Pizzazz In Your Diligence, A Structure That Works, And Other Lessons From Recent M&A Cases - Part II

Tuesday, April 1, 2008 - 01:00

Part I of this article, which appeared in the March 2008 issue of The Metropolitan Corporate Counsel, discussed the antifraud and the risk allocation paradigms for dealing with disclosure obligations and liability disclosure, summarized below. Please visit to view Part I.

The Trend In Disclosure Obligations

The move to the Risk Allocation Paradigm puts added pressure on a Buyer's due diligence efforts, for unless it discovers an issue in due diligence it cannot negotiate to allocate the risk in the Risk Allocation Paradigm. The problem for Buyers, however, is that recent court decisions have tended to follow the Risk Allocation Paradigm for Disclosure Obligations as well.

Antifraud Paradigm

Disclosure Obligation

Seller must disclose all information that is material to the business.

Liability Exposure

Seller is liable if business diligence is false or misleading.Seller has no liability for matters disclosed in business diligence.

Risk Allocation Paradigm

Disclosure Obligation

Seller has to disclose only that information requested by Buyer.

Liability Exposure

Seller has liability only for those things specifically enumerated in the Acquisition Agreement and only to the extent provided in the Acquisition Agreement.

In the recent Allegheny case, the Buyer claimed that it had been defrauded by the false financial statements that were the subject of the Seller's representation and warranty (Buyer pursued a fraud claim to get around the contractual limitation on damages). The Seller countered that Allegheny couldn't recover for fraud because it received later diligence material that should have put it on notice that the financial statements that were ultimately the subject of the representation and warranty were not accurate. The first court to consider Allegheny's fraud claim dismissed the claim because the court felt that "Allegheny could have discovered the truths that [the Seller] obscured or omitted had it pursued its diligence with a little more pizzazz."1On appeal, the Second Circuit Court of Appeals upheld the basic principle that "New York courts are generally skeptical of claims . . . asserted by sophisticated businessmen engaged in major transactions [who] enjoy access to critical information but fail to take advantage of that access." 2In essence, if the Seller gave the Buyer access to information, the onus is on the Buyer to use that access to discover the adverse facts. However, the appellate court held that the lower court had held Allegheny to too high a standard and gave Allegheny a second chance to show "that its reliance on the alleged misrepresentations was not so utterly unreasonable, foolish or knowingly blind as to compel the conclusion that whatever injury it suffered was its own responsibility." 3

Taking the trend one step further is the lower court decision in the Genesco case. In the Genesco case, the erstwhile Buyer lost a critical argument because it failed to show sufficient pizzazz in following up on its diligence requests. In that case, the Court excused the Seller from liability for withholding critical updated financial information because the request for an update had been made before the updated information was available and the Buyer's financial advisor failed to renew the request after the updated information was available.4

Lesson to be learned for Disclosure Obligations is that the diligence process needs to be undertaken in a formal manner, with appropriate follow up work done on missing information and the conclusions and the reconciliation of potentially conflicting information appropriately documented. Ignore diligence that is offered at your own risk.

Lesson: Legal Structure Matters

In the recent private equity boom, private equity buyers were (at times) perceived as having an advantage over strategic buyers due to perceived greater access to financing and due to the fact that business diligence disclosed to a private equity bidder would not be in the hands of a competitor if a deal didn't close. Private equity buyers exploited this perceived advantage to develop acquisition structures different from, and less Seller-favorable than those used by strategic buyers. However, the credit crunch has exposed both the fallacy of the perceived advantages offered by private equity buyers and the flaws in the private equity buyer legal structure. This has left private equity buyers looking for a new acquisition structure.

