Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

How much would you pay for a “fair chance” at offering employment to a competitor’s top salespeople? What if you had valued the goodwill associated with these key employees to be worth nearly $3 million dollars, but was told by a court that your failure to structure an asset purchase properly entitled you to only one dollar in damages? A recent case before Delaware’s Court of Chancery illustrates how disciplined deal management by a company’s executive officers and thoughtful planning by legal counsel are essential to securing a buyer’s rights to the intangible business asset of human capital.

When the CEO of Ivize LLC, strode into the former Milwaukee offices of one of his company’s chief rivals on July 27, 2007, he was stunned to find the office in disarray and the absence of the branch’s manager and two top sales associates. Just the previous day, he had closed an asset purchase deal in which his company bought the Kansas City and Milwaukee branches of Compex Litigation Services for $3.4 million. As an established, nationwide provider of litigation support services to law firms and other clients, Ivize placed little value in Compex’s proprietary software, business model, or trade secrets. Instead, its CEO was primarily interested in buying what he regarded as Compex’s most valuable asset: its customers.

Ivize accordingly allocated approximately $2.9 million of the purchase price for Compex’s two branches to goodwill associated with the transferred businesses. With respect to Compex’s Milwaukee office, the goodwill in concrete terms meant the customer relationships developed by its two top salespeople, who respectively accounted for 65% and 35% of the branch’s sales. Where, he wondered as he gazed around in disbelief at Compex’s largely abandoned offices, were the top salepeople? 

Equally puzzling to the CEO was the disappearance of Compex’s Milwaukee branch manager. The CEO had been led to believe that the manager had accepted Ivize’s offer of temporary employment during a brief post-closing transition period coupled with a severance payment of one year’s salary. What the CEO didn’t know was that shortly after Ivize and Compex signed a letter of intent on March 5, 2007, Ivize’s Chief Operating Officer and Compex’s CEO told the manager that if the asset purchase transaction successfully closed the combined Milwaukee businesses would be run by his longtime professional rival.          

Not surprisingly, the manager bristled at the news that he would soon lose his job to a business competitor. While Ivize conducted due diligence on Compex’s Kansas City and Milwaukee businesses, the manager used his position as a branch manager to undermine the transaction. He immediately informed Compex’s Milwaukee employees of the prospective buyout and told them he intended to start up his own litigation support services company. Over the next several weeks, the manager successfully solicited the top salepeople to join his new venture, held meetings to discuss his business plans on Compex’s premises, redirected some of Compex’s business to his new company, pilfered customer records, and stole company equipment.  

Eventually, the CEO succeeded in winning back some of Compex’s former customers, but in spite of his efforts the Milwaukee office’s sales slumped by 45%. Ivize sued Compex in the Delaware Court of Chancery for breaching its representation in the asset purchase agreement that “since April 1, 2007 [Compex] has operated only in the usual and ordinary course.” After reviewing the agreement and the conduct of the parties, the court determined that Ivize had in fact bargained for the physical assets of Compex, such as its computer equipment and office leases, and for “a fair chance at retaining the employees of Compex (who were the “essence” of the business) – not a contractual right to sign the employees to employment and/or non-competition agreements.” 

The court explained that Ivize could have structured the transaction so that the execution of employment and non-competition agreements with Compex’s primary salespeople was a condition to closing, which would have strengthened Ivize’s contractual rights under the asset purchase agreement. More important, it would have allowed Ivize to walk away from the deal rather than sink several million dollars into a quickly evaporating pool of goodwill. If Compex’s employees had signed employment and non-competition agreements with Ivize prior to the transaction’s closing, Ivize could have pursued the top salespeople and other defecting employees under the terms of those agreements. 

Although the court held that Compex breached its “ordinary course” representation in the asset purchase agreement, it nevertheless declared that “Ivize should not be rewarded with the same damages it would have been entitled to had it structured the agreement properly.” Because Ivize was not able to establish compensatory damages to the court’s satisfaction, the court awarded $1 dollar in nominal damages as a token acknowledgement of a technical injury. 

