. For example, unbeknownst to you, a seller may be insolvent, and the transfer of assets to you may violate bulk sales or fraudulent conveyance laws. This could enable the seller’s creditors to pursue claims against you.

Conversely, in some transactions you may not be buying all of the assets you think you are. Obviously, in a poorly structured asset purchase transaction, you may inadvertently omit assets that are necessary to run the acquired business. However, even in a merger or stock purchase, you may not get the benefit of the bargain you believe you’ve struck. A third party may have a lien on stock, or you may be acquiring a subsidiary that relies on a seller’s back office support or other shared assets that won’t be transferred to you.

But do not dismay. There are ways to protect yourself. While it may be impossible to eliminate these risks completely, an experienced M&A lawyer can offer you quite a few mechanisms to mitigate them—namely:

1. due diligence,
2. representations and warranties,
3. pre-closing covenants,
4. certifications,
5. legal opinions,
6. conditions to closing and termination rights,
7. indemnification rights / breach of contract claims and
8. post-closing covenants.

Then, of course, there’s the law itself. You’re afforded some protection by state common (i.e., judge-made) law and statutory law as well as federal law, including, in some deals, the federal securities laws. For example, a public M&A target may have been making disclosures about its business and operations, which are required by various laws and securities exchange listing requirements to be true. However, I won’t be discussing these laws in this post.

Instead, I’ll be introducing you to the above-listed tools, which improve your position relative to the baseline protections of the law alone. In later posts on The M&A Lawyer Blog, I’ll examine each of these topics in greater detail.

You’re buying a company: here’s how you protect yourself

Tool No. 1: Due Diligence

Succinctly put, M&A due diligence is the process by which you see for yourself what you are buying before you buy it. It’s like looking under the hood of a car with your mechanic, pulling the vehicle’s history report, checking the seller’s background and confirming the title is clean.

More precisely, I would define M&A due diligence as:

a detailed legal, operational and financial investigation by a transacting party and its advisers of publicly available and confidential information and materials relating to the business, assets, liabilities, properties, condition, operating results, operations and prospects of a subject company or set of assets, undertaken for the purpose of determining value, identifying risks (legal, operational and financial as well as closing risk), confirming representations and warranties and (of particular relevance to this post) identifying and assessing assets and liabilities.

Due diligence typically occurs prior to signing definitive agreements governing a transaction, though occasionally some diligence will remain after signing but before closing. The process involves review not only by your attorneys but by your finance team and operational personnel. Other specialist advisers may be asked to participate, as well, such as environmental consultants.

Legal (as opposed to operational and financial) due diligence may involve review by your attorneys of target company organizational documents, board actions, permits and governmental filings, material contracts, real property instruments, lien searches, insurance policies, governmental and third party communications, patents, trademark registrations, licenses and other intellectual property, credit agreements and other financing documentation, tax returns and filings, employee compensation and benefits plans, collective bargaining agreements, environmental reports, litigation pleadings and more.

Buyers may also conduct inspections of facilities and assets and hold meetings with key personnel. All of this will be facilitated by the seller and its lawyers and other advisers, and is typically run through an online portal known as a data site or virtual data room. Information identified during the due diligence process may impact the structure of the transaction and the terms of the purchase agreement. It is the first, and quite possibly most important, means by which you ensure you are buying what you expect to be buying.

Tool No. 2: Representations and Warranties

Representations and warranties are statements of past or present fact relating to the business, assets, liabilities, properties, condition, operating results, operations and prospects of a subject company or set of assets, typically contained in the principal agreement governing the transaction, made by one party to an M&A transaction to another. Inaccurate representations and warranties may result in the incurrence of liability by the party that made the statements. In other words, where due diligence involves your own review of what you’re buying, representations and warranties are statements from the seller about what you’re buying, which, if untrue, generally entitle you to seek some form of redress.

