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M&A in Brief: Q2 2022

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| Legal Update


  1. Delaware Clarifies “Pro-Sandbagging” Stance
  2. Employee Benefits Issues in M&A Transactions
  3. Taking Stock of Considerations for an All-Stock Deal
  4. Tips and Tax Planning Opportunities for Business Owners in Advance of a Sale

1. Delaware Clarifies “Pro-Sandbagging” Stance
by Mark Tarallo and Mary Moran

In almost every M&A transaction, the parties spend some time discussing (if not heavily negotiating) the right of the buyer to bring claims against the seller even if the buyer knew about the potential claims before closing the transaction. This concept, sometimes referred to as “sandbagging,” was addressed by the Delaware Supreme Court in Eagle Force v. Campbell (2018)—a decision that left some doubt as to whether or not Delaware was a “pro-sandbagging” jurisdiction. In a recent case, Arwood vs. AW Site Services, LLC (March 9, 2022), the Delaware Chancery Court addressed the issue of sandbagging in an M&A transaction governed by Delaware law and clarified any ambiguity resulting from the Eagle Force decision. Vice Chancellor Slights clearly expressed that Delaware should be considered a “pro-sandbagging” jurisdiction and found in favor of the defendant’s counterclaims for breach of representations despite highly unusual circumstances.

Recent Delaware Chancery Court Ruling

In Arwood, the court considered claims brought by a seller for release of the escrowed portion of the purchase price, as well as counterclaims by the buyer for contractual misrepresentation and fraud. The facts were very different from the typical M&A transaction. The seller, who was unsophisticated and not represented by counsel, essentially turned over all of his books, records, financial statements, and business documents directly to the buyer to enable the buyer to perform a due diligence investigation and put an agreed-upon valuation on the target group of companies. In addition, the seller signed multiple letters of intent and the eventual asset purchase agreement (as well as various ancillary documents) without any negotiation, proposed revisions, discussion, or review. 

Despite the unfettered access and extensive due diligence, the buyer failed to uncover an improper billing scheme in which the seller regularly overbilled customers. The billing practices were not uncovered until well after the closing of the transaction, when the buyer was having difficulty achieving the financial results it had anticipated based on its review of the seller’s business. The buyer then refused to release the portion of the purchase price that had been escrowed to cover indemnity claims. When the seller sued to require the buyer to release the escrowed funds, the buyer brought counterclaims against the seller alleging, among other things, contractual misrepresentations and fraud on the part of the seller (in connection with the billing practices). The court found that the buyer did not meet the standards for fraud. The court held that the seller had not acted with scienter, and that the buyer could not prove “justifiable reliance” on the misrepresentations, in part because of the unrestricted access that the buyer had in the diligence process. 

Two Key Issues Addressed by the Court

The court did, however, find in favor of the buyer on the breach of contract claims and held that the buyer “was entitled to rely upon the accuracy of the representation regardless of what the due diligence may have or should have revealed.” The court specifically addressed two questions:

  1. What is the state of sandbagging as a defense in Delaware; and
  2. What is the standard applicable to a defense of sandbagging—what the buyer actually knew or what the buyer should have known?

The court addressed the first issue quickly, holding that Delaware “is, or should be, a pro-sandbagging jurisdiction.” The court found no reason to deviate from Delaware’s “contractarian” approach, noting that while “there is something unsettling about allowing a buyer to lay in wait on the other side of closing with a breach claim he knew before closing he would bring against the seller, the risk of such litigation, like any other risk, can be managed expressly in the bargain the parties strike.” The court laid out a simple analysis for dealing with the breach of contract claim, consistent with long-standing Delaware precedent: “[T]he question is simple: was the warranty in question breached? If it was, then the buyer may recover—regardless of whether she relied on the warranty or believed it to be true when made.”

With respect to the second issue, the court held that, even if Delaware was not a pro-sandbagging jurisdiction, the defense would not be applicable here because the buyer did not have actual knowledge of the misrepresentations prior to the closing. The court found that “actual knowledge” should be the standard when addressing the concept of sandbagging, not “should have known.” This is particularly important given the facts, where the buyer had unrestricted access to every aspect of the seller’s business, and arguably “should have known” that the seller’s stated financial results from operations were not reliable (and in fact the buyer likely knew there were material issues with the seller’s business practices, given that the buyer asked for a reduction in the purchase price of almost 25% after completing the due diligence review process).     