In its opinion, the Court of Chancery focused on how an inadequate deal structure curtailed Ivize’s remedies under the asset purchase agreement. But Ivize’s executive officers could have averted the need for appropriate contractual remedies if they had managed the deal properly. Given that the asset purchase agreement was signed on the transaction’s closing date, the CEO should have ensured that Ivize had executed employment and non-competition agreements with Compex’s key employees in hand prior to signing the agreement.  The irony is that while Ivize’s executives recognized the importance of goodwill generated by human capital, they did not understand the nature of goodwill associated with customer relationships and consequently failed to take appropriate actions to protect the company from the inherent dangers in bargaining for such an intangible asset.

 

 

 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

Defaults

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

After nonpayment, the most important defaults are those involving covenants. These are not static events. Covenants apply to the activities of the borrower throughout the life of the loan. Failure to comply with a covenant can result in the default of the entire loan agreement, even if the borrower is current in its payment obligations. A covenant default is therefore a powerful tool in the hands of the lender, and lenders frequently use covenant defaults to impose additional restrictions on a borrower or even to accelerate repayment of the loan.

Covenant defaults usually have a cure period. The borrower is given a chance to correct the default before it becomes a reason to accelerate the loan. Covenant defaults are sometimes classified in two groups: those that have short cure periods, such as five days of less, and those that have longer cure periods, usually thirty days. The shorter cure periods are reserved for those important covenants that can’t be readily corrected, such as the delivery of an incorrect financial statement. The longer periods are reserved for the things that can be corrected with proper diligence, such as compliance with laws, removing liens from properties and delivering compliance certificates.

A special class of defaults is reserved for bankruptcy and insolvency. These generally trigger immediate default of the credit agreements.

Remedies

Once a default has occurred and the borrower has run out of time to correct it (if such a right exists) the lender has the ability to accelerate the loan and demand that all amounts due under the loan be repaid immediately. Any obligation of the lender to continue extending credit under a revolving credit facility is canceled. If the borrower fails to immediately prepay the loan, as is generally the case once a default occurs, the lender is then free to exercise the security instruments and liens it carefully acquired when the loan was made. Also at this time the defaulted loan begins to bear a higher, default interest rate.  

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Representations and warranties serve two functions. They are part of the due diligence process where the private equity buyer looks at all material information about the target’s business; representations and warranties reflect the results of this investigation. They are also the insurance policy that the seller gives the private equity buyer about the truth and accuracy of the business information. The “representations” are assertions that the information furnished is correct and the “warranties” are legal obligations to stand behind the statements financially.

The subject matters of the representations and warranties cover all major facets of a business. Although the representations are worded in absolute terms, in practice the seller creates a schedule of exceptions and attaches them to the purchase agreement. These exceptions contain information about the company’s business and assets that deviate from the standard representations. Accordingly, these exceptions are important to the private equity buyer and their disclosure often provokes further negotiations.

Many representations overlap one another. For example, a representation that the seller has no liabilities other than those disclosed in its financial statements overlaps with the representation that there is no litigation pending against it, since the litigation may be treated as a liability required to be disclosed in the financial statements. Also, some representations are more important than others, such as those involving the seller’s financial statements. Finally, special attention will be devoted to representations in areas of special importance to a seller. For example, a seller with extensive real estate holdings will give representations on these matters that are far more detailed than sellers whose only real estate is rented office space. In the end, the seller must give detailed representations in every area remotely relevant to its business, with special focus on those areas where the seller generates its revenues.

Sometimes, a representation is qualified “to the knowledge” of the seller, meaning that seller is only responsible for a breach if it knew that the representation was false. Because it is difficult to prove whether a company knew a fact or not, the “knowledge” qualification is granted sparingly.

The following outlines the principal representations made by a corporate seller of business assets, the subject matters covered by the representation and a comment on why the representation is included in the purchase agreement.

2.1 Valid and Binding. 

The purchase agreement is a valid and binding agreement of seller, enforceable in accordance with its terms.

This confirms that all internal approvals (board of directors and shareholders) have been given for the deal. Seller has no legal defenses to enforceability of the contracts. This representation is typically confirmed through a legal opinion from seller’s attorneys.

2.2 No Consents. 

No consent or approval is required to be obtained by seller in connection with its execution or performance of the purchase agreement.

This identifies any third party consents that may be necessary to complete the deal.

