Presenting a live 90-minute webinar with interactive Q&A Drafting Stock Purchase Agreements: Price, Reps, Warranties, Indemnification, Taxes, Securities Laws and More THURSDAY, FEBRUARY 4, 2016 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Allen Sparkman, Partner, Sparkman & Foote, Denver and Houston Neal A. Jacobs, Managing Attorney and Principal, Jacobs Law Group, Philadelphia Matthew A. Cole, Corporate Department Chair, Jacobs Law Group, Philadelphia The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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Strafford CLE Webinar-February 4, 2016 Drafting Stock Purchase Agreements Key Provisions in Stock Purchase Agreements Matthew A. Cole and Neal A. Jacobs Jacobs Law Group, PC
Key Provisions in Stock Purchase Agreements A. Purchase Price B. Representations and Warranties C. Indemnification D. Miscellaneous Key Provisions Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 6
Purchase Price How calculated Defining the amount of the purchase price: 1. Stated Purchase Price Amount: i.e., $11,000,000 $1.0 MM escrowed at signing to be released at closing. $8.0 MM at closing. Or other staged releases $2.0 MM held in escrow to be released 2 years from closing Subject to any set off or indemnity claims Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 7
Purchase Price How calculated 2. Stated Purchase Price Amount with adjustments for balance sheet items (working capital adjustments): Preliminary Purchase price established as of signing. Anticipated account balances as of the anticipated closing date. Typically focused on working capital account balances Preliminary Purchase Price will be adjusted at closing based on the actual closing date account balances. Risks are allocated to Seller Price paid may go up or down depending on whether projected account balances are hit on the closing date Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 8
Purchase Price How calculated Defining the amount of the purchase price: 3. Stated Purchase Price Amount based on last audited statements: Pricing locked-in on signing. Buyer has risk of leakage, losses in account balances reflected as of closing date. Buyer has the benefit of income and cash flow from the date of signing. 4. Stated Amount with adjustment for performance based earn-outs Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 9
Purchase Price How calculated 4. Stated Amount with adjustment for performance based Earn-outs. Earn-Out creates a variable purchase price component Only paid if various performance metrics are met Seller is given incentive to ensure the success of the Buyer s acquisition and operation of the acquired entity. Accounting terminology can be key: The Metrics -- Financial versus Non-Financial Financial: EBITDA Gross Revenue Net Revenue Net Income Gross Profit Net Profit Accounting Terminology: Cash Accounting Accrual Accounting Tax Accounting GAAP Other Income recognition formulas Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 10
Purchase Price How calculated 4. Earn-outs (Cont d). Metrics (Cont d): Non-Financial: Product Development Prototype to Beta Beta to Commercial Regulatory approval FDA FCC EPA Etc. Expansion to New Territories Quality Measures Other Measures (opening of mine, start of production, etc.) Earn Outs are typically about 20% of the overall Purchase Price. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 11
Purchase Price What Type of Consideration? 1. Cash 2. Promissory Note 3. Buyer Stock 4. Combination of two or more of the above Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 12
Purchase Price Cash Cash in Hand is the Noblest Work of God Anonymous Lawyer: Show me the money Rod Tidwell to Jerry Maguire Jerry Maguire 1996 Sellers typically want cash. Seller is immediately giving up control and wants an immediate compensatory amount in exchange for doing so. Typically require the buyer to pay by wire transfer or cashiers/bank/certified check. Note that wire transfers in the late afternoon, on Fridays and on the last or first business day of the month sometimes do not arrive that day. This should be considered when scheduling a closing. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 13
Purchase Price Promissory Note Why a promissory note? Sometimes a note is used due to tight credit markets Difficulty in obtaining acquisition financing Buyer may have cash flow issues, Possible need for funds above the escrow to use for anticipated indemnity claims (set off against the installment payments under the promissory note). Considerations: Existing bank debt Acquisition financing Subordination Personal guaranties Percentage of deal locked up in Promissory Note Acceleration provisions Is note negotiable or non-negotiable Pledges of collateral, assets and/or stock Default terms Enforcement rights. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 14
Purchase Price Promissory Note (Cont d.) Default and enforcement can prevent unique challenges: If a default in payment, does the seller have the right to step back in as an owner; a right to manage the company; impact on company, employees and creditors. Guaranties by individuals or parent entities that are owners of the buyer may be requested as well. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 15
Purchase Price Buyer Stock or Other Equity Securities The buyer s use of stock for all or part of the purchase price usually only occurs if the buyer is a public company. With public company stock as deal currency, the seller has a ready means of determining value and liquidity because of the ability to sell the shares on the open market. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 16
Purchase Price Buyer Stock or Other Equity Securities (Cont d.) There are many complexities to using buyer stock as part of the purchase price for both buyer and seller, particularly complying with securities laws and determining what type of liquidity the buyer is willing to provide the seller for the shares. For example, if the buyer is not willing to register the shares with the Securities and Exchange Commission, the seller may not be able to sell the shares quickly even though the buyer has a public market for its shares generally. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 17
Combinations of Purchase Price Consideration The most often seen combination for sales of privately-held businesses is a combination of cash and promissory note. The blend (and interest rate on the purchase price balance) may be heavily negotiated, though common down payments at closing on the purchase price are in the 10-30% range. For sellers to public companies, there may be a strong incentive to avoid a purchase price solely in buyer stock. The reasons for this range from: Uncertainty about the future stock price; Desire to diversify economic interest and reduce risk; To simply not wanting to be an investor in someone else s business. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 18
Earn-outs The Contingent Purchase Price An earn-out refers to contingent post-closing purchase price payments that are made if various targets are met by the acquired business. Buyers favor earn-outs. Sellers generally do not (or at least should strongly consider not accepting an earn-out unless they are in control of: means of achieving the earn-out post closing, for example: Sales; Production and delivery of product or service; Regulatory approval of product or service; and Company competitive offerings. the accounting policies and procedures used to track the achievement of the earn-out. Gross Revenue; Cost of Goods sold; SG &A; EBITDA; and Other financial metrics. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 19
Earn-outs The Contingent Purchase Price Whether a Seller should accept an earn-out depends on the level of control post closing and the obligation on the Buyer to achieve the earn-out. Reasonable efforts; Reasonable commercial efforts; Commercially reasonable efforts; Diligent efforts; Commercially reasonable and diligent efforts; Good faith efforts; Commercially reasonable best efforts; Every effort; and Best Efforts. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 20
Earn-outs Why Have They Become More Popular in Recent Years? Multi-decade trend towards transactions in the internet economy and/or service economy where businesses may not have significant track record of profits. These types of transactions may lead to a widening Valuation Gap between buyers and sellers. The wider the gap, between the parties views on value, the more likely the parties will head towards an earn-out as a gap filler. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 21
The Valuation Gap and Earn-outs Earn-outs seem to be a way for buyers and sellers to avoid the difficult negotiations required to reach final agreement on a purchase price. Avoidance comes at its own price: the likelihood that disputes between seller and buyer will occur later, post-closing. The Delaware Chancery Court has noted in a relatively recent case that since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today s disagreement over price into tomorrow s litigation over the outcome. Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009). Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 22