Here’s a long list of subjects that may be addressed by seller representations and warranties:

• organization and good standing
• authority and enforceability
• absence of conflicts
• capitalization and ownership
• subsidiaries
• financial statements
• books and records
• accounts receivable and accounts payable
• inventories
• absence of undisclosed liabilities
• absence of certain changes and events
• assets
• real property
• intellectual property
• material contracts
• tax matters
• employee benefits
• employment and labor
• environmental, health and safety
• compliance with law
• legal proceedings
• customers and suppliers
• product warranties
• product liability
• insurance
• related-party transactions
• guarantees
• brokers and finders fees and
• full disclosure.

Few, if any, transactions will include all of these representations and warranties, and many of them overlap at least in part. Nonetheless, when buying a company you will work with your M&A attorney and other advisers to craft and negotiate a set of seller representations and warranties that are appropriate for your deal and reflect your priorities, which will be informed by information you will have identified during the due diligence process. Importantly, representations and warranties are usually required to be true and correct not only at signing of the transaction agreement but also at closing of the transaction. This protects you from downside exposure if intervening events adversely impact the business.

Once finalized and reflected in a signed agreement, inaccuracies in representations and warranties may entitle you to refuse to close the transaction (if falsehood is discovered between signing and closing) or recover monetary monetary damages from the seller post-closing. Consequently, sellers have a strong incentive to ensure the accuracy and completeness of their representations and warranties, thus providing you with another means of ensuring you are acquiring only the assets and liabilities you wish to buy.

Tool No. 3: Pre-Closing Covenants

Assuming your deal has a gap period between signing and closing, as most do, your principal transaction agreement should contain covenants (i.e., promises to do or refrain from doing something) from the seller designed to mitigate the risk that you’ll be buying more or less than you expect. Three common covenants are particularly helpful in this regard.

First, there’s usually an “Access and Investigation” covenant through which the seller promises to permit you to access the acquired business and its books and records.  Here’s an example:

From the date hereof until the Closing, upon reasonable notice, the Seller shall cause its officers, directors, employees, agents, representatives, accountants and counsel and shall cause the Company and the Subsidiaries and each of the Company’s and the Subsidiaries’ officers, directors, employees, agents, representatives, accountants and counsel: (i) to afford the officers, employees, agents, accountants, counsel, financing sources and representatives of the Purchaser reasonable access, during normal business hours, to the offices, properties, plants, other facilities, books and records of the Company and each Subsidiary[, including access to enter upon such properties, plants and facilities to investigate and collect air, surface water, groundwater and soil samples or to conduct any other type of environmental assessment,] and to those officers, directors, employees, agents, accountants and counsel of the Seller, the Company and of each Subsidiary who have any knowledge relating to the Company, any Subsidiary or the Business and (ii) to furnish to the officers, employees, agents, accountants, counsel, financing sources and representatives of the Purchaser such additional financial and operating data and other information regarding the assets, properties, liabilities and goodwill of the Company, the Subsidiaries and the Business (or legible copies thereof) as the Purchaser may from time to time reasonably request.

While such a covenant is primarily designed to plan for and implement your integration of the acquired business, it will also enable you to continue to evaluate the acquired business before closing and complete any outstanding due diligence items.

Second, your agreement will require the seller to operate the acquired business during the gap period in the ordinary course consistent with past practices. Here’s an example:

The Seller covenants and agrees that, except as described in Section 5.01(a) of the Disclosure Schedule, between the date hereof and the time of the Closing, neither the Company nor any Subsidiary shall conduct its business other than in the ordinary course and consistent with the Company’s and such Subsidiary’s prior practice. Without limiting the generality of the foregoing, except as described in Section 5.01(a) of the Disclosure Schedule, the Seller shall cause the Company and each Subsidiary to (i) continue their advertising and promotional activities, and pricing and purchasing policies, in accordance with past practice; (ii) not shorten or lengthen the customary payment cycles for any of their payables or receivables; (iii) use their best efforts to (A) preserve intact their business organizations and the business organization of the Business, (B) keep available to the Purchaser the services of the employees of the Company and each Subsidiary, (C) continue in full force and effect without material modification all existing policies or binders of insurance currently maintained in respect of the Company, each Subsidiary and the Business and (D) preserve their current relationships with their customers, suppliers and other persons with which they have had significant business relationships; (iv) exercise, but only after notice to the Purchaser and receipt of the Purchaser’s prior written approval, any rights of renewal pursuant to the terms of any of the leases or subleases set forth in Section 3.20(b) of the Disclosure Schedule which by their terms would otherwise expire; and (v) not engage in any practice, take any action, fail to take any action or enter into any transaction which could cause any representation or warranty of the Seller to be untrue or result in a breach of any covenant made by the Seller in this Agreement.

