If you are the seller (or one of the sellers) of the shares of stock or of the assets of a Company operating a going business, and the buyer finances the acquisition by borrowing through a bank or other financial institution, there are circumstances where the sellers may be liable to the lending bank even though the acquisition transaction and contract is entirely between the sellers and the buyer.
Picture it: the sales price of the business is substantial and, therefore, the loan financing is also large; during the period prior to the signing of the acquisition agreement, the sellers and executives of the Company meet with representatives of the buyer for purposes of negotiation of the contract and due diligence investigation; in the course of these meetings, the sellers and the Company executives also meet with representatives of the lending bank for purposes of explaining the business or documents of the Company produced by the sellers in connection with the due diligence; in these meetings, statements are made by the sellers and the Company executives, not only to representatives of the buyer, but also those of the bank; Company documents, produced in connection with the due diligence and given to the buyer, are turned over to the bank in connection with the loan financing; and, perhaps, some of these documents are either given by the Company directly to the bank or even prepared especially for the bank by the Company.
Naturally, the tendency on the part of the sellers and the Company executives in these situations will usually tilt strongly in the direction of demonstrating the most favorable prospects for the Company to the bank, both as a result of the buyer’s urging as well as the natural desire of the sellers (and the Company executives if they foresee advantage to them in completing the transaction) to bring about a successful acquisition. Often in these circumstances, companies are requested by buyers and banks to conduct what is effectively a “road show”, i.e., independent meetings at which sellers and individual executives are requested to explain the operations of the Company to the bank contemplating the acquisition financing; effectively, to “sell” the deal.
In short, during the pre-acquisition contract period, there is usually ample opportunity and incentive for the sellers and Company executives to make oral and written statements respecting the past and current operations and the financial condition of the Company and its future prospects. Enormous pressure is brought to bear to provide such statements and, to a greater or lesser extent, the statements are indeed provided.
Let’s assume that months (or perhaps a year or more) after the closing of the acquisition transaction, the Company’s operations (under its new management) turn sour and the Company eventually fails. Its shares of stock and other assets become effectively worthless, or yield, on liquidation, only a small portion of the aggregate financing debt due to the bank and that, like falling dominoes, the buyer, which had modest equity financing to begin with, itself becomes insolvent and any other guarantors of the debt to the bank, such as shareholders of the buyer, find themselves financially impaired, their capitalization having been drained in the attempt to rescue the Company. Now further assume that the trustee in bankruptcy for the Company, urged by its creditors, seeks to lay culpability for the failure of the Company’s business at the doorstep of the sellers. This danger was foreseen by the sellers and their attorneys at the time of the contract negotiations and adequate protection was devised to greatly reduce or entirely eliminate the sellers’ risk against this kind of exposure. They have in the acquisition agreement erected formidable defenses to such claims, by or on behalf of the buyer, which carefully delineate and circumscribe the sellers’ area of risk arising from the acquisition transaction and limited the magnitude of the risk, both in amount and in duration, by caps, baskets, damage limitation provisions, cure notices, contractual periods of limitations, and other devices. The sellers remain assured, therefore, that the claims by or on behalf of the buyer based only upon the acquisition transaction are reasonably defined and circumscribed.
Not so fast. Under the circumstances presented here, there is yet another peril, that of liability by the sellers individually to the bank based upon claims of misrepresentation and breaches of agreement respecting the financing transaction. Because of the size of the financing transaction, including any equity investment by the bank in participation with the buyer, the sellers may be incurring liabilities to the bank which are not delineated and limited by the protections in the acquisition agreement but, instead, are indistinct and even unknown. If the bank is unable to fully recover its losses from the Company itself, the buyer, any guarantors of the financing debt to the bank, and any security, the bank’s impulse will be to turn to the sellers for recoupment. The legal foundations for any action instituted by the bank may be: breach of oral agreements and warranties made or given directly with or to the bank by the sellers in pre-acquisition contract discussions; both oral and written misrepresentations contained in statements and documents made or delivered prior to the acquisition agreement directly by the sellers to the bank; and oral and written misrepresentations contained in statements and documents made or delivered indirectly by the sellers to the bank through the intermediary of the buyer and its representatives prior to the execution of the acquisition agreement.
