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DEI for legal teams
Jeff Peterson

DEI for legal teams

January 11, 2022/in Corporate Transactional Law, News /by Jeff Peterson

DEI for Legal Teams

What legal responsibilities do business owners have to implement Diversity, Equity, and Inclusion into the workplace and how can a well-executed DEI strategy positively impact valuation? It is important for organizations to not only have strategies for implementing DEI and anti-harassment policies but also to implement them through effective training. Keeping employees safe and creating an inclusive workspace is not only smart from a culture and engagement perspective, it is always wise to reduce the risk of an employment lawsuit.

Training is not only for simply meeting compliance requirements, it can highlight different perspectives on the company culture and open the dialogue to create opportunities for team bonding, changes in HR policies, and increase productivity in the workplace by increasing the sense of ownership and agency employees have.

Training is no longer the sole purview of Human Resources, rather it is now a joint effort of leadership, HR, and the legal department of any mid-sized and larger organization.

DEI Training

When considering the costs of both diversity, equity and inclusion training and harassment prevention training, especially in a hybrid or remote world of work it can be easy to overlook the hidden risk-cost of not engaging in effective training.

Consider remote sessions with small teams as a way to keep the company running while creating “pods” of team members who are bonded through their experience and also able to disseminate their learning to other teams in the organization. (this is not a replacement for each person receiving training, of course).

Spending more money on an effective, motivating training program may, in fact, save money on time spent by employees, leadership and legal doing endless sessions to no positive impact. Starting with leadership and working your way down to those in middle management ensures that the message is consistent, that everyone is on board, and that the message doesn’t disappear after the training is over.

An Ounce of Prevention

From a risk management perspective, the cost of prevention is easily offset by not only the risk of harassment or discrimination action but also by the compliance requirements of each state.

Employment lawsuit damages and penalties can be significant if you lose, and legal fees in the hundreds of thousands even if you win. By adopting a comprehensive anti-harassment policy and providing effective training, employers can show that they have taken active steps to create a positive, inclusive and safe workspace.

Losing employees because of poor company culture, an unsafe workplace, or lack of diversity has costs to the employee in their pain and suffering and also costs to the organization in lower morale and therefore lower productivity, increased resignation rates, damage to brand reputation, and brand loyalty and increased insurance costs.

Weigh the cost of high-quality training against those of failing to promote a safe and inclusive workplace and company culture to truly understand the cost of DEI and harassment training.

How to Select a DEI Training Company

High-quality content, engaging activities, real-world experience, and well-presented experiences are essential to employee engagement. A “cheesy” or out-of-touch free-online course is likely to backfire causing employees to out the efforts on social media as ineffective and creating a hostile workplace environment to try another type of training program in the future.

By giving employees and management a high-quality experience the message is that leadership is invested in the DEI initiative, that tolerance for harassment or exclusion is very low and that the employees must take the program seriously.

Programs that include real-world experiences and immersive training in emotional intelligence and leadership strategies can change behaviors, not only of potential harassers but of bystanders and the company as a whole.

A well-executed DEI training program can create lasting and positive change. And that is priceless.

Disclaimer: The foregoing blog post does not constitute legal advice, but instead only addresses the general topic of DEI Training. Anyone seeking legal advice should consult with an attorney regarding its specific circumstances and needs.

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Chinese companies are delisting off the N.Y.S.E.
Jeff Peterson

Chinese Companies Delisting off the NYSE

January 4, 2022/in News, Securities Law /by Jeff Peterson

According to a December 2021 article from the New York Times, dozens of Chinese companies publicly traded on the N.Y.S.E. may be delisted over the course of the next three years because of ongoing disputes over audit transparency in Chinese and Hong Kong-based accounting firms.

The United States and China have been arguing about the audit issue for roughly more than a decade since the 2011 meeting and agreements signed by President Barack Obama and President Hu Jintao.

At issue are audit standards for publicly traded companies.