Considerations for Buyers and Sellers on Sandbagging Language

As many parties agree to use Delaware law as governing law for their transaction documents, it is important to consider the impact of this decision. For now, Delaware is squarely in the “pro-sandbagging” camp, and silence in an agreement will allow a buyer to bring claims. In many transactions, the parties agree not to include any type of sandbagging language in the agreement, and instead, will rely on “applicable law.” Sellers who want to avoid any potential sandbagging claims must include specific anti-sandbagging language. Further, if there are issues that could result in post-closing claims, sellers must disclose them clearly and with specificity, so that if there is the possibility of a defense of sandbagging the seller can show that the buyer had specific knowledge of the particular issue. Buyers should consider pushing for pro-sandbagging language, even in jurisdictions such as Delaware, in order to avoid any doubt about their right to bring post-closing claims.

2. Employee Benefits Issues in M&A Transactions
by Tracy Vitols

Whether on the buy-side or the sell-side, employee benefits issues can have an impact on corporate transactions in many ways. Generally, the most important factor in evaluating employee benefits issues is the structure of the transaction. In a sale of assets, the buyer can generally choose if it wants to assume any or none of the seller’s benefit plans. With the exception of successor liability for certain types of plans, the buyer can generally avoid employee benefit plan liabilities in an asset sale. Compare that to a merger or sale of stock where the buyer assumes the liabilities of the seller, including the seller’s benefit plans. Thorough due diligence in a transaction is critical to identifying potential risk, whether in a stock transaction or an asset transaction.

Almost all purchase agreements have exhaustive representations and warranties regarding benefit plans. These representations in the purchase agreement need to be carefully reviewed and are frequently among the most heavily negotiated provisions of the agreement. The seller must ensure that its employee benefits representations are accurate in order to avoid what could be significant indemnity claims. Given how detailed the benefits representations typically are, they should be carefully reviewed by both the seller’s counsel and benefits specialists to make sure that the representations are accurate and that any potential issues or exceptions are clearly disclosed. The seller is also responsible for ensuring that requested benefits documentation is timely provided to the buyer for due diligence review. In turn, the buyer is responsible for reviewing that benefits documentation and identifying areas of risk and potential liability. As part of the overall review, the buyer will also be developing a strategy for employee benefits post-closing (i.e., plan design, participant communications).

Potential Risks

There are a number of high-risk benefits issues that can materially impact a transaction. For instance, if the seller has union employees and participates in a multiemployer pension plan, there can be significant withdrawal liability issues associated with that plan. Another example of a high-risk benefit is the funding status of a seller’s defined benefit pension plan. Unlike a 401(k) plan, a defined benefit pension plan must maintain a certain funded status which could require ongoing financial contributions to the plan, and if the intent of the buyer is to terminate the defined benefit plan, the plan is required to be fully funded. A third high-risk area is retiree medical. If the seller has extended to its retirees (either verbally or in writing) health coverage for life for example, this may have a significant cost impact to the potential buyer. There are special and complex rules for each of these examples, all of which can have serious financial implications if not addressed prior to closing.

401(k) Plans

There are unique issues for 401(k) plans as well. In a stock transaction, the buyer will assume the seller’s 401(k) plan unless the plan is terminated before closing. In an asset sale, the seller’s employees may become covered under the buyer’s 401(k) plan. For diligence purposes, it is important to review not only the written plan documentation, but also the Form 5500s, nondiscrimination testing results, summary plan description, and vendor agreements. This information is helpful to the buyer not only for assessing risk and potential liabilities but also for comparing plan features and design.  The seller representations are important in this regard as errors to a 401(k) plan may not always be in the written plan document, but rather the plan’s administration and operations. Ultimately, the buyer must decide whether to assume the seller’s 401(k) plan or terminate it. If the latter, it is important to identify any outstanding participant loans from the seller’s 401(k) plan and evaluate alternatives to avoid a deemed distribution of loan balances post-closing.

Smoothing the Transition

The transition of employees in any transaction should not be overlooked. It is favorable for both parties to ensure a smooth transition of employee benefits for affected employees. One tool frequently used to accomplish this is COBRA continuation coverage for group health plans. Generally, the parties to the sale can allocate the responsibility for providing COBRA administering continuation coverage within the purchase agreement. However, in the event this doesn’t happen or if there is a default, federal guidance governs COBRA obligations to the parties for those individuals currently on COBRA, or who become eligible for COBRA as a result of the transaction. The responsibility for each party will depend on the type of transaction (asset sale versus stock sale). As part of the diligence process, it is important to identify from the seller whether there are any individuals currently on COBRA or that become eligible for COBRA as a result of the sale. Another way to ensure a smooth transition of benefits is to include a post-closing covenant obligating one of the parties to provide certain accommodations for affected employees. For instance, the buyer’s benefit plans can recognize past service with the seller for purposes of eligibility and vesting, require a waiver of waiting periods or pre-existing condition limitations, and issue credits for co-pays and deductibles.  