Provisions like these sometimes include longer lists of specific actions required to be taken (or prohibited from being taken) by the seller. Generally speaking, the more comprehensive and specific the list, the more favorable it is to the buyer. These conduct of business provisions help preserve the business you’re acquiring and maintain it in a condition that is similar to what you investigated through due diligence. As discussed below, a seller’s failure to comply with these requirements may permit you to terminate the transaction and pursue a claim for damages against the seller.

The final member of our troika of gap period buyer protections is a requirement that the seller notify you of certain material developments impacting the acquired business or the transaction. A pro-buyer example may provide:

Until the Closing, the Company and the Seller will give prompt notice to the Purchaser of (a) the occurrence, or non-occurrence, of any event, the occurrence or non-occurrence of which would reasonably be expected to cause any representation or warranty of the Seller contained in this Agreement to be untrue or inaccurate [in any material respect], in each case at any time from and after the date of this Agreement until the Closing, (b) any failure to comply with or satisfy [in any material respect] any covenant or agreement to be complied with or satisfied by the Seller or the Company under this Agreement and (c) the failure of any condition precedent to the Purchaser’s obligations under this Agreement. No notification pursuant to this Section will be deemed to amend or supplement the Seller Disclosure Schedule, prevent or cure any misrepresentation, breach of warranty or breach of covenant, or limit or otherwise affect any rights or remedies available to the Purchaser, including pursuant to Article 7 or Article 9.

The relevance of this language to the topic of this post is self-evident. Note in particular the last sentence, which clarifies that, even if notice is duly delivered, it will not be deemed to have modified or corrected any representation, warranty, covenant or condition, thereby preserving your rights to terminate the agreement or pursue indemnification.

Tool No. 4: Certifications

When you close your deal, along with delivering the purchase price, stock certificates, bills of sale and the like, you and the seller will usually exchange certificates from certain of your respective officers. There are two different types of common closing certificates: officer’s certificates and secretary’s certificates.

A seller’s officer’s certificate is usually a one-page document in which a senior officer of the seller certifies to the buyer that:

1. the seller’s representations and warranties were true when the transaction agreement was signed and remain true at closing and
2. the seller and the target have complied with pre-closing covenants.

A seller’s secretary’s certificate is also a one-pager. Here, though, the secretary (or equivalent officer) of the seller certifies to the buyer that the individuals signing the transaction agreements and officer’s certificate have the authority to bind the company. These certificates frequently also include certified copies of the target’s organizational documents and any required board and shareholder resolutions.

Together, these closing certificates offer you an additional layer of protection by substantiating the representations, warranties and covenants provided by the seller and offering you an additional basis for recovery in the event you later discover any breaches by the seller.

Tool No. 5: Legal Opinions

As discussed in a prior post, you may request that a seller’s attorney render a written legal opinion to be delivered to you at closing. These opinions are intended to provide you with assurance that certain legal matters are as they have been described by the seller in its representations and warranties. A typical opinion might cover the following matters:

• the target was duly formed,
• the target is in good standing in relevant states,
• the target’s capital structure (i.e., shares outstanding),
• the transaction and transaction agreements will not violate the target’s charter and other organizational documents or material contracts,
• there is no litigation pending or threatened against the target and
• any issuance of stock or other securities in the transaction complies with federal and state securities laws.

While commonplace in the past, buyers only rarely request seller legal opinions today on account of the legal fees that must be incurred to obtain them as well as the buyer’s ability to confirm independently many or all of the matters that would be addressed by the opinion. Nonetheless, in transactions where you may be particularly concerned about any of the subjects commonly addressed by seller legal opinions, you may wish to request one.