The Securities and Exchange Commission currently has the authority to delist The Securities and Exchange Commission currently has the authority to delist companies that do not have approved overseas audits. The Public Company Accounting Oversight Board (the “PCAOB”) has thus far been unable to fully inspect the audit papers and other documents of accounting firms in China and Hong Kong. These pending audits will affect the listings of such entities as Didi Rideshare and more than 190 other companies in a similar situation.

The aforementioned accounting firms have signed audit reports for nearly 200 publicly listed companies on the N.Y.S.E.. Those companies all run the similar risk of being delisted if the transparency requirements of the PCAOB are not met. The potentially non-compliant audit reports account for a combined global market capitalization of $1.9 trillion.

China is increasingly willing to trade on the Hong Kong exchange and leave the American markets indefinitely. At the start of 2021, China Telecom, China Unicom, China is increasingly willing to trade on the Hong Kong exchange and leave the American markets indefinitely. At the start of 2021, China Telecom, China Unicom, and China Mobile were delisted by the N.Y.S.E. to comply with an executive order that barred Americans from investing in companies with ties to the Chinese military. This and the recent delisting of Didi indicates that investors in the US will have to risk Chinese fiscal oversight regulations and less transparency if they want to invest in the companies now listed exclusively on the Hong Kong Stock Exchange.

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Charging Bull sculpture in New York City
Jeff Peterson

M&A trends for 2022

December 22, 2021/in Mergers & Acquisitions, News /by Jeff Peterson

The road ahead for Mergers & Acquisitions

2021 saw robust mergers and acquisitions activity. As the year came to a close, there has been no sign that this trend of increased M&A activity will slow down. So, what trends should business owners and M&A attorneys look for in 2022? Hindsight is 2020… well, it’s 2021 but who’s counting?

The drivers of increased M&A activity

Looking back at the year 2021, the greatest drivers of the increased M&A activity were COVID’s impact both on business owners’ choice to retire or sell, and on their choice to grow into new markets through well-priced sales of companies who struggled during the shutdown and supply chain disruptions that followed.  Increased liquidity affected M&A volume driven by PPP loans, EIDL loans and low-interest rates making capital less expensive. And the change in the world of work from analog to digital, accelerated by the remote work surge that has bolstered SaaS, digital security, and other remote-work facilitation hard and software companies. 

Looking forward to 2022

It is challenging to predict the trends that will define the coming year. One thing COVID has taught the business community is that the unexpected can throw a wrench into the best-laid plans at any moment. While we can look at the past year to see how certain language and activity is affecting the M&A markets right now, these are inferences, not a crystal ball to predict the future.  One way to look at the coming shifts is to look at the changes in volume of certain terms in SEC filings in M&A transactions that have closed over the past 2 years. As we look at the 2022 market trends we can see that there are upticks in reported language in those SEC filings of M&A closings as reported in Bloomberg Law’s article here. The trends indicate that certain terms are appearing more in the last quarter of 2021 than in previous years by notable amounts.  

“Remote work” 

“ESG” 

“Climate Change” 

“Crypto” 

And because this is now year 3 of the pandemic and we show no signs of moving past it, “COVID” and “vaccine” rank among the terms which have seen marked upticks in the latter half of 2021. 

According to other surveys from MiBiz,”automotive, energy, financial services, technology and media, and health care rank as the top five most-active sectors for [2022]”. 

Environmental, Social, and Corporate Governance (ESG) and its impact on M&A volume

In addition to shifts in the interest in ESG and climate-friendly business, the Private Equity activity in 2021 has been strong. Despite impending tax legislation and increased antitrust scrutiny, business owners continue to seek to diversify their portfolios by acquiring companies that give them access to new products, services, and technologies. With PE funding more accessible than ever, the M&A landscape seems to be robust and headed for another bull year. 