Stock Purchase Agreement Representations and Warranties 1. The meanings of the terms representation and warranty 2. Who is making the representations and warranties? 3. What purpose do representations and warranties serve? 4. Some Representations and Warranties with Significant Liability Exposure Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 23
Do Representation and Warranty have the same meaning? Typically, stock purchase agreements refer to representations and warranties interchangeably. Sometimes, this is not a good practice as described below. However, there are some differences that are useful when drafting buyer disclaimers and non-reliance provisions. These provisions are usually requested by the seller, who wants to limit the universe of representations and warranties on which the buyer may claim reliance in entering into the deal. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 24
The meaning of Representation A statement from a party about certain facts regarding the business or events that have occurred with respect to a business as of a certain date. Usually, the date is the signing of the stock purchase agreement and, additionally, the date of a later closing. Remember a representation is a statement of a fact. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 25
The meaning of Warranty This is essentially a guaranty regarding certain characteristics relevant to the business, such as regarding title to assets. The use of the term warranty in the business sale context is somewhat different, however, than the more commonly understood meaning of the term, such as a warranty of good working condition for an appliance for 1 year from the date of purchase. This is because a warranty in the business sale context, like a representation, is typically as of a certain date, and not typically a guaranty of a set of facts or characteristics over a period of time. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 26
Who makes the representations and warranties? The seller provides many representations (and warranties) in a stock purchase agreement. The buyer provides relatively few, which is logical as the buyer needs to confirm many different facts regarding the existing business whether the parties structure the purchase as an asset sale or stock sale. If a significant portion of the purchase price is being paid by promissory note, the seller may ask the buyer for more representations and warranties than is customary in order to determine the financial soundness of the buyer in its role as a debtor to the seller. The concern here may be the solvency of the buyer and Potential claims for fraudulent conveyances or preferences Representations and warranties typically serve different purposes for the buyer and seller. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 27
The Purpose of Representations and Warranties in Stock Purchase Agreements Buyer Perspective Negotiating the representations and warranties in a purchase agreement is part of the due diligence process for the buyer. Depending on the type of business, a buyer will want to review financial statements, accounts receivable and payable records, key customer and supplier contracts, tax returns and many other documents to form an opinion on whether the business is profitable and not burdened by major liabilities. As a supplement to this investigation, the buyer may want to ask for very broad representations and warranties about the seller s business. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 28
The Purpose of Representations and Warranties in Stock Purchase Agreements Seller Perspective The representations and warranties that a seller can obtain from a buyer are usually limited. The selling shareholders often not only own but also work actively in closely-held businesses, so the due diligence necessary or even desirable regarding the buyer will not be extensive. The typical representations a buyer may be willing to provide include that the buyer is validly formed and in good standing, the buyer has the power and authority to enter into the transaction, the buyer does not need another person s consent to enter into the transaction, and that entering into the transaction will not cause the buyer to violate any agreement, judgment or governmental order. The seller will also provide these representations to the buyer, and will also provide numerous additional representations. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 29
Liability Issues for Some Key Representations and Warranties Some Representations and Warranties in Stock Purchase Agreements that tend to have significant liability associated with them include: i. Title to Shares ii. iii. Due Authorization Taxes iv. Environmental v. Employee Benefits We are focusing on seller representations and warranties because the seller makes far more representations and warranties to the buyer, and has far greater exposure if they are false, than does the buyer. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 30
Liability Issues for Some Key Representations and Warranties (Cont'd.) Note that, unlike in an asset purchase agreement, some of these representations concern the corporation s operations (Taxes, Environmental, and Employee Benefits) and others concern the state of facts about the shareholders themselves (Title to Shares, Due Authorization). One cannot take a one-size-fits-all approach to which representations and warranties may cause the most liability for sellers because some of those listed above do not even apply to all sellers. For example, a seller that is a multi-office executive search firm may have little likely exposure for environmental representations if the seller does not own the real property where its offices are located. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 31
Limiting Liability for Representations and Warranties There are many different ways for a seller to attempt to limit his liability for various representations and warranties. Below is a brief list of some of these techniques: i. Knowledge Qualifiers - To the knowledge of the selling shareholder, after reasonable inquiry.... ii. Materiality Qualifiers These concern eliminating selling shareholder liability for representations and warranties that may be breached for reasons that are immaterial, e.g., a reasonably prudent buyer would not think that the breach was significant enough to require renegotiation of the price or other economic terms of the stock purchase. iii. Quantitative Qualifiers These set a bright line standard for whether a selling stockholder has breached a representation or warranty. iv. Deductibles, Baskets, and Caps under Indemnification Provisionsdiscussed briefly below. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 32
Indemnification in Stock Purchase Agreements 1. A Sample Basic Indemnification Provision 2. Indemnification Procedures 3. Introduction to Escrows and Set-Offs- Further Buyer Protections 4. Introduction to Baskets and Caps- Limiting Seller Indemnification Liability Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 33
A Sample Basic Indemnification By Seller Provision If Selling Shareholder breaches (or in the event any third party alleges facts that, if true, would mean that Selling Shareholder has breached) his representations, warranties, and covenants contained in this Agreement, Selling Shareholder will indemnify, hold harmless and defend each Buyer Party from and against any Adverse Consequences that any Buyer Party may suffer resulting from, arising out of or caused by the breach or the alleged breach. We will now briefly analyze each of the highlighted terms in this provision. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 34
Seller: the Likely Indemnitor Many agreements contain mutual indemnification obligations, but the limited number of representations and covenants of the buyer make the indemnification obligation of the buyer far less valuable to the seller than the indemnification obligations owed by the seller to the buyer. Indemnification in stock purchase agreements usually is concerned with breaches by the seller of its representations, warranties, and covenants to the buyer. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 35
Selling Shareholders Representations, Warranties and Covenants A Potentially Large Universe While there may seem to be a small universe of representations and warranties for which a selling stockholder could have liability (title to shares, due authorization, a few others), that often is far from the case in many stock purchase transactions. A buyer often wants to understand the nature of the business underlying the stock being sold. Consequently, even if there is management other than the shareholders themselves, the shareholder will be asked to make representations and warranties about the business of the corporation itself. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 36
Selling Shareholders Representations, Warranties and Covenants A Potentially Large Universe (Cont'd.) If the selling shareholders have significant bargaining power, they may be able to avoid this. However, it is more likely that the selling shareholders will be on the hook for many of the representations about contracts, taxes, intellectual property and other matters that would typically be the responsibility of the corporation itself in an asset sale. Because of these circumstances, a selling shareholder s indemnification burden may be significantly greater than at first glance would appear to be the case. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 37