Private equity buyers, as an institutional matter, are unwilling to expose their funds to unlimited damages in the event a deal does not close. Historically, the private equity shops got protection by using a financing contingency in their Acquisition Agreements, under which they would not have to close if they were unable to obtain financing for the acquisition. Competitive forces led to the elimination of the financing contingency and instead private equity buyers gravitated to an acquisition structure in which they would form shell companies to acquire public companies, and would thus have no legal exposure to the target company. These private equity buyers would tell the public company board "not to worry" because they were in the business of doing deals, and as a commercial matter if they "backed out" they would never be able to do another deal. During the course of negotiations those deal structures quickly transmogrified into a Rube Goldberg construct of (1) a "reverse breakup fee" payable by the shell company if the deal didn't close due to certain specified conditions, (2) a guarantee by the private equity sponsor to pay the reverse breakup fee, and (3) a commitment by the sponsor to fund the equity of the shell company if certain conditions were met. There were almost infinite variations on the structure, including variations on the triggers for the reverse breakup fee and the ability of the target company to enforce the private equity sponsor's equity commitment.

The recent credit crunch has put those Rube Goldberg structures to the test; the lesson learned appears to be that quite often the private equity buyers got the liability protection they were looking for. For example, in the proposed sale of ADS to a private equity buyer, the Buyer formed two shell companies that contracted with ADS. When the Office of the Comptroller of the Currency sought financial assurance from the shell companies that they were unable to provide, the shell companies asserted a closing condition. ADS then sued to force the private equity sponsor to provide the requested financial assurances. The private equity sponsor responded that it had no contract with ADS and no contractual obligation to provide any such assurance (a defense that would not have been available had it contracted directly with ADS). ADS subsequently withdrew the suit.

The recent URI case also demonstrated the success of the private equity structure. That case centered on whether the legal structure gave the shell companies an option to walk away from the deal upon the payment of the reverse breakup fee or whether the target URI could force the shell companies to obtain the debt and equity financing and close if there was no breach of the Acquisition Agreement. The case turned on whether the interrelationship of the specific performance provision and the limitation-on-remedies provision created an ambiguous contract. The Delaware Chancery Court concluded that the contract was sufficiently ambiguous that the Court should look outside the contract to evidence of the negotiations. Because that evidence was not sufficiently clear, the Court applied the obscure "forthright negotiator" principle of Delaware law and found in favor of the private equity buyer and did not order specific performance.5

While the private equity buyers prevailed in these and other cases, as a systemic matter these may have been pyrrhic victories. Sellers are much less willing to contract with private equity buyers using the shell company structure, and private equity buyers are searching for a new way to do deals. Perhaps we will see a return to the financing condition, but this time with the risk on the Buyer, with liquidated damages payable if the financing is not obtained.

Lesson to be learned: The business deal is not just a matter of price, representations and warranties and closing conditions. The legal structure chosen (both as to the entities and law) can substantively affect the deal.

Lesson: Choice Of Law Matters

In the back of most contracts, buried in an article often labeled "Miscellaneous," is usually found a provision in which the parties choose which State's law governs the contract. This provision is often an afterthought, or bargained like the trading of Monopoly properties (I want New York, you want California, fine we'll compromise on Delaware), but can determine the outcome of a subsequent dispute.

Choice of law mattered in the Genesco case. In that case, the contract provided that it was governed by Tennessee law and subject to suit in a Tennessee court. (The Volunteer State is not a typical choice in multibillion-dollar M&A transactions.) By applying Tennessee law, as discussed above, the Court held that the Seller was not liable for withholding the updated financial information.6One wonders whether, if Genesco had been a case under New York law, the Buyer would have been able to apply the principles of Allegheny to show that its reliance on the unupdated financial information was reasonable, and the Court would have reached a different result. Alternatively, if Delaware law had been used, would the party withholding the updated financial information failed to qualify as a "forthright negotiator" and had the contract construed against it?

Lesson to be learned: Federalism matters; choose the governing law carefully. If there is a key issue research the difference in state law and choose wisely.

1Allegheny 500 F.3d at 181.

2Allegheny 500 F.3d at 181.

3Allegheny 500 F.3d at 182.

4 See Genesco at 25 .

5United Rentals ,937 A.2d at 844-845.

6 See Genesco at 25.

Maurice M. Lefkort is a Partner with the law firm of Willkie Farr & Gallagher LLP and regularly advises strategic and private equity clients in the buying and selling of businesses.

Please email the author at with questions about this article.