The fact that the Biden Build Back Better legislation appears stalled for the foreseeable future means that increased business taxes are now pushed off into the future means that businesses who acquire or merge will not face the kind of tax bracket jump that they would have under the proposed bill. This roadblock removal may stoke the fires of the already hot M&A market. 

Overall the 4 major players in the 2022 M&A market can be culled down to: 

1: A hot Private Equity Market

In 2021, PE transaction value rose more than 55%

2: ESG forces

Businesses may consider purchasing or divesting assets to align with ESG. Practically speaking environmental factors will affect the future of business and strong ESG will allow businesses to better adapt to those shifts.

3: Remote work

Digital transformation of analog processes means more investment in SaaS companies and other cloud-based initiatives.  From cyber security to remote teams management, digital is the way forward.

4: Inflation

The sharp spike in inflation may mean a temporary slowing of M&A activity, though the inflation between 2007 – 2009 did nothing to curb Mergers and Acquisitions. This inflationary bubble is likely to dissolve with low interest rates still in place once the supply chain issues resolve. 

To sum it all up: 

The M&A market is not slowing down.  Successful M&A strategies will involve specific industry targeting and an awareness of the elevated valuations that exist in certain market sectors. Increased deal complexity will necessitate better assessments of risk and liability as well as stringent due diligence processes and targeting of the correct funding sources for each transaction.

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M&A AGREEMENTS
Jeff Peterson

SANDBAGGING CLAUSES IN M&A AGREEMENTS

November 10, 2021/in Mergers & Acquisitions, News /by Jeff Peterson

Agreement For The Sale Of A Business

In an agreement for the sale of a business, there will be a number of representations and warranties by the seller across the spectrum of the company’s business, including its ownership of assets, its financial condition, its compliance with a variety of laws (among others, employment and environmental laws), and the existence of any adverse material events. If an issue arises post-closing that violates the representations and warranties, then the indemnity provisions in the agreement will dictate that the seller must compensate the buyer for any resulting loss, including payment of attorneys’ fees, settlements, judgments, etc.

What Is A Sandbagging Clause?

A sandbagging clause refers to a provision in an M&A agreement that addresses whether a buyer’s pre-closing knowledge about the cause of a subsequent loss will have on the buyer’s indemnity claim. The colloquial term “sandbagging” refers to whether or not the buyer can know about the facts giving rise to the loss and still claim indemnity, or “sandbag” the seller by moving ahead with knowledge of a material issue.

There are two types of sandbagging clauses, a pro-sandbagging clause that allows the buyer to have knowledge of the facts giving rise to the loss and still receive indemnification, or an anti-sandbagging clause, which prohibits buyer from receiving indemnity if it knew of the facts giving rise to the loss.

Although it may seem counter-intuitive to allow for pro-sandbagging clauses where a buyer can recover despite closing with knowledge of the problem, there are good reasons for such a clause to be included. One is that prohibiting buyer from recovering would provide a disincentive to conduct thorough due diligence, as the buyer would not want to discover facts that could later bar indemnification. Anti-sandbagging clauses will also give rise to disputes regarding buyer’s knowledge before closing. Perhaps the buyer’s best argument, however, is that listing the problematic matter in the disclosure schedule is the best way to address any post-closing issues, as the parties can negotiate appropriate provisions ahead of time if necessary, e.g., buyer can either accept the disclosure and bear the risk going forward, or require that seller provide express indemnity for the matter so listed.

A seller’s rebuttal on this issue is that a pro-sandbagging clause would allow the buyer to discover an issue in due diligence and not inform the seller, which could provide a disincentive to the buyer to raise the issue ahead of time and address with the seller in the agreement.

M&A Agreements & Pro-Sandbagging Clauses

In terms of market prevalence, pro-sandbagging clauses are far more common in M&A agreements, generally due to the fact that buyers hold the keys (i.e., money) to the deal and are generally not inclined to restrict their rights on important issues like indemnification. Although recent statistics show that it is quite common for M&A agreements not to address sandbagging at all, that should not be taken as an indicator that the concept is often ignored. Many state laws themselves provide an answer as to whether a buyer can “sandbag” the seller if the agreement does not address the issue, and buyers will generally choose a state law that is pro-sandbagging.