Selling Shareholders Representations, Warranties and Covenants The Materiality Scrape Very pro-buyer: A Materiality Scrape provision excludes and disregards all materiality qualifiers contained in sellers reps and warranties. Renders materiality a nullity. Thus any violation is a breach. Example: For purposes of this Article 12 [indemnification article], any inaccuracy in or breach of any representation or warranty made by the Seller in this Agreement shall be determined without regard to any materiality, Material Adverse Effect or other similar qualification contained in or otherwise applicable to such representation and warranty. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 38
Indemnification for a Contract Party s Acts a Necessity? One issue to consider is whether a seller should be required to indemnify the buyer against claims the buyer has against the seller itself (as opposed to buyer indemnification rights for third party claims involving a seller s breach of representations/warranties or covenants). This argument is that the buyer has a contract claim against the seller for breaches of the contract, so why do they also need indemnification? While there may be some sound principles in a seller making this point, most buyers will reject it and want the comfort of indemnification. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 39
What does to indemnify mean? A leading commentator on drafting contracts, Kenneth Adams, has cited a Black s Law Dictionary s definition: 1. To reimburse (another) for a loss suffered because of a third party s or one s own act or default.... Adams, Kenneth A. A Manual of Style for Contract Drafting, 2nd ed., Section 12.131. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 40
Do not forget Defend (if you are the indemnitee) Most indemnification provisions contain the introductory clause Seller hereby indemnifies, holds harmless and will defend or some variation of these words. The defend magic word is very important, because it is shorthand that the buyer will not only be reimbursed for losses from a seller breach of its representations/covenants, but also that the seller will defend the buyer against litigation. As Kenneth Adams notes, however, it is best to provide for this in more detail in a provision regarding defense procedures so what was intended by the parties is as clear as possible: [y]ou d be better off omitting it [the word defend ] and instead addressing in the provisions governing indemnification procedures how defense of nonparty claims is to be handled. Adams at Section 12.147. Despite Adams suggestion, we would not advise removing the word defend from the introductory clause as, even if it seems redundant when a detailed indemnification procedure exists in the agreement, it unambiguously signals to anyone trying to interpret the indemnification provision what was intended by the parties at the beginning of the indemnification section. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 41
Buyer Party Term Attorneys need to think carefully about who is entitled to indemnification. A Buyer will argue for anyone potentially related to Buyer having the right to be indemnified for Seller s breaches and the consequences flowing from the breach. The Seller needs to consider how much including everyone in the Buyer s world could potentially significantly increase not only total indemnification exposure, but the number of indemnification claims that may be made. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 42
Adverse Consequences Term This is an exceptionally buyer-favorable definition because it covers all aspects of loss or damage, including attorney s fees, that the Buyer Parties may incur in connection with a Seller breach. Sellers may want to try to place some limits on the breadth of this definition, or at least consider this definition s expansive coverage, in light of any baskets or caps that Seller is able to negotiate (as discussed below) to limit Seller s overall indemnification liability. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 43
Drafting Indemnification Procedures As noted above, this provision covers the defense of indemnification claims by the indemnitor (the Seller for our discussion). These procedures can involve a fair amount of negotiation, including how quickly indemnification claims must be made to the Seller, who chooses counsel for the related legal work, who pays for counsel (again, it is best to be clear that the Seller is required to defend the Buyer Parties), and rights of the Seller to settle different types of claims (monetary, equitable, contract versus tort, for example). Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 44
Set-Offs of Purchase Price Promissory Notes As is common, a Buyer will pay a portion of the purchase price in a promissory note. One way for the buyer to quickly be reimbursed for an indemnification claim and related expenses is to permit the buyer a right of set off under that note. This would reduce the balance of the purchase price (and the accruing interest) that Buyer must pay Seller. Sellers often resist this because, while it is not money out of pocket, it may encourage Buyer indemnification claims because it is such an easy remedy for Buyer to use. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 45
Escrows of a Portion of the Purchase Price This is another heavily negotiated concept. Particularly for potentially large liabilities discovered in due diligence such as taxes and environmental matters, a Buyer may insist that a portion of the purchase price be escrowed for a period of time. The Seller will resist this, especially if it is for a large percentage of the total purchase price and for a lengthy time period. One way to mitigate the harshness of an escrow is for it to burn-off and be paid the Seller in installments, either after certain events occur or based on the lapse of time periods. One issue both parties must carefully consider is who will serve as escrow agent. It has become less desirable for the attorneys for one party to serve as escrow agent than it has in the past, so a true third party, such as a bank, may need to be retained. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 46
Baskets and Caps- Limiting Seller Liability A basket refers to the threshold dollar value of indemnification claims that must be made before a Buyer can actually obtain payment (or set-off) from Seller. The purpose of baskets is to prevent Buyers from making repeated claim for a few thousand dollars that need to be addressed, a time-consuming and possibly costly process for Seller. In effect, the amount below the basket threshold is a deductible. For example, if Buyer is purchasing a Selling Shareholder s stock for $2,000,000, the parties may agree to an indemnification basket that Buyer may not submit indemnification claims to Seller unless they total in excess of $75,000. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 47
Baskets and Caps- Limiting Seller Liability (Cont d.) Once the Buyer exceeds this threshold, the parties will need to provide for whether the Buyer s claims are from the first dollar or whether the $75,000 is a true deductible, meaning that the Buyer can only make indemnification claims, and be paid for them, for amounts exceeding $75,000. The parties may negotiate different baskets and deductibles depending on the type of claim. (e.g., tax versus employee benefits) A cap is another tool by which Seller s limit their indemnification liability. This allows the Seller to have a pre-determined maximum liability amount for all indemnification claims, third party or direct, of Buyer. There may be multiple caps or even sub-caps, depending on the type of indemnification claim made. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 48
Stafford Webinar February 4, 2016 Drafting Stock Purchase Agreements Allen Sparkman SPARKMAN + FOOTE LLP 1616 17th St., Ste. 564 P.O. Box 609 Denver, CO 80202 Houston, TX 77204 303.396.0230 (voice) 713.401.2922 (voice) 303.748.8173 (cell) 713.859.7957 (cell) 1.720.600.6771 (fax) 1.218.783.6986 (fax) sparkman@sparkmanfoote.com www.sparkmanfoote.com
Stock Purchase Agreements Representations and Warranties Sandbagging Assume Seller represents that Seller has $10,000,000 of product in inventory. In the course of due diligence, Buyer learns that Seller s inventory is actually only $8,000,000. Will Buyer nevertheless be permitted to recover on a claim that Seller has breached this representation? SPARKMAN + FOOTE LLP 50
Stock Purchase Agreements Representations and Warranties Sandbagging This will depend on whether their agreement contains or does not contain an anti-sandbagging provision and what law applies. SPARKMAN + FOOTE LLP 51
Stock Purchase Agreements Representations and Warranties Sandbagging The Private Target Mergers and Acquisitions Deal Points Study (M&A Committee, ABA BLS) reports that 41% of the deals it reviewed included a provision permitting sandbagging, that 10% included a prohibition and that 49% were silent. SPARKMAN + FOOTE LLP 52
Stock Purchase Agreements Representations and Warranties Sandbagging If the agreement is silent, the law of some states, e.g., Colorado, would say that Buyer could not recover because, knowing before closing of Seller s misrepresentation, Buyer could not have relied on Janie s representation. Associates of San Lazaro v. San Lazaro Park Properties, 864 P.2 nd 111 (Colo. 1993) (Buyer discovered inaccuracies due to its own independent investigation after signing and consequently did not rely on the seller s information at closing and thus waived its warranty claim). SPARKMAN + FOOTE LLP 53
