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SAFEGUARDING THE BUYER’S POST-CLOSING CLAIMS
FOR INDEMNIFICATION
Reprinted with Permission
New Jersey Lawyer, December 2002/No. 18
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how to protect a buyer’s claims for indemnification from the seller s of a
business, after the closing of the transaction, whether the sale is in the
form of a stock purchase or an asset purchase.
Where an Asset purchase agreement is involved, and the seller is a
closely held entity, customarily, but not always, all of selling owners
are required to be parties to the agreement. The purpose of making owners
who are not active in the business of the seller parties is to have them
join in the warranties and representations, and in the duty to indemnify
the buyer post-closing for breaches of the warranties and representations
in the purchase agreement.
Failure of the buyer at the time of the negotiation of the purchase
agreement to consider safeguards for the buyer’s post-closing claims for
indemnification against the seller and the selling owners for breaches of
warranties and representations in the purchase agreement can result in the
purchase agreement being left without any practical remedy.
Typically, letters of intent do not cover much, if anything, concerning
specific warranties and representations which the buyer will insert in the
purchase agreement. Often the letters of intent omit this subject
completely or merely state that the purchase agreement will contain the
warranties and representations customary for such transactions. However,
even where a hint is given about the requirement of warranties and
representations, nothing is said about which of them will merge at closing
and which will survive and for how long. Additionally, letters of intent
and deal point memoranda commonly are silent regarding provisions for
indemnification that will be part of the purchase agreement.
When the purchase agreement is drafted and negotiations commence on
warranties and representations and indemnification, the parties often do
not give much direction to their attorneys on what positions they should
take and whether any of the issues could constitute a deal-killer. The
indemnification provisions are sometimes first addressed with serious
interest after the draft purchase agreement has been furnished to the
seller and the selling owners’ lawyer. With the foregoing in mind,
consider the following unfortunate scenario.
An Unfortunate Scenario
The deal was a stock purchase, with the entire purchase price paid at
closing. The company was owned by three people - the company’s president
and chief operating officer, who owned 75% of the stock (the major
shareholder), and two investors who were not active in the business (the
non-active shareholders). The non-active shareholders were made parties to
the stock purchase agreement solely to bind them to the sale of their
shares and to make specific warranties and representations regarding their
ownership of the shares, free of liens and claims of others. The buyer
acquiesced in the non-active shareholders’ request that they not be
required to join in the warranties and representations and attendant
indemnification undertakings concerning the business of the company, its
assets and liabilities.
The stock purchase agreement provided that except for tax liabilities
(regarding which there was no contract limitation period), most of the
warranties and representations survived the closing for only 12 months,
and that any claim for indemnification had to be made within that 12-
month period. The buyer, its attorney and accountant agreed to this
because they were confident that if there were any worms in the woodwork
they would come to light relatively soon after the closing.
However, despite the fact that the buyer was sophisticated and had
engaged in reasonable due diligence in making the deal, a little over a
year after the closing the buyer learned that it had substantial claims
against the major shareholder for breach of warranties and
representations. By the time the claims were uncovered and demand for
indemnification was made, the major shareholder had transferred almost all
of his assets to his spouse.
The first and most devastating problem for the buyer is that its claim
for indemnification, absent a showing that the warranties and
representations were made fraudulently, will be barred by the one-year
limitation provision in the agreement. But even if the agreement provided
for a longer period for the buyer to assert a claim for an indemnified
liability, the buyer would have difficult recovering its damages. Yes, the
buyer could start suit against the major shareholder and his spouse,
asserting that the transfer of assets to the spouse was fraudulent as
because the major shareholder did not receive reasonably equivalent value
in exchange for the transfer and the major shareholder believed or should
have believed that he would incur an obligation to the buyer for an
indemnified liability beyond his ability to pay when due. But it is
obvious that such a suit would be expensive, time consuming and lead to an
uncertain result, since what the major shareholder believed or should have
believed may difficult to prove.
What Safeguards Could the Buyer Have Required in the Purchase
Agreement?