Closing the Deal

Benefits issues present some of the most significant risk in an M&A transaction because of the potential involvement of the IRS, the DOL, and other agencies. Whether an asset or stock transaction, it is recommended to have the employee benefits representations, documentation, and covenants reviewed to reduce risk, ensure a smooth transition at closing, and avoid any last-minute issues.

3. Taking Stock of Considerations for an All-Stock Deal
by Joshua French and Kelly Dutremble

Over the past few years, deal studies by SRS Acquiom have generally evidenced that U.S. public companies represent a little more than one-third of buyers in U.S. private company M&A transactions. However, the global IPO market is booming in ways not seen for years, with over 1,000 companies going public in the United States alone in 2021. As a result, there are a number of newly public companies with sizable market capitalizations that may be seeking growth through acquisition. What better way to accomplish such growth than to acquire with stock and not take the balance sheet hit that comes from a cash or debt-financed acquisition?

For sellers, while stock-based valuations may look promising and the allure of an increase in stock value if the expected synergies come to pass may be enticing, there are considerations that should be taken into account when contemplating an all-stock acquisition.

  • Enterprise Valuation – The most obvious concern of accepting stock in lieu of cash is the very nature of the highs and lows of the public markets. While you will agree upon an enterprise valuation in cash in a letter of intent, that will translate into stock based on a negotiated metric that will depend on the recent stock price of the buyer. Frequently this will take the form of a trailing average of 15-30 days from the date of signing, but that may mean that the price on the day of closing is less than the price being used to determine the number of shares you receive. Generally, a price collar is used to give some degree of certainty to the deal pricing, but just because an enterprise valuation in a letter of intent says that you’re being acquired for $100 million in an all-stock deal doesn’t mean that on the day of closing the stock will actually be worth $100 million.
  • Reverse Business Diligence – You’ve built an amazing business that has attracted an exciting public company strategic partner and together you’re going to take things to the next level…but you better be sure about that to have the kind of financial success you expect. You should utilize financial advisors to undertake an analysis on the buyer’s current stock price and fundamentals to assess the health of the buyer pre- and post-acquisition, as well as to have a clear understanding of how your business will fit into the larger organization.
  • Ability to Sell the Stock – If you receive cash in an acquisition, you can turn around the next day and do whatever you want with it. If you receive public company stock in an acquisition, that is far less likely to be the case. It is important to understand the securities and potential employment-related restrictions on your ability to sell the stock you receive. A key part of the negotiation should revolve around the lock-up period which sellers are subject to and what obligations that buyer has to register the shares it is issuing in the transaction. Relying on an exemption from registration from provisions like Rule 144 could result in having to hold the stock for upwards of a year depending on whether the recipient is considered an insider. Separate from this, if you are continuing to provide services to the buyer following the transaction, you should be well aware of what blackout restrictions are applicable to personnel. Frequently public companies restrict their employees from selling during a window surrounding earnings releases. This blackout period can be upwards of 45-60 days each quarter.
  • Debt and Expenses – The concept of an “all-stock” transaction is likely to be a misnomer, as most sellers have outstanding debt and transaction expenses which must be paid in cash. If the acquired company does not have the cash on hand in the business to pay these costs, then it is important to identify what costs must be paid in cash and negotiate that the buyer will make that cash available as a deduction from purchase price. You certainly do not want to get to the end of a transaction and ask your lenders to accept the buyer’s stock in satisfaction of your debt. That will not end well.
  • Vesting of Consideration – While this is a topic that is worthy of an article in its own right, special care must be taken to the extent any portion of the consideration is subject to continued employment. Treating the receipt of deal consideration (including payment of an earn-out) as contingent on the recipient continuing to perform services for the surviving company raises a potential issue as to whether such consideration should be treated as compensation for services rendered (i.e., ordinary income). This would greatly increase the tax liability of these recipients. It is imperative that you involve tax counsel to carefully review how the consideration is paid to avoid this recharacterization of what you thought was a capital gain.

Under the right circumstances, an all-stock acquisition could be a lucrative outcome for a high-growth business, but you need to be fully aware of the partnership you are entering into and consider these factors in your negotiations.