Stock Purchase Agreements Representations and Warranties Sandbagging Delaware courts hold that the warranties and representations in a purchase and sale agreement serve an important risk allocation function and that, accordingly, a seller s breach of its representations and warranties constitutes a breach of contract and does not require the buyer to demonstrate reliance. Universal Enterprise Group, L.P. v. Duncan Petroleum Corporation, (Case No. 4948-VCL, Del. Ch. 2013). SPARKMAN + FOOTE LLP 54
Stock Purchase Agreements Representations and Warranties Sandbagging State law treatment of sandbagging claims depends on whether the state treats breach of a representation or warranty as a tort or as a breach of contract. See generally, Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, 36 Del. J. Corp. L. 1081 (2011). SPARKMAN + FOOTE LLP 55
Tax Benefitting Claims Buyers should resist seller requests to tax-benefit any claims paid by the seller to the Buyer. SPARKMAN + FOOTE LLP 56
Tax Benefitting Claims A common ploy by Sellers is to assert that if the Seller has to pay a claim made by the Buyer, the Seller s payment should be reduced by the tax benefit the Buyer receives from the payment. The Private Target Mergers and Acquisitions Deal Points Study (hereafter, Deal Points Study ) reports that 52% of deals provided for a reduction in the Seller s liability for the tax benefit to the Buyer. Moreover, according to the Deal Points Study, 44% of deals included an express requirement that the Buyer mitigate losses. A mitigation requirement may well include an obligation to maximize tax benefits. A representative purchase and sale agreement contained this simple provision: For purposes of this Agreement, any determination of Losses shall be reduced by any Tax Benefits actually received by the Indemnified Party. An obligation on the part of the Buyer to take tax benefits into account raises several questions. SPARKMAN + FOOTE LLP 57
Tax Benefitting Claims The Seller s tax benefit argument is basically that it is unfair to the Seller to allow the Buyer to receive a gross indemnification payment and also to be able to enjoy the tax benefit arising from the circumstances upon which the Buyer s indemnification claims are based. For example, if the Seller has represented that there are no closing date liabilities other than those disclosed, but it is later discovered that there was an undisclosed pre-closing payable of $1,000, the Buyer would have a breach of representation claim for $1,000, If the Seller paid the Buyer a $1,000 indemnification payment because of this claim, the Seller argues that the Buyer could also claim an expense deduction on its income tax return with respect to this pre-closing liability that would save the Buyer (at the 35% rate) $350 of federal income tax. SPARKMAN + FOOTE LLP 58
Tax Benefitting Claims The problems include that the Buyer most likely will not be able to deduct its payment but, instead, will have to include it as a capital cost of purchasing the Seller s assets or equity. There are some provisions in the regulations under IRC 461 that appear to allow a buyer to deduct a liability where the target sells buyer a trade or business and, as part of the sale, buyer expressly assumes a liability described in IRC 461(h), but it appears unlikely that a buyer would be considered to have expressly assumed the liability it pays because of the seller s misrepresentation. Another significant problem is what happens if a dispute arises between the Buyer and Seller with respect to whether the Buyer realized a tax benefit and, if so, how much. Will the Seller be permitted to examine the Buyer s income tax returns? Will the Seller be able to require the Buyer to take a position on its tax return that may disadvantage the Buyer in some way? SPARKMAN + FOOTE LLP 59
Overview of Tax Considerations A fundamental issue is whether the parties wish to structure the transaction as one that will be wholly or partially tax-free: Acquisition for all cash or partly cash and debt will be taxable. Sellers ordinarily will have long-term capital gain except for recapture items. Buyer will obtain cost basis in stock or assets acquired. Special considerations if stock of S corporation is acquired. Acquisition for Buyer s stock may be tax-free. Incorporation on eve of acquisition to attempt to have tax-free treatment. SPARKMAN + FOOTE LLP 60
Overview of Tax Considerations Taxable acquisition Buyer will ordinarily want to acquire assets Tax basis in assets rather than acquired stock Avoidance of seller liabilities Seller of course will ordinarily prefer sale of stock. Combination of taxable acquisition and tax-free incorporation As an inducement to senior owners/management, the buyer may arrange an opportunity for such persons to participate in the formation of an affiliate of the buyer in a transaction that is intended to be tax-free under IRC 351. SPARKMAN + FOOTE LLP 61
Tax-Free Reorganizations Of the 8 different types of tax-free reorganizations (Section 368 of the Internal Revenue Code), the most common are: Type A reorganization (incl. statutory direct merger or consolidation; forward and triangular mergers) Type B reorganization (stock-for-stock acquisition) Type C reorganization (stock-for-assets acquisition) Type D divisive reorganization (spin-offs, split-offs, and split-ups) SPARKMAN + FOOTE LLP 62
TAX-FREE REORGANIZATIONS Four conditions must be met: Continuity of ownership interest (usually satisfied if purchase price at least 50% acquirer stock) (may be as low as 40% in some circumstances) Continuity of business enterprise ( substantially all requirement usually satisfied if buyer acquires at least 70% and 90% of FMV of target gross and net assets) Valid business purpose (other than tax avoidance) Step transaction doctrine (must not be part of larger plan that would have resulted in a taxable transaction) SPARKMAN + FOOTE LLP 63
Type A Reorganization To qualify as a Type A reorganization, transaction must be a statutory merger or consolidation; forward or reverse triangular merger No limits on composition of purchase price (except in reverse triangular merger) No requirement to use acquirer voting stock (except in reverse triangular merger) At least 50% of the purchase price must be in acquirer stock SPARKMAN + FOOTE LLP 64
Type A Reorganization (cont.) Advantages: Acquirer can issue non-voting stock to target shareholders without diluting its control over the combined companies Acquirer may choose not to acquire all of the target s assets Allows use of more cash in purchase price than Types B and C reorganizations Disadvantages: Acquirer assumes all undisclosed liabilities Requires acquirer shareholder approval if new shares are to be issued or number of new shares exceeds 20% of the firm s shares traded on public exchanges. Limitations of asset dispositions within two years of closing SPARKMAN + FOOTE LLP 65
Continuity of Interests and Business Enterprise Principles 1 Purpose: To ensure that subsidiary mergers do not resemble sales, making them taxable events Continuity of interests: A substantial portion of the purchase price must consist of acquirer stock to ensure target firm shareholders have a significant ownership position in the combined companies Continuity of business enterprise: The buyer must either continue the acquired firm s historic business enterprise or buy substantially all of the target s historic business assets in the combined companies. Continued involvement intended to demonstrate long-term commitment by acquiring company to the target. 1These principles are intended to discourage acquirers from buying a target in a tax free transaction and immediately selling the target s assets, which would reflect the acquirer s higher basis in the assets possibly avoiding any tax liability when sold. SPARKMAN + FOOTE LLP 66
Direct Statutory Merger ( A Reorganization) Acquiring Firm Assets & Liabilities Acquirer Stock & Boot Target Firm ( (assets and liabilities merged with acquirer) Target Stock Target Shareholders (Receive voting or nonvoting acquirer stock in exchange for target stock and boot) Contracts may need to be assigned or transferred. Under some state laws, e.g. C.R.S 7-90-204, a merger does not constitute a conveyance, transfer, or assigment. Remaining target assets/liabilities assumed by acquirer; acquirer & target shareholder approval required in most states; dissenting shareholders may have appraisal rights. No asset write-up. Target s tax attributes transfer to acquirer but are limited by Section 382 and 383 of Internal Revenue Code (IRC). SPARKMAN + FOOTE LLP 67
Statutory Consolidation ( A Reorganization) Company A (Contributes assets & liabilities to Newco) Assets/Liabilities Company B (Contributes assets & Liabilities to Newco) New Company (Newco) Company A Shareholders Comment same as Slide 20. Newco Stock Company B Shareholders SPARKMAN + FOOTE LLP 68