Although a seller will generally be faced with an agreement that will allow for sandbagging, either by express clause or application of state law, being armed with that knowledge will help the seller focus more intently on its due diligence process, and negotiate appropriate provisions for any items that do arise. And those sellers in a strong negotiating position can look at an anti-sandbagging clause as a good “get” in negotiating the transaction.

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Jeff Peterson

FLORIDA MAN BEING SENTENCED FOR WIRE FRAUD IN CONNECTION WITH TRADING COMPANY

October 30, 2020/in News /by Jeff Peterson

The United States Attorney’s Office for the Southern District of Florida issued a press release about a Kissimmee, Florida resident being sentenced to more than seventeen years in prison after having been convicted at trial of wire fraud.

Previous Records

Michael John Alcocer Roa had previously been convicted at trial by a jury of five counts of wire fraud, in violation of Title 18, United States Code, Section 1343.  U.S. District Court Senior Judge Patricia A. Seitz sentenced Alocer to 210 months’ imprisonment, to be followed by 3 years of supervised release.  He is also subject to a potential restitution order.

The press release asserted that Alcocer set up a Florida corporation called Inovatrade Inc. (“Inovatrade”) in October 2008 and between 2008 and 2011, Alcocer told people they could trade foreign currencies at Inovatrade, set up managed accounts in which others could trade foreign currencies on their behalf, or earn guaranteed interest payments of approximately 15% per year or greater. Alcocer represented during this time that Inovatrade maintained all its clients’ accounts segregated, safeguarded, and protected in a trust account.

Excuses and Cash Outs

The U.S. Attorney’s Office went on to state that based on those and other representations, Inovatrade received over $7 million from customers, who were sent detailed account statements over time. But when individuals requested to withdraw their money from Inovatrade, many were unable to do so, receiving instead a litany of excuses from Alocer.

The press release stated that financial records associated with Inovatrade and Alcocer introduced at trial showed little to no actual trading took place in the Inovatrade accounts, and that Alcocer cashed out and transferred millions of dollars of that money from the Inovatrade accounts to personal accounts in the United States and in Panama.

The U.S. Attorney’s Office press release can be found at the following link:

https://www.justice.gov/usao-sdfl/pr/kissimmee-resident-sentenced-more-17-years-wire-fraud

Jeff Petersen is an attorney licensed in California and Illinois representing clients in a wide variety of regulatory enforcement actions. She can be reached in California at 858.792.3666 and in Illinois at 312.583.7488. 

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SEC SUIT
Jeff Peterson

TEXAS OIL COMPANY PAYS $5.4 MILLION TO SETTLE SEC SUIT

October 29, 2020/in News /by Jeff Peterson

The SEC entered into a settlement on its recently-filed securities suit against defendants Southlake Resources Group, LLC (“Southlake”), Cody Winters, and Nicholas Hamilton. The defendants consented to entry of the SEC’s proposed final judgments without admitting or denying the allegations in the SEC’s complaint.

Joint Ventures

The SEC alleged that from approximately June 2010 through approximately September 2014, Winters, directly and through Southlake, a company he owned and controlled, raised more than $5.2 million from more than 70 investors in 26 states by selling interests in several oil-and-gas joint ventures. None of the offerings were registered with the Commission, and none of the individuals that Winters and Southlake employed to cold call potential investors, including Hamilton, were registered with the SEC as a broker or associated with a registered broker.

Misinformation On Productions and Revenue

The SEC further alleged that in written offering material provided to investors, Winters and Southlake made untrue and misleading statements and omissions of material facts regarding, the use of offering proceeds, projections for oil-and-gas production and revenue, and commingling and loaning investor funds. In addition, the SEC alleged that in each offering, Winters overstated the projected well costs by almost 100% and omitted to disclose to investors Southlake’s actual cost and profit information.