4. Tips and Tax Planning Opportunities for Business Owners in Advance of a Sale
by Johanna Sullivan

For founders and owners of closely-held businesses, the separation between business and personal is often indistinguishable. While business considerations will most likely drive the decision to sell, opportunities to achieve the best overall financial result for you and your family in a sale are easily missed without a deliberate effort to focus on proper planning for your personal affairs at the same time. As you begin to consider a sale, or even sooner, various strategies are available to ensure that you obtain the best personal result and maximize the total value retained for you and your family after a sale.  

Estate and Gift Tax Planning:  Each individual is currently able to transfer $12.06 million to family members and other beneficiaries, during life or at death, free of federal estate and gift tax. The tax rate applied to the transfer of assets over $12.06 million is 40%. It can be beneficial to “use” all or a portion of this exemption through lifetime gifts because all post-gift appreciation in the transferred property avoids future transfer tax. For example, let’s say an individual transfers $1 million to an irrevocable trust for the benefit of her children, thereby using $1 million of her estate and gift tax exemption (and thus has $11.06 million remaining). The trustee then invests that $1 million in the stock market, and at the time of the donor’s death, the trust assets have grown to $1.5 million. None of the assets in the trust are subject to estate tax at the donor’s death, and the donor has effectively transferred $1.5 million to her children while using just $1 million of her estate and gift tax exemption. That $500,000 in appreciation passes to the donor’s children free of any transfer taxes – a net tax savings of $200,000. 

Privately-held businesses can provide some of the best estate and gift tax planning opportunities available because of the ability to leverage relatively low valuations of an illiquid asset through a variety of planning techniques. In many instances, the value of a business interest transferred by gift can be reduced significantly because of discounts that are available for lack of control and lack of marketability of minority interests. In addition, private businesses, especially in their early stages, have nearly unmatched potential for growth. In both situations, the difference between the value determined at the time of the gift and the future value received upon a liquidity event passes to your beneficiaries free of additional estate and gift taxes.

Income Tax Planning:  It is also important to understand the income tax consequences associated with the sale of your business, which is influenced by several factors, including the corporate structure of the business, the structure of the transaction, and the cost basis attributed to the shares or the assets being sold. Depending on these factors, there may be strategies available to mitigate portions of the income tax liability resulting from the sale. 

Qualified Small Business Stock:  If the business is a C-corporation, you may own stock that is characterized as qualified small business stock (QSBS) under Section 1202 of the Internal Revenue Code. Up to $10 million of the gain realized on the sale of QSBS is exempt from income taxes, with limitations per taxpayer and per company. You may be able to increase the total QSBS income tax exemption available to your family by making a gift of QSBS shares to an irrevocable trust. 

Charitable Planning:  If you are charitably inclined, the year of a sale can be a good time to make a charitable gift to offset a large taxable event. Two commonly-used charitable planning strategies include charitable remainder trusts and donor-advised funds. 

A charitable remainder trust (CRT) is a trust in which the donor, or some other person, has the right to an income stream from the trust either for life or a set number of years. At the end of the term, the assets remaining in the trust pass to charities you select. At the time the trust is funded, the donor receives an income tax deduction for the value of the amount passing to charity in the future, which is discounted based on the value on the preceding non-charitable interest. In addition, any capital gains realized inside the CRT are not subject to income tax. In the context of a business, you may be able to transfer a portion of your ownership interest to a CRT prior to a sale to obtain a twofold tax benefit: (i) an income tax deduction on your individual income tax return for the value of the (ultimate) charitable gift; and (ii) elimination of capital gains tax on the sale of the business interest contributed to the trust.

A donor-advised fund (DAF) is a charitable giving account typically operated by the charitable arm of a large financial institution or by a charitable organization. When you make a contribution to a DAF, you receive an income tax deduction in the current year for the full value of the charitable gift. In addition, the assets inside the DAF are not subject to capital gains or income tax, allowing them to grow tax-free. The donor then has the ability to recommend grants from the DAF to charitable organizations of their choosing as they wish over time.     

Start Planning Early. The best time to begin planning is now. Some planning strategies – particularly those that take advantage of a low valuation – are more effective the earlier they are started. Other strategies must be completed before any agreement for sale or letter of intent (LOI) is in place. As with many things, the devil is in the details, which means that it is important for you and your advisors to have adequate time to consider your particular circumstances to determine the best way to achieve your intended results.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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