Forward Triangular Merger ( A Reorganization) Target Firm (Merges assets and liabilities with the parent s wholly-owned subsidiary) Parent s Stock/Cash Acquiring Company Subsidiary s Stock Target Assets and Liabilities Subsidiary (Shell created by parent and funded by parent s cash or stock) Parent s Stock & Boot Target Stock Target Shareholders (Receive voting or nonvoting stock held by parent s wholly owned subsidiary in exchange for target stock) Substantially all and continuity of interests requirements apply. Flexible form of payment. Avoids transfer taxes and may insulate parent from target liabilities and eliminate acquirer shareholder approval unless required by stock exchange or new shares issued exceed 20% of acquirer s outstanding shares. No asset writeup. Target tax attributes transfer but subject to limitation. Target shareholder approval required. However, as target eliminated, nontransferable assets and contracts may be lost. SPARKMAN + FOOTE LLP 69
Reverse Triangular Merger ( A Reorganization) Acquiring Company Target Firm (Receives assets and liabilities of acquiring firm s wholly owned subsidiary) Parent s Voting Stock Subsidiary s Stock Subsidiary s Assets and Liabilities Subsidiary (Shell created by parent and funded by parent s voting stock merged into target firm) Parent s Stock & Boot Target Stock Target Shareholders (Receive parent s voting stock held by parent s wholly owned subsidiary in exchange for target stock) Target survives as acquirer subsidiary. Target tax attributes and intellectual property and contracts transfer automatically; may insulate acquirer from target liabilities and avoid acquirer shareholder approval. At least 80% of purchase price must be in acquirer voting shares. No asset writeup. Acquirer must buy substantially all of the FMV of the target s assets and target tax attributes transfer subject to limitation. SPARKMAN + FOOTE LLP 70
Type B Stock for Stock Reorganization To qualify as a Type B Reorganization, acquirer must use only voting stock to purchase at least 80% of the target s voting stock and at least 80% of the target s non-voting stock Cash may be paid in lieu of fractional shares Acquirer may pay expenses of target if creditor paid directly. Used mainly as an alternative to a merger or consolidation Advantages: Target may be maintained as an independent operating subsidiary or merged into the parent Stock may be purchased over a 12 month period allowing for a phasing of the transaction (i.e., creeping acquisition ) Disadvantages: Lack of flexibility in determining composition of purchase price Potential dilution of acquirer s current shareholders ownership interest May have minority shareholders if all target shareholders do not tender their shares SPARKMAN + FOOTE LLP 71
Type B Stock for Stock Reorganization Acquiring Firm (Exchanges voting shares for at least 80% of target voting & non- Voting shares ) Shell Stock Target Stock Acquirer Voting Stock (No Boot) Target Shareholders Wholly-Owned Shell Subsidiary Target Assets and Liabilities Target Firm (Merged into acquiring firm s subsidiary) Buyer need not acquire 100% of target shares, shares may be required over time, and may insulate acquirer from target liabilities. May insulate parent from target s liabilities and tax attributes transfer subject to limitation. Suitable for target shareholders with large capital gains and therefore willing to accept acquirer shares to avoid capital gains taxes triggered in a stock for cash sale. SPARKMAN + FOOTE LLP 72
Type C Stock for Assets Reorganization To qualify as a Type C reorganization, acquirer must purchase 70% and 90% of the fair market value of the target s gross and net assets, respectively. The acquirer must use only voting stock Boot cannot exceed 20% of FMV of target s pre-transaction assets (value of any assumed liabilities deducted from boot) 1 The target must dissolve following closing and distribute the acquirer s stock to the target s shareholders for their canceled target stock Advantages: Acquirer need not assume any undisclosed liabilities Acquirer can purchase selected assets Disadvantages: Technically more difficult than a merger because all of the assets must be conveyed Transfer taxes must be paid Need to obtain consents to assignment on contracts Requirement to use only voting stock potentially resulting in dilution of the acquirer shareholders ownership interest 1 Value of assumed liabilities viewed as part of purchase price. SPARKMAN + FOOTE LLP 73
Type C Stock for Assets Reorganization Acquiring Firm (Exchanges voting shares for at least 80% of FMV of Target assets) Target Assets Acquirer Voting Stock & Boot Target Firm (Liquidates and transfers Acquiring Firm shares and any remaining assets to shareholders) Acquirer Voting Stock & Boot Target Cancelled Stock Target Shareholders Enables buyer to be selective in choosing assets and any liabilities, if at all, it chooses to assume. Avoids transfer taxes, requires consents to assignment, and potentially dilutive to acquirer shareholders. No asset writeup. Tax attributes transfer to acquirer subject to limitation. SPARKMAN + FOOTE LLP 74
Type D Divisive Reorganizations Type D Divisive Reorganizations apply to spin-offs, split-ups, and split-offs Spin-Off: Stock in a new company is distributed to the original company s shareholders according to some pre-determined formula. Both the parent and the entity to be spun-off must have been in business for at least five years prior to the spin-off. Split-off: A portion of the original company is separated from the parent, and shareholders in the original company may exchange their shares for shares in the new entity. No new firm created. Split-up: The original company ceases to exist, and one or more new companies are formed from the original business as original shareholders exchange their shares for shares in the new companies. For these reorganizations to qualify as tax-free, the distribution of shares must not be for the purpose of tax avoidance. SPARKMAN + FOOTE LLP 75
Implications of Tax Considerations for Deal Structuring In taxable transactions, target generally demands a higher purchase price Higher purchase price often impacts form of payment as buyer tries to maintain PV of transaction by deferring some of purchase price Buyer may avoid EPS dilution by buying target stock or assets using a non-equity form of payment in a taxable transaction If buyer wants to preserve cash and obtain target s tax credits, buyer may use its stock to purchase target stock in a non-taxable transaction SPARKMAN + FOOTE LLP 76
Continuity of Interests and Business Enterprise Principles 1 Purpose: To ensure that subsidiary mergers do not resemble sales, making them taxable events Continuity of interests: A substantial portion of the purchase price must consist of acquirer stock to ensure target firm shareholders have a significant ownership position in the combined companies Continuity of business enterprise: The buyer must either continue the acquired firm s historic business enterprise or buy substantially all of the target s historic business assets in the combined companies. Continued involvement intended to demonstrate long-term commitment by acquiring company to the target. 1 These principles are intended to discourage acquirers from buying a target in a tax free transaction and immediately selling the target s assets, which would reflect the acquirer s higher basis in the assets possibly avoiding any tax liability when sold. SPARKMAN + FOOTE LLP 77
Acquiring (Transferee) Corporation No gain/loss recognized when it receives assets in tax-free reorganization Carryover basis of qualifying property Gain recognized lesser of gain realized or FMV of nonqualified property received Carryover holding period SPARKMAN + FOOTE LLP 78
Shareholders & Security Holders (1 of 2) No gain/loss on stock or securities received if exchanged solely for stock or securities as part of reorganization plan Gain recognized lesser of gain realized or cash plus FMV of other property received SPARKMAN + FOOTE LLP 79
Shareholders & Security Holders (2 of 2) Basis of stocks & securities received Adjusted basis in stocks & securities given up + Gain recognized on the exchange - Money & FMV of other property received = Basis of nonrecognition property received SPARKMAN + FOOTE LLP 80
Divisive Reorganizations Part of corporation s assets transferred to a second corporation which is owned by either the original corporation or its shareholders Divisive D reorganizations Split-off Spin-off Split-up SPARKMAN + FOOTE LLP 81
Split-off Corporation transfers assets to a controlled subsidiary in exchange for subsidiary s stock Subsidiary s stock then transferred to one or more shareholders in exchange for parent corporation stock SPARKMAN + FOOTE LLP 82
Spin-off Corporation transfers assets to subsidiary in exchange for subsidiary s stock Parent distributes subsidiary s stock to all parent shareholders on a pro rata basis Parent receives nothing in exchange for distribution of subsidiary stock SPARKMAN + FOOTE LLP 83
Split-up Existing corporation transfers all assets to two or more new controlled subsidiaries in exchange for subsidiaries stock Parent distributes all stock of each subsidiary to existing shareholders in exchange for all outstanding parent stock and liquidates SPARKMAN + FOOTE LLP 84
Judicial Restrictions on Reorganizations (1 of 2) If judicial restrictions are not met, reorganization loses its tax-free status Continuity of proprietary interest Old owners must continue ownership Continuity of business enterprise Old assets must be used in new business SPARKMAN + FOOTE LLP 85