Finally, the SEC alleged that at Winters’ direction, Southlake engaged in conduct contrary to written representations to investors about the use of offering proceeds. For example, Southlake took undisclosed profit and overhead payments from the offering proceeds and used offering proceeds to acquire working interests for itself in undisclosed transactions.

The consent agreement with the SEC required the company to pay back $5,235,650 collected from investors, plus $285,761.70 in interest, as well as penalty payment from Winters and Hamilton of $160,000 and $50,000, respectively.

Jeff Petersen is an attorney licensed to practice in California and Illinois representing clients in a wide variety of SEC investigations and enforcement matters. He can be reached in California at 858.792.3666 and in Illinois at 312.583.7488.

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INDEMNITY PROVISIONS
Jeff Peterson

MANHATTAN TAX ATTORNEY AND CPA INDICTED FOR TAX EVASION

October 29, 2020/in Corporate Transactional Law, News /by Jeff Peterson

The United States Attorney’s Office for the Southern District of New York announced that Manhattan tax attorney Harold Levine and Florida certified public account Ronald Katz were charged in Manhattan federal court in an eight-count Indictment with engaging in a multi-year tax evasion scheme involving the diversion of millions of dollars of fees from a Manhattan law firm, and the failure to report that fee income to the IRS.   

U.S. Attorney for the Southern District of New York Preet Bharara said in the release: “As tax professionals and partners at professional firms, both Harold Levine and Ronald Katz knew better.  But as alleged, they engaged in a multi-year scheme to divert and evade taxes on millions of dollars of fee income.”

The Indictment alleged that Levine, a tax attorney and former head of the tax department at a Manhattan law firm, participated in a scheme with Katz to divert from the law firm over $3 million in fee income from tax shelter and related transactions that Levine worked on while at the firm.  In addition, per the Indictment Levine failed to report that fee income to the IRS on his personal tax returns, and Katz received and failed to report to the IRS over $1.2 million in fee income.     

The Indictment alleged that as part of the fee diversion scheme, Levine caused tax shelter fees paid by a firm client to be routed to a partnership entity he co-owned with Katz and thereafter used approximately $500,000 to purchase a home in Levittown, New York, then took improper tax deductions on the home as rental property. 

The Indictment also alleged that Levine made false statements about the purported rental property when questioned by IRS agents concerning his involvement in certain tax shelter transactions and the fees received for those transactions, and urged a third party to make false statements to the IRS about that property. 

Levine and Katz are scheduled to be arraigned on October 31st.

Jeff Petersen is an attorney licensed in California and Illinois representing clients in a wide variety of regulatory matters. He can be reached in California at 858.792.3666 and in Illinois at 312.583.7488.

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Jeff Peterson

DEFINING A SELLER’S KNOWLEDGE IN AN M&A AGREEMENT

October 24, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

Representations and Warranties

In an agreement for the sale of a business, there will be a number of representations and warranties by the seller across the spectrum of the company’s business, including its ownership of assets, its financial condition, its compliance with a variety of laws (among others, employment and environmental laws), and the existence of any adverse material events. If anissue arises post closing that violates the representations and warranties, then the indemnity provisions in the agreement will dictate that the seller must compensate the buyer for any resulting loss, including payment of attorneys’ fees, settlements, judgments, etc.

Because a breach of the seller’s representations and warranties can result in a costly indemnification obligation, the seller will be keenly interested in limiting its exposure to the extent possible. One way to do this is with a knowledge qualifier for certain representations and warranties, i.e., language which limits the extent of the representation and warranty on a specific matter to the actual or constructive knowledge of the seller.