2.3 Financial Statements. 

The financial statements of seller identified and furnished to buyer are accurate and complete in all material respects, are consistent with the books and records of seller (which have been maintained in all material respects in accordance with good business practices), have been prepared in accordance with generally accepted accounting principles consistently applied and fairly present in all respects the financial condition and results of operations of seller as of the dates thereof and for the periods covered thereby.

This is the most important representation, as financial statements are the lynch pin of private equity transactions.

2.4 No Undisclosed Liabilities. 

Seller has no liabilities or obligations except as identified in a schedule, disclosed or reserved against in its latest balance sheet, or incurred in the ordinary course of business consistent with past practice since the date of the latest balance sheet.

This is an important catch-all representation on liabilities. It forces seller to specifically identify any liabilities not properly reflected in its financial statements.

2.5 Taxes. 

Seller has filed all tax returns required to be filed and has paid all amounts required to be paid on such returns.

This provides specific verification that taxes have been reported and paid.

2.6 Title to Assets. 

Seller has good, valid and marketable title to its assets; seller owns its real property free and clear of liens; and the assets being conveyed to buyer constitute all of the assets (tangible and intangible) used in connection with the operation of the business as presently operated by seller.

The last part of the representation confirms that seller is transferring all of the assets used in its business, and there are not other assets held by other parties that are used in the business.

2.7 Intellectual Property. 

Seller owns or has the right to use all of its intellectual property; the transfer of this property will not alter or impair any such rights or require any consent or approval; the intellectual property is subsisting, in full force and effect, has not been canceled, expired, or abandoned, and is valid and enforceable; and seller’s business does not infringe upon, misappropriate or otherwise violate any intellectual property rights owned or controlled by any third party.

Intellectual property is a unique class of assets that gets its own set of representations. Buyer can independently verify the validity of patents and trademarks, but not even seller may know whether its business infringes the intellectual property of others.

2.8 Contracts. 

None of seller’s contracts are in default and the transactions contemplated by the purchase agreement will not require the consent or approval of any other party to the contracts.

This identifies all of seller’s contracts and certifies that the contracts are enforceable and no consents are required to transfer them. Consents can be time-consuming and expensive to obtain.

2.9 Employee Plans. 

Seller’s employee benefit, savings, welfare and pension plans comply with law and there are no unfunded pension liabilities.

Benefits have their own federal laws and regulations and it’s customary to break benefit plans out into their own section.

2.10 Labor Relations. 

Representations about seller’s relations with labor unions and the existence of organized labor activities at seller.

This is the place for seller to identify any union activities at its plants, even if no union has been formally recognized.

2.11 Litigation. 

There is no litigation pending or, to the best knowledge of seller, threatened against seller or any of its properties.

Pending litigation is easy to identify and has usually been reserved against on the balance sheet. A buyer is interested in learning if any litigation has been threatened, which may not be reflected in the balance sheet.

2.12 Compliance with Laws. 

Seller has complied with all laws applicable to its business.

The representation is generally easy for the seller to give. Issues can arise where the business operates in a heavily regulated area.

2.13 Absence of Changes. 

Since the date of the last balance sheet, the business has been conducted in the ordinary course consistent with past practices and there has not been any unusual transaction.

This brings disclosure about the business current since the last balance sheet date and requires the seller to identify any transactions outside the ordinary course since that date.

2.14 Inventory. 

Seller’s inventory consists of merchandise of a quality and quantity usable and saleable in the ordinary course of business consistent with past practice, except to the extent of normal obsolescence or to the extent written down or reserved against in accordance with GAAP, and is fit for its intended purpose.

This ensures that the quantity and quality of seller’s inventory is acceptable. The representation implies many subjective determinations about obsolescence and GAAP reserve policies that are more art than science.

2.15 Suppliers. 

Identifies the top suppliers to the business and represents that none of them changed its method of doing business with seller nor indicated that it intends to do so.

Buyer wants to know that it will continue to have a stable source of supply from the key suppliers to the business.

2.16  Accounts Receivable. 

Seller’s accounts receivable arose in the ordinary course of business, are legal, valid and binding obligations of the respective debtors enforceable in accordance with their terms, are not subject to any counterclaim, set-off or defense and have been accurately and fairly reflected in the latest balance sheet.

This representation is a statement that the receivables are collectible in full at their stated amount subject to any reserves established in the most recent balance sheet.