Judicial Restrictions on Reorganizations (2 of 2) Business purpose Valid business purpose for transaction Step transaction doctrine IRS may collapse series of independent transactions if all part of same plan SPARKMAN + FOOTE LLP 86
Tax Attributes Tax attributes follow assets NOLs, capital losses, E&P, general business credit, inventory methods Acquiring corporation obtains control of both assets & attributes in A, C, and acquisitive D reorganizations Asset ownership does not change in B reorganizations SPARKMAN + FOOTE LLP 87
Limitation on Use of Tax Attributes (1 of 2) 382 & 269 prevent assets or stock purchases if primary purpose is obtaining loss carryovers 382 & 269 also prevent a loss corporation from purchasing a profitable corporation if primary purpose is using its existing losses SPARKMAN + FOOTE LLP 88
Limitation on Use of Tax Attributes (2 of 2) 383 restricts tax credit and capital loss carryovers if 382 applies Restrictions similar to NOLs 384 prevents pre-acquisition losses of either acquiring or target corporation (loss corporation) from offsetting built-in gain recognized during 5 yrs after acquisition by another corporation (gain corporation). SPARKMAN + FOOTE LLP 89
Incorporation on Eve of Acquisition ( 1 of 22) Only corporations may engage in tax-free reorganizations under IRC 368. A target LLC may want to incorporate to be able to engage in a tax-free reorganization. SPARKMAN + FOOTE LLP 90
Incorporation on Eve of Acquisition ( 2 of 22) Incorporation of an LLC ordinarily will be tax-free under IRC 351. IRC 351 requires, inter alia, that [n]o 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... of the corporation. SPARKMAN + FOOTE LLP 91
Incorporation on Eve of Acquisition ( 3 of 22) Section 351 defines control as the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. SPARKMAN + FOOTE LLP 92
Incorporation on Eve of Acquisition ( 4 of 22) Incorporations on the eve of a stock swap or initial offering may raise questions under the step-transaction doctrine regarding whether the incorporators had control immediately after the incorporation. If an LLC converts to a corporation, it will be treated for federal income tax purposes as a transfer of all the assets of the LLC to the corporation in exchange for the stock of the corporation, followed by liquidation of the LLC and distribution of the stock to its members. SPARKMAN + FOOTE LLP 93
Incorporation on Eve of Acquisition ( 5 of 22) If the members of an LLC enter into a stock exchange agreement with another corporation after converting the LLC to a corporation, the IRS may seek to treat the transaction as a taxable exchange of the acquirer s stock for LLC interests by invoking the step transaction or substance over form doctrines. SPARKMAN + FOOTE LLP 94
In such a case, the IRS would assert that the LLC members did not actually acquire control of the corporation formed by converting the LLC to a corporation, but rather never had control because they received the stock of the resulting corporation as part of a pre-conceived plan to transfer the stock in the stock exchange with the public acquiring SPARKMAN + FOOTE LLP 95 corporation. Incorporation on Eve of Acquisition ( 6 of 22)
Incorporation on Eve of Acquisition ( 7 of 22) S. Klien on the Square, Inc. v. Comm r, 188 F.2d 127 (2d Cir. 1951), cert. denied, 342 U.S. 824 (1951); Hazeltine Corp. v. Comm r, 89 F.2d 513 (3d Cir. 1937); Intermountain Lumber Co. v. Comm r, 65 T.C. 1025 (1976); Rev. Rul. 1979-194, 1979-1 C.B. 145; Rev. Rul. 1979-70, 1979-1 C.B. 144; Rev. Rul. 1970-522, 1970-2 C.B. 81; see also, e.g., Abegg v. Comm r, 429 F.2d 1209; King Enters., Inc. v. Comm r, 418 F.2d 511 (Ct. Cl. 1969); McDonald s Rests. of Illinois, Inc. v. Comm r, 688 F.2d 520 (7th Cir. 1982); Rev. Rul. 2001-26, 2001-1 C.B. 1297 (all applying step transaction principles to a series of events taking place over several months). SPARKMAN + FOOTE LLP 96
Incorporation on Eve of Acquisition ( 8 of 22) The regulations under 368 take seriously the business-purpose requirement. Treas. Reg. 1.368-1(b) states that the reorganization provisions are concerned with readjustments of corporate structures... required by business exigencies. SPARKMAN + FOOTE LLP 97
Incorporation on Eve of Acquisition ( 9 of 22) Treas. Reg. 1.368-1(c) provides that a scheme that involves an abrupt departure from normal reorganization procedure in connection with a transaction on which the imposition of a tax is imminent is not a plan of reorganization. SPARKMAN + FOOTE LLP 98
Incorporation on Eve of Acquisition ( 10 of 22) This would include a transaction where the corporate reorganization was considered a disguise for concealing its real character, where the object and accomplishment is the consummation of a preconceived plan having no business or corporate purpose other than tax avoidance. SPARKMAN + FOOTE LLP 99
Incorporation on Eve of Acquisition ( 11 of 22) See also Treas. Reg. 1.368-2(g), which states that the transactions must be undertaken for reasons germane to the continuance of the business of a corporation, and that the statute contemplates genuine corporate reorganizations which are designed to effect a readjustment of continuing interests under modified corporate forms. SPARKMAN + FOOTE LLP 100
Incorporation on Eve of Acquisition ( 12 of 22) To make an LLC reorganization as a corporation work, the conversion to the corporate form must be done before an agreement is reached about the sale; the corporation s existence should be at least somewhat old and cold. The conversion of the partnership or LLC to a corporation should not be completed on the eve of entering into the stock exchange agreement. SPARKMAN + FOOTE LLP 101
Incorporation on Eve of Acquisition ( 13 of 22) In Weikel v. Commissioner, 51 TCM 432 (1986), a taxpayer transferred a patent he owned personally to a newly formed corporation, Dispersalloy, Inc., and then four months later entered into an Agreement and Plan of Reorganization for a share-for-share exchange (similar to a type B reorganization). SPARKMAN + FOOTE LLP 102
Incorporation on Eve of Acquisition ( 14 of 22) The Tax Court held that the taxpayer had a substantial business purpose for the formation of Dispersalloy, Inc. and the transfer of his patent to it in September 1973. In this case, the taxpayer was in negotiations with Johnson & Johnson at the time of formation of his corporation. He was also talking to other potential acquirers at the time. SPARKMAN + FOOTE LLP 103
Incorporation on Eve of Acquisition ( 15 of 22) Perhaps most importantly for the determination of a business purpose, the taxpayer s attorney had advised him that he should incorporate whether or not he did a deal with Johnson & Johnson since: SPARKMAN + FOOTE LLP 104
Incorporation on Eve of Acquisition ( 16 of 22) It was clear that any acquirer would want to structure an acquisition of the taxpayer s business so that it could be treated as a pooling of interests; and It made sense to incorporate because the taxpayer s business was beginning to generate profits. SPARKMAN + FOOTE LLP 105
Incorporation on Eve of Acquisition ( 17 of 22) In objecting to the non-recognition of gain on the appreciated asset (the patent), the IRS relied on West Coast Marketing Corp. v. Commissioner, 46 T.C. 32 (1966), and Rev. Rul. 1970-140, 1970-1 C.B. 73. The court in Weikel distinguished West Coast Marketing on the grounds that: SPARKMAN + FOOTE LLP 106
Incorporation on Eve of Acquisition ( 18 of 22) 1) The taxpayer in West Coast Marketing transferred real estate to a new corporation solely to facilitate a transfer to an unrelated corporation; 2) All of the detail of the transfer to the acquiring corporation had been agreed on at the time of the transfer; and SPARKMAN + FOOTE LLP 107
Incorporation on Eve of Acquisition ( 19 of 22) 3) The taxpayer s corporation was liquidated soon after the acquisition. SPARKMAN + FOOTE LLP 108
Incorporation on Eve of Acquisition ( 20 of 22) Likewise, the court distinguished Rev. Rul. 1970-140 on the basis that the taxpayer in the ruling had already agreed to transfer the stock of the new corporation before the taxpayer incorporated it and transferred property to it. In both cases, the new corporation was not old and cold before the transaction was finalized. SPARKMAN + FOOTE LLP 109
Incorporation on Eve of Acquisition ( 21 of 22) Weikel illustrates the importance of establishing a business purpose for the incorporation of the LLC apart from the potential acquisition and incorporating the LLC before there is a binding agreement to dispose of the shares received by the members. SPARKMAN + FOOTE LLP 110
Incorporation on Eve of Acquisition ( 22 of 22) Interestingly, in a case arising out of the same transaction that was held in abeyance pending the decision in Weikel, Johnson & Johnson argued that its acquisition of Dispersalloy should be treated as a taxable purchase. Johnson & Johnson wanted a cost basis. SPARKMAN + FOOTE LLP 111
Corporate Inversions The basic concept of an inversion is a transaction in which a United States parent becomes a subsidiary of a new foreign parent corporation ( NFP ). If done alone under NFP, it is a self-inversion If done in connection with a target (typically foreign), it is a combination migration transaction SPARKMAN + FOOTE LLP 112