Tool No. 6: Conditions to Closing and Termination Rights

Again assuming your deal has a gap period between signing and closing, the principal transaction agreement will include conditions precedent that must be satisfied or waived before each party will be required to consummate the transaction. Among other things, these will generally require that the other party’s representations and warranties will have been true when made and remain true at closing, and they will require that the other party will have complied with its pre-closing covenants. Frequently, a buyer will also require as a condition precedent that the acquired business will not have experienced a material adverse change—an adverse change in the target’s business that is consequential to the company’s long-term earnings power. Occasionally, a buyer may be able to negotiate for a requirement that it will have satisfactorily completed its due diligence examination of the target.

If these conditions aren’t satisfied by an agreed-upon deadline or if an irremediable breach of representations, warranties or covenants shall have occurred prior to closing, the non-breaching party will usually have the right to terminate the transaction agreements and walk from the deal.

Altogether, these conditions and termination rights, when considered in light of well-crafted seller representations and warranties and pre-closing covenants, reduce the risk that you’ll be buying a lemon.

Tool No. 7: Indemnification Rights / Breach of Contract Claims

M&A indemnification rights, among other things, entitle you to be compensated by the seller for losses you incur on account of a breach of any of the seller’s representations, warranties and covenants contained in the principal transaction agreement. In other words, if you buy a business that’s worse than you expect based on the enforceable promises made by the seller, you can recover damages.

You may be wondering why I would include such rights in a list of tools intended to help ensure you acquire only what you want to acquire in an M&A deal. After all, don’t indemnification rights materialize only if there’s a problem identified post-closing—that is, after you’ve already acquired something more or less than you wanted?

Actually, no. You may be entitled to indemnification even if you exercise your termination rights prior to closing upon learning of a breached representation, warranty or covenant. More importantly, though, indemnification rights provide a reason for the seller to care about its representations, warranties and covenants. Without recourse, even a perfectly crafted buyer-favorable set of seller representations, warranties and covenants will be of little value. Falsehood and non-compliance would be irrelevant.

Of course, without an indemnity, you may be entitled to damages for breach of contract. These would have a similar disciplining effect on the seller along the lines of that afforded by indemnification. Both indemnification rights and the ability to pursue recovery for breach of contract create negative consequences for the seller if it breaches your agreement, thereby increasing your confidence level in what you’ve been told by the seller about the acquired business.

Tool No. 8: Post-Closing Covenants

The final means by which you can increase the likelihood that you’ll buy only the assets and liabilities you intend is to include protective post-closing covenants in the transaction agreements. There are three common types of such covenants that protect you (in addition to the indemnification provisions described above, which are also a form of post-closing covenants).

First, if you’re buying a division or other part of a larger organization, assets that were used in the operation of the business prior to closing may be found after closing not to have been transferred to you. To address this risk, M&A transaction agreements may require the seller either to transfer the assets to you or otherwise provide you with the benefits you would have received if they had been conveyed to you at closing.

Second, as previously discussed, the parties may enter into transition services agreements to ameliorate the challenges of transitioning an acquired business to new ownership. Through these agreements, sellers promise to deliver necessary support to the target company and buyer for an agreed-upon period post-closing.

Finally, M&A transaction agreements usually contain some form of “Further Action” covenant through which the parties agree to exercise efforts to effect the intentions of the parties. An example may provide:

Each of the parties hereto shall use all reasonable efforts to take, or cause to be taken, all appropriate action, do or cause to be done all things necessary, proper or advisable under applicable Law, and to execute and deliver such documents and other papers, as may be required to carry out the provisions of this Agreement and the Ancillary Agreements to which it is a party and consummate and make effective the Transactions.

Catch-all provisions like these are designed to serve as a final means of ensuring the outcome of the transaction is as the parties intended when all else fails. If through some oversight or otherwise all of the other above-described tools have failed to get you the complete set of assets and liabilities you had expected in the deal, you may exercise your rights under the Further Action provision to attempt to compel the seller to take some additional steps to get you the benefit of your bargain.

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