Even if the potential for claims by the bank of this nature were perceived by the sellers and their attorneys, the absence of a formal agreement between the bank and the sellers within which may be included appropriate safeguards to reduce, or entirely eradicate, sellers’ exposure to bank claims of this kind, render the prospect of liability-risk reduction on the part of the sellers to the bank, decidedly more difficult. Since the possible foundations for a claim by the bank fall entirely outside the conventional shield of protective devices installed by the sellers’ attorneys in the acquisition agreement, those limitations on the magnitude and amount of the sellers’ risk will afford little assistance. Moreover, since the prospective foundations for the bank’s claims are not themselves circumscribed by a clearly delineated written agreement but, instead, will be an amalgam of oral statements and various statements contained in a number of the Company’s documents provided in connection with the due diligence review, the potential threat to the sellers presented in these circumstances is vague, amorphous and open ended. Therefore, the overriding questions become: is there something that can be done by sellers under these circumstances to avoid entanglement in the kind of difficulties described here? What precautions may sellers and their attorneys take to avoid these pitfalls?
The law, in its search to do justice and its indifference to the sensibilities of parties on either side of a dispute, provides to sellers neither virtual safety nor complete peril. Most, if not all, jurisdictions in the U.S. will impose liability in the case of intentional misrepresentation, or false statements recklessly made, based on a showing that the sellers knew or had reason to know that the bank would rely upon them and in fact did.1 If the sellers’ misrepresentations occurred as a result of negligence or carelessness, they will be actionable in most states, even if not made directly, if it can be shown that they were intended by the sellers to be conveyed to the bank to be used by the bank for purposes of making its decision in providing the acquisition financing, that the sellers conducted themselves in such a way as to evince an understanding that the bank would rely on the statements for that purpose and that the bank did indeed rely upon them.2 In some jurisdictions, the bank, it appears, need not to go so far; it would suffice if it could show that the indirect negligent misrepresentation were made by the sellers knowing (or with reason to know) that the bank would rely upon them.3
The lesson is clear: the fact that the sellers had no transactional relationship with the bank and that the sellers and the bank did not enter into a written contract, will not, in itself, insulate them from exposure to liability to the bank either based upon contract, warranty, or misrepresentations. In a complex acquisition transaction involving substantial financing, the sellers, buyer and the financial institution are so drawn together in their dealings as to provide substantial opportunity to supply evidence that the sellers made their statements, or reasonably should have known that their statements were made directly to the bank, or that they would be conveyed to the bank and relied upon by it for the specific purpose of providing the acquisition financing.
Plainly, the law will not permit both the buyer (or its bankruptcy trustee) as well as the bank to recover for the same losses. Thus, in a similar circumstance to that posited here, the U.S. District Court dismissed the claim of the financial institution against the sellers upon the reasoning that the losses to the financial institution were indirect and derivative of those sustained by the buyer of the business since the claims of and injuries to the financial institution and its claims were precisely the same as those sustained by the buyer which had the primary right to the claim.4 The court, however, recognized significant exceptions to the general rule excluding the secondary party’s derivative claim, namely: (i) where the party with the primary right to bring the claim was incapable of doing so, e.g. because it was insolvent, defunct or had given a release,5 and (ii) where the party with the secondary standing has either a claim or suffers an injury that is substantially separate and distinct from the claim or injury sustained by the party with the primary standing.6 To reenforce this, the Jackson National court makes it clear that its dismissal of the action is only temporary pending the outcome of the legal proceeding maintained by the buyer on the same basis and for the same injuries, i.e., the court wishes to permit an assessment of the outcome of that proceeding to determine whether, in fact, there would be duplicative recovery.
Although the courts have attempted to clarify the areas of exception to the rule that indirect and derivative claims may not be maintained, the guidelines for predictive action remain blurred. Thus, what will constitute an inability on the part of a primary party to proceed with its claim – is bankruptcy necessary or will mere insolvency suffice and would the secondary party be entitled to institute suit against the defendant where the primary party has settled with and released the defendant for an amount which the secondary party charges is inadequate? If so, how is inadequacy determined? Furthermore, granting, as the Jackson National court indicates, that a mere attempt to rename the claim or injuries sustained by the secondary party will not support its lawsuit, what of the case where there is reality and substance to the secondary party’s assertion of separate and distinct claims and injuries? If, in our situation, the bank were to allege that the sellers made separate and distinct representations to it (not made to the buyer at all) and upon which it specifically relied in lending additional amounts to the buyer, or relied upon in making an equity investment to the buyer, which in either case, resulted in separate, distinct and additional damages to the bank, would this be a separate and distinct claim with damages such as the bank could rely upon as the basis for maintaining a direct action against the sellers? The area of uncertainty extends even beyond these issues. Suppose the terms of the acquisition agreement exclude certain of the representations upon which the bank intends to rely, or limit the amount of damages recoverable for misrepresentation asserted by the bank or preclude recovery because of the contractual limitation period – may the bank, nevertheless, proceed with its claim on the reasoning that it may do so because the buyer may not obtain recovery with respect to the claims regarding which recovery is precluded and, therefore, the possibility of a double recovery is obviated? In short, can the very terms of the acquisition agreement designed to shield the sellers and limit the buyers’ risk of recovery, be turned on their head, and used as the foundation for expanding the area of risk of the sellers to the bank?