Corporate Inversions Inversions offer four main areas of potential tax benefits: Future foreign expansion under NFP outside of U.S. tax net. Tax efficient leverage on the group s U.S. operations. Restructuring of foreign legacy operations owned by the U.S. group. Better access to offshore cash for NFP dividends, share buybacks, etc. SPARKMAN + FOOTE LLP 113
Corporate Inversions The IRS issued regulations under IRC 367 in the mid 1990 s that require in selfinversions and other combination transactions that the U.S. shareholders of the U.S. parent recognize gain (but not loss) on the exchange of their U.S. parent stock for stock of NFP. SPARKMAN + FOOTE LLP 114
Corporate Inversions In 2004, Congress added section 7874 to the IRC to limit inversion transactions (mostly self inversions) not at the shareholder level with a tax (although those rules were retained) but at the NFP level (and sometimes at the U.S. parent level. SPARKMAN + FOOTE LLP 115
Corporate Inversions Section 7874 s main weapon is to treat the NFP as a domestic corporation for all U.S. tax purposes if three conditions are met: SPARKMAN + FOOTE LLP 116
Corporate Inversions The three conditions are: A foreign corporation acquires substantially all of the assets or stock of a domestic corporation or partnership; Former equity holders of the U. S. company own more than 80% of the NFP; and The overall group, tested after the deal, does not have substantial business activities in the country where the NFP is incorporated. SPARKMAN + FOOTE LLP 117
Corporate Inversions If the above three conditions are met except that former equity owners of the U.S. company own 60% or more but less than 80% of the stock of the NFP, an excise tax is imposed on the untaxed value of officers and directors stock-based compensation, and limits are placed on the use of the U.S. company s tax attributes with respect to transactions with the NFP and other related foreign corporations. SPARKMAN + FOOTE LLP 118
Corporate Inversions-IRC 7874 Example Canadian Newcorp, publically traded on Toronto stock exchange, acquires all of the membership interests of a domestic LLC taxed as a partnership. SPARKMAN + FOOTE LLP 119
Corporate Inversions-IRC 7874 Example Canadian Newcorp, as a result of section 7874 is treated as a U.S. corporation for all purposes of U.S. taxation. But is still a Canadian corporation as far as Revenue Canada is concerned. SPARKMAN + FOOTE LLP 120
Corporate Inversions-IRC 7874 Example Canadian shareholders who receive dividends from Newcorp are taxable in U.S. Revenue Canada views them as having received dividends from a Canadian corporation. SPARKMAN + FOOTE LLP 121
Corporate Inversions-IRC 7874 Example Unclear of effect on this of U.S.-Canada income tax treaty. Shareholders may have to rely on foreign tax credits to be made whole. SPARKMAN + FOOTE LLP 122
Strafford CLE Webinar-February 4, 2016 Drafting Stock Purchase Agreements Securities Law Issues in Stock Purchase Transactions Matthew A. Cole Jacobs Law Group, PC
Sales of 100% of a Corporation s Stock are Securities Offerings? Yes. If you are selling some or all of the stock you own in a corporation, you are engaging in a securities offering. The United States Supreme Court in Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985) ruled that a sale of a business structured as a stock purchase involved the sale of a security under federal securities law. Note that in an asset sale, this issue does not arise. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 124
Other Equity Sales and the Securities Laws While the courts and regulators have sometimes held that other types of equity interests, such as membership interests in limited liability companies, are not securities under federal or state law, it is prudent to treat all equity sales of a business as securities offerings. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 125
Consequences for Sellers and Buyers Unless there is an applicable exemption from registration, securities offerings and sales must be registered with the Securities and Exchange Commission and possibly state regulators, a costly, time-consuming process. Sellers need to conduct some due diligence regarding their buyers. Sellers may want to obtain various securities exemption-related representations and warranties from buyers to qualify for particular exemptions. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 126
Consequences for Sellers and Buyers (Con t.) If the buyer is a private equity fund or other institutional purchaser, it is much easier to handle this issue because the financial strength of the buyer will often determine whether various securities registration exemptions apply. There may also be added complications if the purchaser is not an accredited investor (someone who meets certain minimum income or asset (other than primary home) requirements). The available securities exemptions may be limited or less certain to apply if the purchaser is not an accredited investor. If the sale of the business is a securities offering, the sale is subject to the antifraud rules of the federal and state securities laws, such as Rule 10b-5. These concern whether the seller has disclosed all material information that would be of interest to an investor regarding the stock and the underlying business being sold. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 127
Are Purchase Price Notes Securities? Generally, Yes. Attorneys are often surprised to learn that a purchase price promissory note is a security. Purchase price promissory notes may seem different from a bond or other debt securities because they often are secured notes, the collateral being the stock sold, and thus do not feel like securities. However,, promissory notes generally are securities. This is because the Securities Act of 1933, which regulates the offer and sale of securities in the United States, includes the term notes in its laundry list of securities. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 128
The Supreme Court on Notes as Securities A United States Supreme Court case, Reves v. Ernst & Young, 494 U.S. 56 (1990), provides that notes are presumed to be securities unless they meet one of four factors in a family resemblance test. The application of the test centers on whether the note seems more like an investment or is more similar to non-investment commercial instruments. For example, home mortgage notes and notes made by small business borrowers secured by the business assets are not securities. There are gray areas here that may be difficult to analyze, so careful consideration is necessary regarding the nature of the purchase price promissory note. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 129
Purchase Price Notes as Securities The note offering may raise more securities law compliance issues than the stock sale itself raises. One reason for this is the nature of the seller versus the buyer. A single buyer, even an individual, who is purchasing all stock of a corporation may be more likely to qualify for various accredited investor-related exemptions than a group of sellers. If there are multiple individual sellers of stock, some of those sellers may own a small portion of the outstanding stock and may not have the financial qualifications to be sophisticated investors. An adult grandchild who inherited a few percent of the stock in a closely held corporation or an employee of the seller would be simple examples of sellers who might not qualify as accredited investors. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 130
Purchase Price Notes as Securities (Con t.) Unless there is an applicable exemption from registration, securities offerings and sales must be registered with the Securities and Exchange Commission and possibly state regulators, a costly, timeconsuming process. Buyers need to conduct some due diligence regarding their sellers for these reasons. Buyers may also want to obtain representations and warranties from sellers regarding whether they are accredited investors as well as on other securities law-related matters. The existence of non-accredited investor can result in difficulties in finding appropriate securities law exemption. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 131
Paying Brokers or Finders Fees in a Stock Sale Securities regulators have historically treated a finder s fee or other payment tied to the sale of stock as an impermissible finder s fee. To be eligible to receive these fees, a finder would have needed to register as a broker-dealer or affiliate with one under applicable securities laws. This, however, is not only the finder s problem. A buyer might be able to have a stock sale unwound because of the involvement of a finder not registered as a broker dealer. This issue does not arise in an asset sale. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 132
Limited SEC Relief for M&A Finders A few years ago, the SEC issued a no-action letter (interpretive guidance that is only applicable to the person who requested the letter but is often used as persuasive authority) relaxing its position that all finders involved in stock sales need to register as broker-dealers. M&A Brokers, 2014 SEC No-Act. LEXIS 92 (Jan. 31, 2014, revised Feb. 4, 2014). The finder does not need to register if a number of criteria are met, including: The finder must not have any authority to bind any parties in the transaction Following the transaction, the buyer must control and actively operate the business purchased through the stock sale The finder must not take possession of funds or securities involved in the transaction The finder must not provide financing for the transaction or assist in forming any buyer group involved in the transaction. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 133