2.17 Related Party Transactions. 

No affiliate of seller is, or in the past has been, a party to any transaction or contract with seller or the owner of an interest in any person which is a competitor or supplier of the business.

An important representation that identifies any transactions or relationships that may not be at arm’s-length.

2.18 Environmental Matters. 

Seller has complied with all environmental laws and has not treated, stored, disposed of, arranged for or permitted the disposal of, transported, handled, released, or exposed any person to, any hazardous substance.

Environmental law compliance is typically treated in a separate section, even though it is covered under the representation that seller has complied with all laws.

2.19 Disclosure. 

All information furnished by seller has been true and correct in all material respects.

This is a catch-all representation saying that the materials and disclosures furnished by seller during due diligence have been accurate in all material respects.

 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

No one cares about the law of sales and collections until something goes wrong.   When disputes arise, the parties dust off the “boilerplate” provisions printed on the back of their purchase orders and invoices. Often these provisions are in conflict with one another or do not cover the issue that actually exists. In these circumstances, where the contract involves the sale of goods, the parties must look to the provisions of the Uniform Commercial Code for answers. This Code, adopted in every State, provides a uniform body of rules for sales of goods. For sales of services, the common law of contracts applies. 

The success of the Uniform Commercial Code in regulating the sale of goods has crossed over into general contract law, and many provisions of the Code have influenced the development of general contract law.

Article 2 of the Uniform Commercial Code: Contract Terms and Conditions

Article 2 of the Uniform Commercial Code covers how and when contracts for the sale of goods are formed; warranty obligations; how contracts must be performed; what happens when a party breaches a contract; and what remedies are available when a breach occurs.

Forming Contracts

Any sale of goods for a price of $500 or more must be reflected in written form. The writing must be sufficient to indicate that a contract for sale has been made by the parties and must be signed by the party against whom enforcement is sought. However, this requirement is waived in sales between merchants if one party sends a written confirmation of the contract and the other party fails to object within 10 days of receipt.

Apart from this requirement of a “writing,” the rules of contract formation are very liberal. A contract may be made in any manner sufficient to show agreement, including conduct by both parties that recognizes the existence of such a contract.

A written offer by a merchant to buy or sell goods which gives assurance that it will be held open cannot be revoked during the time stated in the offer. If no time is stated, then the offer must remain open for a reasonable period of time, but not in excess of three months.

If the customer’s purchase order contains one set of terms and conditions, and the acceptance or invoice contains another set, the additional terms of the invoice become part of the contract unless the offer limits acceptance to the terms of the offer or they materially alter it. In addition, conduct by the parties that recognizes the existence of a contract will be sufficient to establish a contract, even though the writings do not establish one. Accordingly, written exchanges and conduct must be tightly controlled to avoid inadvertent contracts.

A party may delegate performance of a contract to someone else, unless the other party has a substantial interest in having the original party perform the contract. Either party may assign its rights under a contract except where the assignment would materially impact the other party’s duties, burdens or risks.

Warranties

Unless the parties otherwise provide, the following warranties are assumed to be made by the seller as to the goods:

1. Seller has title to the goods and the right to transfer them.

2. The goods are delivered free from any security interest or other lien (other than those the buyer actually knows of).

3. The goods are “merchantable” (generally, the goods are fit for the ordinary purposes for which they are used).

4. When seller has reason to know any particular purpose for which goods are required and buyer is relying on seller’s skill or judgment to select goods, there is an implied warranty that the goods are fit for such purpose.

5. A statement of fact relating to goods creates an express warranty that the goods conform to the statement.

6. A description of the goods creates an express warranty that the goods conform to the description.

7. A sample creates an express warranty that the whole of the goods conform to the sample.

Special care must be taken to exclude or modify these warranties if they cannot be supported. Generally, the contract should contain express language that excludes warranties, or states that goods are sold “as is” or “with all faults.”         

Performance

The UCC spells out how contracts are to be performed in cases where the parties have omitted the details. For example, if a buyer has paid all or part of the price of goods and the seller becomes insolvent, the buyer may recover the goods from the seller if the seller’s insolvency occurred within 10 days after receipt of the first installment of the price. Also, the buyer has the right to inspect goods at a reasonable place and time and in any reasonable manner before payment is due.