Given these circumstances, does there exist any set of guidelines, any rules, that may assist sellers of a business in avoiding the rocks and reefs that are presented here? There are two fundamental canons to be observed by sellers in this situation. First is that all steps in the negotiating, due diligence, document production and presentation processes, including with respect to any statements made or documents presented to the financial institution even following the signing of the definitive agreement, should be subject to careful prior review and control by the sellers and their attorneys. The second is that, whatever the protective devices employed by the sellers, there are no assurances that risk of liability to the financial institution will be entirely eliminated, especially if the sellers or their representatives meet with the financial institution. Thus, at best we are dealing here with risk minimization procedures.
At the very inception, the sellers should designate an individual to act as their lead spokesperson and chief negotiator, serving to coordinate all negotiating, due diligence and presentation efforts on behalf of the sellers and all other activities of the sellers in connection with the transaction. By centralizing control of all these activities in one individual, the sellers will have created the most effective mechanism to deal with the problems presented here. The lead spokesperson should be assisted by a coordinating committee comprised of one or more (the number depending upon the size and complexity of the transaction) attorneys, accountants, and/or business managers. The duties of the individuals within the coordinating committee should be clearly delineated. Since the transaction is legally and financially driven, it should be comprised of at least one attorney and one accountant or financial person.
The agenda and substance of discussions for any meeting should be reviewed by one or more members of the committee in advance and the spokespersons should be restricted, as much as possible, to one or more members of the committee. Above all, general random statements and discussions should be avoided. Statements made on behalf of the seller at the meetingsshould be direct, factual and limited to what is plainly truthful and defensible. A diary should be kept setting forth the dates and attendance at each meeting and the substance, in as much detail as practicable, of what was said. Due diligence meetings should be designated as such and their scope should be practically limited to a review of the financial documents of the Company, with an absolute minimum of discussion. Presentation meetings should be carefully planned and kept to an absolute minimum. Writings pertaining to the finances or operations of the Company which are not documents regularly prepared on its behalf should be avoided. Copies of all documents delivered to either the buyer or the bank should be kept by the sellers within a file relating to the acquisition transaction alone. If at all possible, distribution of documents by the sellers directly to the bank should be avoided. In all events, the due diligence investigation by the financial institution should be made by it entirely with and through the buyer and should be conducted entirely separately from the due diligence investigation by the buyer.
If possible, a written disclaimer of any representations and warranties by the seller, acknowledged and executed by the financial institution, should be obtained. Such a statement, ideally, should also include a complete disclaimer of any representations or warranties by virtue of any of the Company’s documents and records provided to the financial institution by the buyer and an acknowledgment that no such documents or records have been provided or are intended to be provided by the sellers directly to the financial institution. Of course, the ideal disclaimer referred to above (or some of it) may not be obtainable by the sellers. Needless to say, any part of it that may be extracted from the financial institution would be of great advantage for the sellers. Written disclaimers of representations and warranties are regularly employed to eliminate the legal obligations that otherwise would arise and, generally, applicable law upholds them. The problem here is not so much legal as practical. The buyer will probably resist based on its concern that the request for the disclaimer alone may cause concern on the part of the financial institution, impairing the buyer’s chances to obtain the necessary financing. The financial institution will, in most circumstances, resist giving the disclaimer, or the mere request for it may even cause the bank to demand specific direct representations to it from the sellers. The sellers themselves may be reluctant to make the request because of their own desire not to place the acquisition transaction in jeopardy.
As a fall-back, the sellers should obtain a similar written disclaimer from the buyer, in effect acknowledging that no representations or warranties were made or intended to be made to the financial institution in any meetings or documents given and a copy of this disclaimer should be provided to the financial institution at the inception of the transaction. Such an acknowledgment should be repeated in the acquisition agreement. The fall-back alternative, of course, not having been executed by the financial institution against whom this protective device is aimed, will not generally have the same efficacy as an acknowledgment signed by the bank.
In the final analysis, the factual circumstances and problem introduced in this article is not capable of a simple all-encompassing panacea. Clearly, the major steps to be taken by the sellers in guarding themselves against unwanted risk exposure to the financial institution are: (i) the control and limitation of oral statements and writings provided to the financial institution; and (ii) obtaining, on a pragmatic case-by-case basis, of as much as the sellers are able to by way of disclaimers by the financial institution and/or the buyer. The fundamental rule by which the sellers should guide themselves in the circumstances is that they should be on guard in overseeing their pre-contract activities in the transaction.