Strafford CLE Webinar-February 4, 2016 Drafting Stock Purchase Agreements Drafting Mistakes in Stock Purchase Agreements Matthew A. Cole Jacobs Law Group, PC
(Some) Drafting Mistakes in Stock Purchase Agreements Many drafting mistakes are the same as those that tend to occur in commercial contracts generally. Boilerplate and Miscellaneous sections of stock purchase agreements should be read more carefully than they generally are. For example, if you have a somewhat outdated notice provision in your stock purchase agreement, e.g., one that does not provide for at least fax, and more preferably, email notices and communications, you need to consider whether that is appropriate for your type of deal. Likewise, consider the strong financial impact that some provisions often appearing in the miscellaneous section, such as loser pays and poorly drafted arbitration clauses may have on your client in a stock purchase transaction. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 135
Providing for venue in a jurisdiction differing from the governing law While occasionally parties may have a reason for having different state governing law and state jurisdiction, it is not typically a good compromise to provide for Delaware governing law and a venue in New York or California. This is because one does not usually want a court in a particular state ruling on any other law than that with which it is most familiar. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 136
Not obtaining representations and warranties about the business itself When purchasing 100% of the outstanding equity securities of an entity, a buyer should not merely be concerned with representations and warranties about the securities sold. Because the buyer is indirectly purchasing the entire business, representations and warranties regarding the entity itself, such as its material contracts, financial statements, intellectual property, compliance with laws, and other common representations and warranties in an asset purchase agreement are equally valuable for a buyer in a stock purchase transaction. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 137
Failing to define accounting terminology carefully Buyers and sellers may want to consider consulting with an accountant to define properly various accounting terms, such as revenue, net income and the like. Consider, for example, whether these terms should be as defined in GAAP, or Generally Accepted Accounting Principles. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 138
Including Vague Earn-Out Provisions Earn-out provisions are difficult to draft. Trying to control how a business operates after you, the seller, are no longer the business owner and often not involved in the business postclosing will be met with strong resistance from the purchaser of your shares. However, not having sufficient control procedures in the stock purchase agreement may mean that the selling shareholder will never be able to be certain whether earn-out milestones have been met or whether a buyer has been able to manipulate the business finances to avoid paying the selling shareholder an earned earn-out. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 139
The date as of which representations and warranties are being made If the stock purchase transaction is one in which the agreement is signed and the closing is some days (or even months later), both parties need to consider as of which date the representations and warranties should be made. Most Buyers will want to the representations and warranties to be true as of both the contract signing and closing date. Sometimes, stock purchase agreements do not provide for this. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 140
The survival of some or all representations and warranties Even if the drafters of the stock purchase agreement are careful to provide that the representations and warranties must be true as of the signing as well as later closing date, problems may arise for Buyers who do not carefully consider what representations and warranties should survive the closing date. Providing for survival allows the Buyer to discover and make a claim of breach even if the Buyer discovers post-closing (but before the expiration of the survival period) that a Seller representation or warranty was untrue as of the closing date (or even the signing date). Copyright 2016, Matthew Cole, Jacobs Law Group, PC 141
The survival of some or all representations and warranties (Con t.) A basic contract law principle is that post-closing discovery of representations and warranty breaches by a Buyer are not actionable unless provisions have been inserted for the representations and warranties to survive the closing date. Some parties will heavily negotiate which representations and warranties survive and for how long. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 142
The survival of some or all representations and warranties (Con t.) As noted above, Buyers may request longer survival period for the Seller representations and warranties that, if breached, will be more costly to the Buyer. Defective title to stock, taxes, environmental matters, employee benefits, and finder s fees are some examples of those more serious representations and warranties. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 143
Permitting Terms of the Agreement to be Disclosed Most parties to a stock purchase agreement enter into a confidentiality agreement that with respect to the Seller s information and, sometimes, Buyer information that will be disclosed to the Seller (such as regarding a Buyer s financial state). Some attorneys do not focus, however, on protecting the confidentiality of the deal itself. The business the Buyer has just effectively purchased may be harmed if a disgruntled Seller can disclose sensitive details about the purchase price and other deal terms. Seller and Buyer should consider mutual non-disclosure covenants to avoid this problem. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 144
Not Preventing Operational Changes Between Signing and Closing How a business is operated post-signing but pre-closing is critical. Not obtaining covenants from the Sellers that they will cause the entity they own to operate the business in the normal course consistent during the period between signing and closing may lead to unwelcome surprises for the Buyer who now owns a business that is not nearly as robust as the Buyer thought it was purchasing. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 145
Failing to Obtain Appropriate Restrictive Covenants from Sellers Failing to obtain non-competition and non-solicitation covenants from the Seller can be a costly problem that will result in a loss in value of the business just purchased. Likewise, Sellers should be wary of overly restrictive noncompetition and non-solicitation covenants requested by Buyer, particularly because courts are typically willing to enforce more stringent restrictive covenants against a seller than they are willing to permit with respect to an employee. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 146
Not Addressing Required Consents at the Entity Level Properly A Seller will typically be asked to represent that selling the shares does not cause a default under any agreement to which the Seller is a party. However, a Buyer will also want to be concerned with agreements, such as leases or financing documents, that the corporation whose shares are being sold is a party to and whether a default or consent is required under those agreements. For example, even though the corporation may be a tenant under a lease and the lease is not being assigned, the lease may contain a provision stating that a change in control of the corporation is deemed to be an assignment requiring landlord consent. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 147
Pitfalls in Using Arbitration While not that common, some parties will request that an arbitration clause be used for all disputes under the stock purchase agreement. Attorneys will want to carefully consider whether this is in their client s best interests. Arbitration is not necessarily less expensive or faster than a courtroom hearing. The parties bear the costs of the arbitrators directly, which can be considerable over time. For example, a panel of three arbitrators can increase the cost of arbitration exponentially over the use of a single arbitrator. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 148
Pitfalls in Using Arbitration (Con t.) Arbitration awards are not appealable in the traditional sense as there is no appellate forum typically for an arbitration judgment. Moreover, the standards for asking a court to overturn an arbitration decision are very high and rarely met. If not drafted properly, the parties expectations about finality of the award may not come to pass, and the parties may end up in court eventually. There are many other drafting traps to avoid, such as not including specific confidentiality provisions regarding the process and award, which can be one reason a party desires to use arbitration rather than the court system in the first place. Copyright 2016, Matthew Cole, Jacobs Law Group, PC 149