Actual vs Constructive Knowledge

As an initial matter, the distinction between actual and constructive knowledge standards is an important one in this context. Actual knowledge of course means that the seller must actually know about the circumstances giving rise to the breach of the representation and warranty in order to be held liable for that breach. Constructive knowledge, on the other hand, will dictate that a breach will occur if seller either knew or should have reasonably known about the facts giving rise to a breach. Obviously, a seller much prefers an actual knowledge standard, as it precludes delving into the factual circumstances to determine whether a reasonable party should have known about the underlying facts of a breach.

To examine the effect of knowledge qualifiers in the M&A context, we’ll use the example a representation and warranty pertaining to existing lawsuits against a company, as well as any present basis for a legal claim to be brought in the future. This very common representation and warranty is generally bifurcated by a knowledge qualifier as follows: (1) the first clause relating to existing lawsuits is unqualified with regard to sellers knowledge; and (2) the second clause, pertaining to any current facts giving rise to a basis for a potential claim, is qualified or limited by the actual or constructive knowledge of the seller.

Breaking Down the Knowledge Qualifiers

Let’s begin by analyzing the first clause and the lack of any knowledge qualifier. If there is an existing lawsuit against the seller as of the time of closing, whether seller knows it or not, the seller will have breached the representation and warranty on absence of lawsuits unless that lawsuit is listed on a disclosure schedule to the agreement. The allocation of risk in this regard makes logical sense, because the suit has been filed before closing based on conduct of seller, and should be seller’s responsibility. In addition, with regard to the issue of knowledge, a lawsuit is a public record and generally needs to be served promptly after filing, so in most circumstances, seller is going to be aware of such litigation. And, if due to a quirk of timing, the seller is not so aware, a buyer is not willing to take on that liability by using a knowledge qualifier.

As for the second clause, however, the existence of any basis for a future claim, generally speaking this clause will be subject to an actual or constructive knowledge qualifier. The allocation of risk here is that if the seller did not actually know (under an actual knowledge standard) or reasonably know (under a constructive knowledge standard) of the basis for a subsequent claim, the seller will not have breached the representation and warranty, and will not owe an indemnity obligation. The reasoning behind the general use of the qualifier here is that a seller cannot be held to know everything about the company, and that some dividing line should be drawn with respect to unasserted claims.

The trend in M&A is for a constructive knowledge standard to be used as the knowledge qualifier. The buyer’s argument in this regard is straightforward: they are unwilling to make the substantial investment in purchasing a company or its assets while allowing a seller to avoid liability based on lack of actual knowledge of its errors or misconduct. Indeed, buyer
will argue, such a standard rewards neglect, in that an unknowing seller will escape liability while a more diligent company would have been aware of the
issue.

Defining Constructive Knowledge

There are a variety of ways to define constructive knowledge in an agreement. One common way is to define knowledge by connecting it to what specific individuals in the company, often the selling principals and officers or directors, knew or should have known in the exercise of reasonable diligence. A seller will want to pay careful attention to this definition to ensure that the constructive knowledge standard does not become overly broad so as to open the door too wide to potential liability. Seller and its attorney should also carefully review the agreement to confirm that knowledge qualifiers are being used appropriately throughout the representations and warranties to limit their scope.

A seller’s indemnity obligation is generally the chief source of liability after closing, so careful review of knowledge qualifiers during the drafting process is a key way for seller to effectively manage this potential exposure.

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Mergers and Acquisitions
Jeff Peterson

MATERIALITY SCRAPES IN M&A AGREEMENTS

October 23, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

Consequences of violations of Representations and Warranties

In an agreement for the sale of a business, there will be a number of representations and warranties by the seller across the spectrum of the company’s business, including its ownership of assets, its financial condition, its compliance with a variety of laws (among others, employment and environmental laws), and the existence of any adverse material events. If an issue arises post-closing that violates the representations and warranties, then the indemnity provisions in the agreement will dictate that the seller must compensate the buyer for any resulting loss, including payment of attorneys’ fees, settlements, judgments, etc.