What could the buyer have done at the time of the negotiation of the
purchase agreement to put himself in a far better position? Perhaps the
buyer could have required any or all of the following, measures, depending
on the buyer’s leverage and other circumstances:
 | The non-tax liability warranties and representations survive for
a much longer period than 12 months from the closing;
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| The non-active shareholders are parties to all of the warranties
and representations and indemnification undertakings, on a joint and
several basis;
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| A substantial part of the purchase price is to be paid over a
period of years, pursuant to a non-negotiable promissory note and
includes a right of set-off against amounts payable under the note in
the event of a breach of a warranty and representation;
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| At closing, a reasonable amount of cash (or the buyer’s stock,
if the transaction involved stock for stock) be placed in an escrow fund
for a substantial period, perhaps ending with the outside date for
survival of the major shareholder’s
warranties and representations;
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| In the absence of an escrow fund, the major shareholder gives a
mortgage or security interest in some form of collateral to secure the
liability on the indemnification undertakings;
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| The major shareholder and his or her spouse both submit a fairly
detailed and certified personal financial statement detail at the time of
the signing of the purchase agreement and that they re-certify the
statements as of the closing date, with the buyer to have the right to
refuse to close in the event of any material adverse changes in the
personal financial statement between contract and closing; and
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| The major shareholder’s spouse sign the purchase agreement for the
sole purpose of joining in the indemnification undertakings, with the
spouse’s liability limited to the value of any assets transferred to the
spouse subsequent to the signing of the purchase agreement. |
Each of these potential safeguards will now be examined in
detail.
Survival Period for Warranties and
Representations
The lawyer for a seller or the selling owners often tries to negotiate
that most of the warranties and representations do not survive the
closing, and that those that do, expire if claims for indemnification are
not asserted within 24 months from the closing (except for taxes and
product liability claims).
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As indicated above, the clients on both sides are usually not much help
on this issue; and sometimes the buyer does not express a strong interest
when his or her lawyer discusses the fine points, risks and probabilities,
with the result that the issue is compromised to the detriment of the
buyer without a profound risk assessment.
While the selling owners and the company have an interest in closure so
that they don’t have a long period of overhang where the buyer can come
back at them, the buyer’s interest in protecting the value of its purchase
has greater weight.
Where the transaction is structured with a long-term pay out of part of
the purchase price, and/or where the deal is a stock purchase rather than
an asset purchase, it is sometimes easier to get the selling shareholders
to agree to a longer period after the closing for survival of the
warranties and representation
Requiring All Shareholders to Have Unlimited Liability
If there is more than one selling owner, it is certainly preferable
that they all join in the warranties and representations concerning the
business and the assets and liabilities, and all are responsible to the
buyer for indemnified liabilities. While the liability of the selling
owners may be apportioned based upon their percentage of ownership, their
liability to the buyer should be joint and several. Non-active owners
should not be excused from signing personally - their lack of knowledge of
the company’s affairs can be covered by their getting indemnification from
the active shareholders (i.e., the major shareholder) and security for the
indemnification in a form mutually agreeable to the non-active
shareholders and the major shareholder.
Spreading Part of the Purchase Price Over a Period of Years
This is difficult if a phased pay out was not part of the handshake
deal, and this was not addressed in the letter of intent. An attempt by
the buyer to negotiate putting a significant part of the purchase price
into a non-negotiable promissory note after the letter of intent is
signed, can kill the deal or create an undo amount of friction. Even where
the deal did call for payment of part of the purchase over a number of
years, the face amount of the note obligation may be insufficient to cover
the amount of the indemnified liability; and, in any event, the recovery
by way of setoff is slow and the immediate damages sustained by the buyer
might have a serious impact.
Escrowing of a
Portion of the Purchase Price
The best protection the buyer can
obtain is escrowing a portion of the purchase price at the closing.
However, escrow arrangements are complex and require careful drafting.
Let’s assume that the purchase price is payable in cash and not in stock
of the buyer. The first issues to be addressed are the amount to be
escrowed and the length of time for the escrow. Each deal will have its
problems and unique solutions. What will be appropriate will depend on
many variables, including the seller or selling owners’ sophistication;
the degree of careful attention to details by the company and the selling
owners in the conduct of the business; the nature of the business; the
familiarity of the buyer with the business; the extent of the buyer’s due
diligence prior to signing of the agreement, and the length of survival
for the warranties, representations and indemnification undertakings. For
example, if the buyer is a strategic buyer, well versed in the business of
the company, and if the company has audited financial statements and a
relatively clean operation, the issues will be more easily resolved that
in some other situations.