Breach of Contract

When there are defects in the goods, or a defect in their method of delivery, the buyer has the option to reject or accept all the goods or accept any portion that is acceptable and reject the rest. A notice of rejection must be delivered “seasonably,” the buyer cannot delay unreasonably.   In addition, if the buyer rejects the goods while they are in his possession, he must follow the reasonable instructions of the seller with respect to the rejected goods. If no instructions are received, the buyer may store the goods for seller’s account, reship to seller or resell for seller’s account.

On the other hand, once the buyer has accepted the goods, he must pay at the contract price for any goods accepted. Acceptance occurs when the buyer after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming, or fails or make an effective rejection (after having an opportunity to inspect). Although accepted goods may not be reshipped to the seller, buyer retains any claim based on non-conformity of the goods to warranties.

When reasonable grounds exist that make one party feel that performance by the other may be impaired, that party may demand assurances of due performance from the other party. Until he receives such assurances, he may suspend his performance. If the cost of performing the contract suddenly increases dramatically due to an event that undermines a basic assumption of the contract, the seller may delay its delivery or even fail to deliver the goods.

Remedies

When a seller discovers that buyer is insolvent, he may refuse to deliver goods except for cash, including payment for all goods previously delivered. When a buyer receives goods on credit while insolvent, the seller may reclaim the goods on demand made within ten days after the receipt.

When a buyer breaches the contract, typically by not accepting goods or failing to pay for goods already received, the seller may recover damages for non-acceptance or cancel. Damages in the case of non-acceptance of goods is the difference between the market price at the time and place of delivery and the unpaid contract price, less expenses saved as a consequence of buyer’s breach. However, if this measure of damages is inadequate to put seller in as good a position as performance would have done, then the measure of damages is the profit (including reasonable overhead) which seller would have made from full performance. Damages, in the case of non-payment, are the price of goods accepted, plus incidental damages. Alternately, when the buyer has failed to accept goods seller may resell the goods in a commercially reasonable manner and recover the difference between the resale price and the contract price, plus incidental damages. The seller does not have to account to buyer for any profit made on the resale.

When a seller breaches the contract by failing to make delivery or when the buyer rightfully rejects goods, then buyer may cancel and recover so much of the price as has been paid. In addition, the buyer may purchase goods in substitution of those due from seller and recover from seller the difference between the cost of the substituted goods and the contract price, together with incidental and consequential damages, but less expenses saved. Alternately, the buyer may recover damages for non-delivery equal to the difference between the market price at the time the buyer learned of the breach and the contract price, less expenses saved.

The measure of damages for breach of warranty is the difference between the value of the goods accepted and the value they would have had if they had been as warranted. The parties may specify liquidated damages in the agreement, but the measure must be reasonable in light of the harm caused by the breach. Unreasonably large liquidated damages are void as a penalty. Any action for breach of any contract for sale of goods must be commenced within four years after the breach occurs. The parties may shorten the period to one year (but not less).

Article 9 of the Uniform Commercial Code: Security Devices

Article 9 of the Uniform Commercial Code contains a powerful tool to aid in the collection of accounts, although many companies do not take advantage of it. It gives sellers of goods the right to retain a security interest in the goods (or other assets of the buyer) until payment. Without a security interest, the seller must take a back seat to creditors (typically banks) that do take advantage of this law.

Security Interests

A seller of goods can retain a security interest in the goods if the following procedures are adopted:

1. The buyer signs an agreement granting a security interest in the goods.

2. A financing statement is filed in the office of the Secretary of State of the state in which the buyer is located or incorporated.

The advantage of a security interest is that the secured party has a priority to the goods in the event the buyer becomes insolvent. Proceeds from any sale of the secured goods must be paid first to the seller in satisfaction of its account. A security interest in goods disappears once the goods are resold to another buyer in the ordinary course of business.

If buyer defaults in payment, a seller with a security interest in goods may take possession of the goods either by judicial process or without judicial process if it proceeds without breach of the peace. A secured party may also require the debtor to assemble the collateral and make it available to the secured party. The secured party may dispose of the collateral by public or private sale in a commercially reasonable manner. Any proceeds of such a sale must be applied first to the expenses of sale and then to the satisfaction of the debtor’s obligations. The secured party may also accept the collateral in full or partial satisfaction of the obligation under certain circumstances.

• Email This
• Print
• Comments
• Trackbacks
• Share Link