What is a materiality scrape?

A materiality scrape is a provision in the agreement that provides that when determining either: (1) whether a representation or warranty in the agreement has been breached; and/or (2) the amount of any loss resulting from such breach, all materiality qualifiers in the agreement are disregarded (i.e., “scraped”). The practical effect of such a provision is to “read out” any materiality qualifiers in the seller’s representations and warranties, such that seller will be liable for any breach and/or any loss resulting therefrom.

Obviously, a seller would prefer to have materiality qualifiers in the agreement to limit its indemnity obligations. The buyer’s argument in favor of a materiality scrape, however, is generally twofold: (1) if the agreement has an indemnity “basket” (i.e., a threshold amount of loss which must be reached before seller has a duty to indemnify), then a materiality threshold is already in the agreement, and the scrape prevents doubling up on materiality hurdles; and (2) excluding the materiality threshold precludes future disputes over what is and is not material.

Arguments against a materiality scrape

The seller has two chief arguments against the use of a materiality scrape. The first is that utilizing such a provision will result in both buyer and seller getting in the weeds about every possible flaw in the company. Pre-closing, seller will be incentivized to list every matter it can think of in the disclosure schedules, not matter how minor, while post-closing, buyer will be incentivized to assert every claim no matter how trivial to reach the basket amount. Seller can also argue that a materiality scrape leads to absurd results. A typical M&A agreement contains a number of provisions that utilize a materiality standard, for instance, a representation and warranty that the seller has made no material misrepresentations in conjunction with the agreement. Reading that qualifier out of the agreement essentially nullifies the governing legal standard for stock purchases that has been in place for decades.

How can buyers and sellers compromise?

The last point segues nicely into how a buyer and seller can compromise on the matter. One way to do so is to exclude the materiality scrape from applying to certain representations and warranties. Another is to use an indemnity basket which excludes the entirety of the basket threshold amount from seller’s indemnity obligation, rather than a “tipping basket” which requires that, once the threshold amount is met, seller indemnify buyer from dollar one of the loss. Lastly, the parties can agree to use a “single scrape”, i.e., nullifying any materiality qualifier in determining the amount of damages, but not when determining whether a breach has occurred in the first instance. Using one or more of these types of provisions will better allocate the risk among the parties, and a seller coming into a deal prepared to negotiate this issue will be in a far better position to achieve a more desirable result.

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INDEMNITY PROVISIONS
Jeff Peterson

INDEMNITY PROVISIONS IN AGREEMENTS FOR SALE OF A BUSINESS

October 20, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

Business Agreements

When business owners receive an agreement for the purchase of their business, it is easy to feel lost in a sea of legalese. The agreement generally can be anywhere from 40 to 100-plus pages, covering a broad range of representations and warranties, tax matter procedures and so on.

Although it is obviously imperative to have experienced counsel guide a business owner through this process, it is also helpful for the owner to understand certain fundamental components of the deal, to be able to analyze the risk profile and assist the attorney in negotiating a final agreement that protects the owner to the fullest extent possible.

Indemnity Provision Component

One such fundamental component of the deal is the indemnity provision, which is a mutual obligation of the buyer and seller to defend and hold one another harmless from certain acts or breaches of the agreement. When a party’s indemnity obligation is triggered, that party will have to pay attorney fees and costs of defending any claim, as well as paying for any monetary loss, arising from that claim, including a settlement, judgment, fine or penalty. In other words, the indemnity provision is (generally speaking) the one way that a seller will have to pay money back to the buyer from the sale of the business. Because of this, it is vital for a seller to understand the mechanics of indemnity, and the ways in which indemnity obligations may be limited.

As an initial matter, a seller’s indemnity obligation generally applies to the following: (1) a breach of the seller’s representations and warranties in the agreement; and (2) a breach of the seller’s contractual obligations in the agreement.