Resistance on the amount the buyer wants escrowed may be overcome by
providing for the release to the selling shareholders or the company of
portions of the escrow fund from time to time, if no claims have been
asserted against the company prior to the time of the scheduled release
from escrow.
Establishing es crow requires detailed provisions for: (a) the investing
of the escrow funds, (b) whether interest earned on the fund accumulates
in the fund, except for distribution of taxes payable on account of the
interest, or whether the interest belongs to the seller or the selling
owners, and (c) the duties and liabilities of the escrow agent, its
compensation, if any, and, if the escrow agent is a lawyer for either
party, provisions stating that the lawyer is not to be disqualified in
representing that party merely because the lawyer acted as escrow agent.
Lastly, the escrow agreement and/or the indemnification provisions of
the purchase agreement, have to deal carefully with the procedures for
giving of notices of claims, responses to them and defense and settlement
of claims.
Getting Collateral to Secure Personal Liability.
This is a sensitive issue and, as with any sensitive issue raised after
the deal points have been agreed upon on a letter of intent or deal point
memo, you can expect resistance from the selling owners to put at risk
their other assets, such as the equity in a home. This may well turn into
a deal breaker. But even if there is other collateral the selling owners
are willing to provide, the negotiations for valuing the collateral as
against the amount of the possible claims and procedures for realizing
upon the collateral can prove to be unduly cumbersome for the buyer.
Accordingly, this form of protection is the hardest to negotiate, and
should be resorted to only if all else fails.
Financial Statements of the Major Shareholder and Spouse
The buyer needs detailed information on the major shareholder’s assets
and liabilities, and the assets and liabilities of his or her spouse, in
order to make a reasonable determination on whether he or she needs
additional safeguards. Furthermore, the financials, which are given prior
to the signing of the purchase agreement, should be updated at the
closing. By requiring the financial statement from the spouse, as well the
major shareholder, the buyer will have an easier time later in determining
whether the major shareholder’s financial statement was complete regarding
assets, and whether assets appearing on the spouse’s financial statement
later might have come from the Major Shareholder.
Getting the Spouse of the Major Shareholder to Sign Personally
Assuming the buyer can get the major shareholder to have his or her
spouse sign personally, it is imperative that the buyer’s counsel require
the spouse to be represented by his or her own counsel, since there are
far too many cases where a spouse later attempts to avoid liability on the
ground that he or she didn’t really know what was involved and had no
legal advice. Moreover, due to the potential for a real or apparent
conflict of interest, it is preferable that the spouse be represented by
his or her own counsel, and not counsel for the major shareholder. The
purchase agreement should identify the lawyer who advised the spouse, and
the spouse should sign the purchase agreement and the closing date
certificate updating the warranties and representations in the purchase
agreement in front of the buyer’s attorney.
Conclusion
Before a buyer’s attorney pulls a standard purchase agreement from his
or her computer and hurries to issue a first draft, the attorney should
take the time to confer at length about the deal with the buyer, the
business intermediary (i.e., a broker) if one was involved, and the
buyer’s accountant. Only after obtaining a complete understanding of the
nature of the business being sold, the reasons for the deal on both sides,
the buyer’s confidence in the results of its due diligence, and how the
price, terms and conditions were agreed upon can the buyer’s attorney make
fine-tuned recommendations with respect to the issues covered by this
article.
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Endnotes
[1] The discussion in this article is also applicable to the
sale of entities other than corporations, such as limited liability companies.
[2] The term selling owners is sometimes used here not only for shareholders or members who are selling
their stock or membership
interests but also, in the case of an
asset sale, for the owners of the entity making the sale (the seller or
the company).
[3] See N.J.S.A. 25:2-25(b)(2).
Philip
L. Chapman is a senior partner with the firm of Chapman, Kessler, Peduto &
Saffer, LLC. Mr. Chapman areas of expertise include counseling family-owned and other closely
held businesses in all aspects of business, corporate and real estate
law. He enjoys the AV rating in the Martindale-Hubbell Legal Directory
and is listed as one of the best corporate lawyers in New Jersey in the
publication Best Lawyers in America. He was one of a three-person
committee that authored the New Jersey Nonprofit Corporation Act, which
became law in October 1983.
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