The first prong is the source of most post-closing indemnity claims. In the sale agreement, a seller will typically make a lengthy series of representations and warranties, from basic items such as attesting to full and unimpaired ownership of the equity and assets of the company, to highly detailed representations and warranties regarding compliance with employment or environmental laws, and an absence of claims for violating any such laws. If there is any legal violation that seller is aware of, that will be listed on a disclosure schedule to the agreement. In typical sale agreements, there are twenty to thirty such representations and warranties, covering the full spectrum of the business. Therefore, unless an item of potential liability is specifically excluded, any breach of the representations and warranties that the business has been run in compliance with the laws, is not encumbered, and is not subject to any claims, can serve as the basis for an indemnity claim by the buyer.

Because of this, it is important for a seller to thoroughly review all the representations and warranties with counsel and identify any potential gaps in compliance and/or future claims. Once identified, seller and counsel can address the matter with buyer’s team and negotiate provisions to address the matter. In most cases, the parties are able to reach agreeable terms on the issue, but identifying it ahead of time and being able to decide whether or not to proceed is invaluable for a seller. It is far better to decide to proceed with a known risk than it is to be surprised later.

Indemnity Protections

A seller can also have certain protections built into the indemnity section of the agreement to limit the indemnity obligations in most instances. For example, the use of baskets and caps are typical in sale agreements, both of which limit a seller’s obligations.

Indemnity Basket

An indemnity basket functions like a deductible of sorts; i.e., until the amount of buyer’s loss reaches X dollars, the seller does not have to make payment for any indemnified loss. Most agreements use what is called a tipping basket, so that when the loss threshold is met, the seller owes indemnity on the entirety of the loss from dollar one.

Indemnity Cap

An indemnity cap is an even more important tool for the seller. A cap will limit the amount of money a seller has to pay for indemnified claims post-closing, subject to certain exclusions. In most mid-market deals, the typical indemnity cap ranges from 5-15% of the total purchase price. Say for instance the indemnity cap is 10% of the purchase price; in such event, if the purchase price is $20 million, the seller’s total indemnity obligation would be limited to $2 million, again subject to certain exceptions. The logic behind this limitation is that the seller needs a certain level of assurance that once it sells the business, the buyer is not going to come back with a slew of claims to essentially claw back the entirety of the purchase price, while still remaining in control of the business.

The limited exceptions to the applicability of the cap track this logic as well. For example, fraud is the main exception to applicability of the indemnity cap. This makes logical sense in that, if the seller has actively defrauded the buyer about the state of the business, the seller should not be able to hold buyer to an indemnity limit that was negotiated on the presumption all parties were dealing in good faith. The inapplicability of the cap to what are deemed “fundamental representations” like unencumbered ownership of equity and assets is logical as well – if the seller does not truly own what it is purporting to sell, then the buyer should not be bound by any cap, as it truly did not receive what it paid for.

Important Provision For The Seller

Lastly, a common protection for the seller in the indemnity section is that indemnity will be set forth as the exclusive remedy for breaches of the agreement, subject to common exceptions for fraud or for a party seeking equitable relief. This is an important provision for seller, because it prevents a buyer from making an “end run” around the carefully-negotiated indemnity provisions and seeking relief from the seller which is not subject to the baskets and caps, among other things.

The various permutations of an indemnity section in an agreement for sale of a business are too involved to address fully here, but identifying some fundamental components of how indemnity works can help facilitate communications with counsel when that large stack of deal documents hits the seller’s inbox.

https://lawofficesjtp.com/wp-content/uploads/2021/11/iStock-857794116-scaled.jpg 1707 2560 Jeff Peterson https://lawofficesjtp.com/wp-content/uploads/2021/11/JTPlogo-01.png Jeff Peterson2020-10-20 11:35:002022-02-10 10:43:44INDEMNITY PROVISIONS IN AGREEMENTS FOR SALE OF A BUSINESS
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